Transport North American Express Inc. v. New Solutions Financial Corp.

Transport North American Express Inc. v. New Solutions Financial Corp.
Collection
Supreme Court Judgments
Date
2004-02-12
Neutral citation
2004 SCC 7
Report
[2004] 1 SCR 249
Case number
29355
Judges
Iacobucci, Frank; Major, John C.; Bastarache, Michel; Arbour, Louise; LeBel, Louis; Deschamps, Marie; Fish, Morris J.
On appeal from
Ontario
Subjects
Contract
Notes
SCC Case Information: 29355
Decision Content
Transport North American Express Inc. v. New Solutions Financial Corp., [2004] 1 S.C.R. 249, 2004 SCC 7
New Solutions Financial Corporation Appellant
v.
Transport North American Express Inc. Respondent
Indexed as: Transport North American Express Inc. v. New Solutions Financial Corp.
Neutral citation: 2004 SCC 7.
File No.: 29355.
2003: October 16; 2004: February 12.
Present: Iacobucci, Major, Bastarache, Arbour, LeBel, Deschamps and Fish JJ.
on appeal from the court of appeal for ontario
Contracts — Interest — Criminal rate — Illegality — Severability — Section 347 of Criminal Code prohibiting effective annual interest rate in excess of 60 percent — Contract found to contravene prohibition — Offending interest rate read down so that contract provided for maximum legal rate of interest — Whether “notional severance” available as remedy in cases arising under s. 347 — Whether application of notional severance appropriate in this case — Criminal Code, R.S.C. 1985, c. C‑46, s. 347 .
The appellant and the respondent entered into a credit agreement pursuant to which the appellant advanced the respondent the sum of $500,000. A commitment letter in respect of the proposed credit facility was signed and provided for the following payments: (a) interest at four percent per month calculated daily, payable monthly in arrears; (b) a monthly monitoring fee of $750; (c) a one percent standby fee; (d) royalty payments of $160,000 in eight quarterly installments; (e) payment of legal and other fees; and (f) a commitment fee of $5,000. In addition to the commitment letter, the parties executed an accounts receivable factoring agreement, a promissory note, a general security agreement and personal guarantees of the indebtedness for up to $500,000. From the outset, the parties had agreed to depart from the terms of the accounts receivable factoring agreement. The application judge granted the respondent’s application for a declaration that the agreement contained an interest component that contravened s. 347 of the Criminal Code and applied “notional severance” to reduce the effective annual interest rate to 60 percent so the agreement would comply with s. 347 . The majority of the Court of Appeal allowed the respondent’s appeal; it struck out the clause providing for interest at a rate of four percent per month, calculated daily and payable monthly in arrears, and left in place the other payments, which amounted to an effective annual rate of 30.8 percent when computed as interest as per s. 347(2).
Held (Bastarache, Deschamps and Fish JJ. dissenting): The appeal should be allowed.
Per Iacobucci, Major, Arbour and LeBel JJ.: The various payments made by the respondent, with the exception of any portion of the payments relating to repayment of principal, satisfy the definition of “interest” in s. 347(2) and cumulatively amount to an interest rate in excess of that permitted by the Code. Notional severance is available as a matter of law as a remedy in cases arising under s. 347 . The traditional rule that contracts in violation of statutory enactments are void ab initio is not the approach courts should necessarily take in cases of statutory illegality involving s. 347 . Instead, judicial discretion should be employed and a spectrum of remedies is available. At one end of the spectrum are contracts so objectionable that their illegality will taint the entire contract — exploitive loan-sharking arrangements and contracts that have a criminal object should be declared void ab initio. At the other end of the spectrum are contracts that, although they do contravene a statutory enactment, are otherwise unobjectionable. Contracts of this nature will often attract the application of the doctrine of severance. In each case, the determination of where along the spectrum a given case lies, and the remedial consequences flowing therefrom, will hinge on a careful consideration of the specific contractual context and the illegality involved. If the case is an appropriate one for the court to sever only those provisions of the loan agreement that put the effective interest rate over 60 percent, and if it is conceded, as it must be, that such rewording alters the agreement of the parties, the question becomes only a choice of the appropriate technique of severance. The preferred severance technique is the one that, in light of the particular contractual context involved, would most appropriately cure the illegality while remaining otherwise as close as possible to the intentions of the parties expressed in the agreement. The “blue-pencil” technique may not necessarily achieve that result. The change effected by the blue-pencil technique will often fundamentally alter the consideration associated with the bargain and do violence to the intention of the parties. Indeed, in many cases, the application of the blue-pencil approach will provide for an interest-free loan where the parties demonstrated in the agreement a clear intention to charge and pay considerable interest.
The application of notional severance to the agreement between the parties in this case was appropriate. Four considerations are relevant to the determination of whether public policy ought to allow an otherwise illegal agreement to be partially enforced rather than being declared void ab initio in the face of illegality in the contract: (1) whether the purpose or policy of s. 347 would be subverted by severance; (2) whether the parties entered into the agreement for an illegal purpose or with an evil intention; (3) the relative bargaining positions of the parties and their conduct in reaching the agreement; (4) the potential for the debtor to enjoy an unjustified windfall. Given that the present case involved a commercial transaction engaged in by experienced and independently advised commercial parties, it is difficult to see why the choice of a 30.8 percent rather than 60 percent rate better fosters compliance with s. 347(1)(a) of the Code. The other considerations also militate in favour of a flexible remedy. There is no evidence on the record to suggest that the appellant has been charged with violating s. 347(1)(a). The contract was entered into for ordinary commercial purposes and there was nothing inherently illegal or evil about this intention. With respect to the third factor, each party in this case had independent legal advice, was commercially experienced and knew what it was getting into. Finally, any potential for an unjustified windfall in this case arises from the respondent possibly not having to repay the principal and interest, or from the respondent possibly not having to pay a commercially appropriate rate of interest on the loan. Given that each party had independent legal advice and knew precisely the obligations that it was taking on, the equities of the situation favour the appellant.
Per Deschamps and Fish JJ. (dissenting): The well-established “blue-pencil” remedy applied in the Court of Appeal respects the trial judge’s findings of fact, as it must, and achieves an equitable result consistent with established principle. The trial judge erred in straining the recognized rules of equity by resorting to what he described as “notional severance”. Even on the assumption that notional severance is available as a matter of law as a remedy in cases arising under s. 347 of the Code, notional severance should be permitted only where: (1) public policy does not require that the entire agreement be declared unenforceable; (2) severance is found to be warranted; and (3) severance simpliciter — or “blue-pencil severance” — is impracticable or would occasion an unjust result. Here, on the facts as found by the trial judge, the first two criteria are satisfied but the third is not: blue-pencil severance is both possible and fair. Unlike notional severance as applied by the trial judge, blue-pencil severance does not do violence to the policy purposes of s. 347 of the Code or require a judicial re-writing of the interest clause agreed to, as such, by the parties. It appears neither “artificial” nor “arbitrary” to sever the criminal rate of interest agreed to as interest and to leave intact the distinct and separate charges not agreed to as interest, and not considered to be interest by either party. This solution still leaves the appellant with a return of slightly more than 30 percent per annum. Further, it appears that all four relevant considerations, examined individually and weighed together, militate here in favour of the remedy applied by the Court of Appeal and against the remedy adopted by the trial judge. The effect of the trial judge’s decision was to stretch the principles of equity in an inappropriate way and to send the wrong message to those who lend money at a criminally prohibited rate to “willing” borrowers who cannot otherwise obtain a loan. They should not be encouraged to believe that if their illegal arrangement is subjected to judicial scrutiny, they will nonetheless recover the highest rate they could legally have charged — and thus suffer no pecuniary disadvantage for having violated s. 347 of the Code.
Per Bastarache J. (dissenting): Severance in the traditional sense, not “notional severance”, should be the remedy available in these circumstances. There is a fundamental difference between striking out offending sections of a contract and rewriting a central provision. Although both approaches interfere in some way with the intent of the parties, the added flexibility of the rewriting approach comes at a considerable cost and it is not supported by any principle of contract law. By contrast, the severance doctrine is a long-standing one. The “blue-pencil” test has been applied several times in the context of violations of s. 347 of the Code to strike out offending interest provisions. Moreover, there is no legal or other principled reason to limit the application of the new approach endorsed by the majority to the criminal rate of interest and other illegal provisions would be open to judicial redrafting. The availability of “notional severance” as a remedy creates greater uncertainty in the law. Under notional severance, courts will be permitted to literally add new words to the parties’ agreement and by doing so, courts will be substituting their intentions for those of the parties.
The approach taken by the majority in this case is also inconsistent with that taken in Garland v. Consumers’ Gas Co., [1998] 3 S.C.R. 112, where the Court interpreted the definition of interest broadly in order to prevent creditors from avoiding the statute by manipulating the form in which payments were made. Under the majority’s approach, a creditor would be permitted to escape the consequences of its avoidance measures by simply reducing the rate applied to the maximum permitted under the Code and this approach is inconsistent with the general objectives expressed in the Code and incompatible with the notion of deterrence. In addition, there do not appear to be compelling reasons to depart from well-established precedent in this case.
Lastly, clause 9.1 of the accounts receivable factoring agreement reflects the parties’ own intentions as to remedy. It cannot be said that the wording of the clause anticipates — still less, provides for — notional severance. In view of the plain meaning of clause 9.1, counsel’s concession as to the intention of the parties, and the letter sent by the appellant’s solicitor to the respondent three weeks after the commitment letter was signed, the blue-pencil approach adopted by the Court of Appeal is entirely consistent with the parties’ own intentions and notional severance is not.
Cases Cited
By Arbour J.
Applied: William E. Thomson Associates Inc. v. Carpenter (1989), 61 D.L.R. (4th) 1; referred to: Garland v. Consumers’ Gas Co., [1998] 3 S.C.R. 112; Still v. M.N.R., [1998] 1 F.C. 549; Cope v. Rowlands (1836), 2 M. & W. 149, 150 E.R. 707; Kocotis v. D’Angelo (1957), 13 D.L.R. (2d) 69; Bank of Toronto v. Perkins (1883), 8 S.C.R. 603; Neider v. Carda of Peace River District Ltd., [1972] S.C.R. 678; Mira Design Co. v. Seascape Holdings Ltd., [1982] 4 W.W.R. 97; Trillium Computer Resources Inc. v. Taiwan Connection Inc. (1993), 11 B.L.R. (2d) 1, aff’d (1994), 11 B.L.R. (2d) 1; Milani v. Banks (1997), 145 D.L.R. (4th) 55.
By Fish J. (dissenting)
William E. Thomson Associates Inc. v. Carpenter (1989), 61 D.L.R. (4th) 1.
By Bastarache J. (dissenting)
Still v. M.N.R., [1998] 1 F.C. 549; Cope v. Rowlands (1836), 2 M. & W. 149, 150 E.R. 707; Bank of Toronto v. Perkins (1883), 8 S.C.R. 603; Steinberg v. Cohen, [1930] 2 D.L.R. 916; Hasiuk v. Oshanek, [1936] 1 D.L.R. 232; Carney v. Herbert, [1985] 1 All E.R. 438; McFarlane v. Daniell (1938), 38 S.R. 337; Attwood v. Lamont, [1920] 3 K.B. 571; Canadian American Financial Corp. (Canada) Ltd. v. King (1989), 60 D.L.R. (4th) 293; Mira Design Co. v. Seascape Holdings Ltd., [1982] 4 W.W.R. 97; Garland v. Consumers’ Gas Co., [1998] 3 S.C.R. 112; Friedmann Equity Developments Inc. v. Final Note Ltd., [2000] 1 S.C.R. 842, 2000 SCC 34.
Statutes and Regulations Cited
Criminal Code, R.S.C. 1985, c. C‑46, s. 347 .
Authors Cited
Fridman, G. H. L. The Law of Contract in Canada, 4th ed. Scarborough, Ont.: Carswell, 1999.
Marsh, Norman S. “The Severance of Illegality in Contract” (1948), 64 L.Q.R. 230 and 347.
Waddams, S. M. The Law of Contracts, 4th ed. Toronto: Canada Law Book, 1999.
Ziegel, Jacob S. “Bill C‑44: Repeal of the Small Loans Act and Enactment of a New Usury Law” (1981), 59 Can. Bar Rev. 188.
Ziegel, Jacob S. “The Usury Provisions in the Criminal Code : The Chickens Come Home to Roost” (1986), 11 Can. Bus. L.J. 233.
APPEAL from a judgment of the Ontario Court of Appeal (2002), 60 O.R. (3d) 97, 214 D.L.R. (4th) 44, 160 O.A.C. 381, 27 B.L.R. (3d) 163, 6 R.P.R. (4th) 1, [2002] O.J. No. 2335 (QL), reversing a judgment of the Superior Court of Justice (2001), 54 O.R. (3d) 144, 200 D.L.R. (4th) 560, 16 B.L.R. (3d) 148, [2001] O.J. No. 1948 (QL). Appeal allowed, Bastarache, Deschamps and Fish JJ. dissenting.
Peter J. Cavanagh and Eric N. Hoffstein, for the appellant.
Robert G. Ackerman, for the respondent.
The judgment of Iacobucci, Major, Arbour and LeBel JJ. was delivered by
Arbour J. —
I. Overview
1 In March 2000, the appellant, New Solutions Financial Corp. (“New Solutions”), and the respondent, Transport North American Express Inc. (“TNAE”), entered into a credit agreement pursuant to which New Solutions advanced TNAE the sum of $500,000. In addition to various other fees and charges, the agreement provided for interest to be paid at the rate of four percent per month, calculated daily and payable monthly in arrears. By all accounts, the various payments called for by the agreement constituted a “criminal rate” of interest as defined in s. 347 of the Criminal Code, R.S.C. 1985, c. C‑46 (the “Code ”). The payments soon became too onerous for TNAE to meet, and the company applied to the Ontario Superior Court of Justice for a declaration that the agreement contained an illegally high rate of interest and should not be enforced.
2 The application judge, Cullity J., ruled that he was not confined to the so-called “blue-pencil” approach to severance in dealing with the statutory illegality of the contract, whereby only discrete illegal promises could be excised. Using “notional severance”, he read down the offending interest rate so the contract provided for the maximum legal rate of interest: (2001), 54 O.R. (3d) 144.
3 Upon appeal to the Court of Appeal for Ontario, Rosenberg J.A., for the majority, concluded that the doctrine of severance only permits the striking of distinct promises from a contract: (2002), 60 O.R. (3d) 97. He reversed the application judge’s finding that notional severance was an available remedial instrument. Rosenberg J.A. found that it was appropriate to strike out or blue-pencil the provision calling for interest at four percent per month, calculated daily and payable monthly in arrears, leaving the balance of the agreement to be enforced in accordance with its terms. Sharpe J.A., agreeing with the reasons of Cullity J., dissented.
4 There is broad consensus that the traditional rule that contracts in violation of statutory enactments are void ab initio is not the approach courts should necessarily take in cases of statutory illegality involving s. 347 of the Code . Instead, judicial discretion should be employed in cases in which s. 347 has been violated in order to provide remedies that are tailored to the contractual context involved. The primary issue in this appeal by New Solutions is whether notional severance, as formulated and applied by Cullity J., is valid in Canadian law and applicable here.
5 Given the desirability of remedial flexibility in cases of statutory illegality arising in connection with s. 347 of the Code , the evolving nature of the law regarding statutory illegality generally and the sound policy basis in which the concept is rooted, I find that notional severance is available as a matter of law as a remedy in cases arising under s. 347 .
6 A spectrum of remedies is available to judges in dealing with contracts that violate s. 347 of the Code . The remedial discretion this spectrum affords is necessary to cope with the various contexts in which s. 347 illegality can arise. At one end of the spectrum are contracts so objectionable that their illegality will taint the entire contract. For example, exploitive loan-sharking arrangements and contracts that have a criminal object should be declared void ab initio. At the other end of the spectrum are contracts that, although they do contravene a statutory enactment, are otherwise unobjectionable. Contracts of this nature will often attract the application of the doctrine of severance. The agreement in this case is an example of such a contract. In each case, the determination of where along the spectrum a given case lies, and the remedial consequences flowing therefrom, will hinge on a careful consideration of the specific contractual context and the illegality involved.
7 The application judge in this case found that (i) the agreement between New Solutions and TNAE only inadvertently violated s. 347 ; (ii) the parties were experienced in commercial matters and negotiated at arm’s length; (iii) there was no evidence that they did not have equal bargaining power; and (iv) they each had the benefit of independent legal advice in the course of the negotiations leading to the agreement. Consequently, the application of notional severance to the agreement between New Solutions and TNAE in this case by Cullity J. was appropriate. I would allow the appeal.
II. Facts
8 For the relevant time period, TNAE was in the business of expedited freight trucking. Ken and Karen Dragosits were shareholders in TNAE and actively involved in the operation of its business. Prior to the end of 1999, other shareholders held a 50 percent interest in TNAE. A corporation connected to these other shareholders provided TNAE the funds needed for the firm’s working capital. A demand was made by this other corporation for the repayment of the funds owed to it by TNAE. The Dragosits and TNAE decided to search out a source for the means to repay the indebtedness.
9 The Dragosits sought financing from BDO Capital, now the appellant, New Solutions, to enable TNAE to repay its indebtedness and for the other shareholders in TNAE to be bought out. The parties eventually entered into an agreement that contained a high rate of interest and also significant other fees and charges. The costly nature of the loan for TNAE no doubt reflected the high risk New Solutions was taking on in making the funds available.
10 Before arriving at their agreement, New Solutions expressed interest in acquiring a 30 percent equity interest in TNAE in conjunction with the contemplated credit facility. The Dragosits resisted this as they wished to be the sole shareholders of TNAE. In lieu of surrendering an equity interest, they agreed that New Solutions would receive a “royalty payment” of $160,000, payable in eight quarterly installments, to reflect the approximate value of a 30 percent equity interest in TNAE.
11 In the negotiations leading up to the agreement, each party had the benefit of independent legal advice. On March 6, 2000, a commitment letter in respect of the proposed credit facility was signed by the Dragosits and provided for the following payments:
(a) interest at four percent per month calculated daily, payable monthly in arrears;
(b) a monthly monitoring fee of $750;
(c) a one percent standby fee;
(d) royalty payments of $160,000 in eight quarterly installments;
(e) payment of legal and other fees; and
(f) a commitment fee of $5,000.
With the exception of the standby fee, all these payments were found by Cullity J. and by Rosenberg J.A. to constitute “interest” under s. 347(2) of the Code . Presumably, the standby fee was not included in the calculation of the effective interest rate because no standby fees were charged since the full credit facility of $500,000 was drawn upon.
12 By March 30, 2000, the parties had, in addition to the commitment letter, executed an accounts receivable factoring agreement, a promissory note and a general security agreement. The Dragosits also each executed personal guarantees of the indebtedness for up to $500,000 plus interest at the rate of 30 percent per annum. From the outset, the parties had agreed to depart from the terms of the accounts receivable factoring agreement. On March 28, 2000, the solicitor for New Solutions wrote to the solicitor for TNAE and the Dragosits, confirming that the parties had agreed on March 27 that they would not strictly follow the terms of the accounts receivable factoring agreement unless New Solutions elected to exercise its rights under it. Instead, the understanding was that TNAE would borrow the full $500,000 from New Solutions and pay the interest, fees and royalties as set out in the commitment letter. According to Cullity J., “the concept of a factoring of receivables was put aside and replaced by a revolving credit facility” (para. 5).
13 The principal amount of $500,000 was advanced by New Solutions. At the outset, TNAE paid interest at the rate of four percent per month, calculated daily and payable monthly in arrears, as well as the other fees and charges, in general accordance with the terms of the commitment letter.
14 The various payments eventually became onerous, and TNAE sought legal advice regarding the repayment of the borrowed funds. TNAE then applied to the Ontario Superior Court of Justice for a declaration that the agreement contained an interest component that contravened s. 347 of the Code . It also sought an order that interest previously paid be returned.
15 On the basis of actuarial evidence, Cullity J. found that the effective interest rate on the loan, if it was repaid in full within two years, was 90.9 percent per annum. In itself, the promise to pay interest at four percent per month calculated daily, payable monthly in arrears, amounted to an effective annual interest rate of 60.1 percent. The remaining payments amounted to an effective annual interest rate of 30.8 percent.
16 New Solutions originally denied that the agreement violated the Code but sought severance and rectification if it did. Cullity J. found that the agreement was in contravention of s. 347(1) (a) and applied “notional severance” to reduce the effective annual interest rate to 60 percent so the agreement would comply with s. 347 . The Court of Appeal allowed TNAE’s appeal; it struck out the clause providing for interest at a rate of four percent per month calculated daily and payable monthly in arrears, and left in place the other payments, which amounted to an effective annual rate of 30.8 percent when computed as interest as per s. 347(2) . New Solutions seeks the restoration of the decision of the application judge.
III. Relevant Statutory Provisions
17 The pertinent text of the relevant provision of the Criminal Code is:
347. (1) Notwithstanding any Act of Parliament, every one who
(a) enters into an agreement or arrangement to receive interest at a criminal rate, or
(b) receives a payment or partial payment of interest at a criminal rate,
is guilty of
(c) an indictable offence and is liable to imprisonment for a term not exceeding five years, or
(d) an offence punishable on summary conviction and is liable to a fine not exceeding twenty-five thousand dollars or to imprisonment for a term not exceeding six months or to both.
(2) In this section,
“credit advanced” means the aggregate of the money and the monetary value of any goods, services or benefits actually advanced or to be advanced under an agreement or arrangement minus the aggregate of any required deposit balance and any fee, fine, penalty, commission and other similar charge or expense directly or indirectly incurred under the original or any collateral agreement or arrangement;
“criminal rate” means an effective annual rate of interest calculated in accordance with generally accepted actuarial practices and principles that exceeds sixty per cent on the credit advanced under an agreement or arrangement;
. . .
“interest” means the aggregate of all charges and expenses, whether in the form of a fee, fine, penalty, commission or other similar charge or expense or in any other form, paid or payable for the advancing of credit under an agreement or arrangement, by or on behalf of the person to whom the credit is or is to be advanced, irrespective of the person to whom any such charges and expenses are or are to be paid or payable, but does not include any repayment of credit advanced or any insurance charge, official fee, overdraft charge, required deposit balance or, in the case of a mortgage transaction, any amount required to be paid on account of property taxes;
. . .
(3) Where a person receives a payment or partial payment of interest at a criminal rate, he shall, in the absence of evidence to the contrary, be deemed to have knowledge of the nature of the payment and that it was received at a criminal rate.
. . .
(7) No proceedings shall be commenced under this section without the consent of the Attorney General.
IV. Issue
18 Are judges in Canada permitted by law to exercise remedial discretion to partially enforce a contract contravening s. 347 of the Code by reading down interest rate provisions to avoid what would otherwise be illegality?
V. Analysis
A. Illegality of the Contract
19 The definition of “interest” in s. 347(2) is broad: see Garland v. Consumers’ Gas Co., [1998] 3 S.C.R. 112, at para. 28. The various payments made by TNAE, with the exception of any portion of the payments relating to the repayment of principal, satisfy the definition of “interest” as defined in s. 347(2) . This includes the “royalty payments”. I agree with the courts below that the payments made by TNAE to New Solutions cumulatively amount to an interest rate in excess of that permitted by the Code .
B. The Doctrine of Illegality
20 The Federal Court of Appeal’s decision in Still v. M.N.R., [1998] 1 F.C. 549, provides a useful summary of the development of the doctrine of illegality, including a discussion of the development and evolution of the doctrine’s common law and statutory branches. In addressing the current state of the doctrine of illegality, Robertson J.A. remarked, at para. 12:
Law reform agencies have been quick to conclude that the law of illegality is in an unsatisfactory state . . . . There is a plethora of conflicting decisions and great uncertainty as to the principles which should be guiding the courts. Arguably, so many exceptions have been grafted on to the common law rule that illegal contracts are void ab initio that the validity of the rule itself is brought into question.
In light of the excellent treatment of the doctrine’s history by Robertson J.A. in Still v. M.N.R., there would be little benefit to fully retracing the doctrine’s history here. Instead, given the evolving nature of this area of law, a very brief survey of some of the existing case law on the application of the doctrine of illegality will provide sufficient context for the finding in this case that notional severance is available as a discretionary remedy in cases where s. 347 has been violated.
21 The historical common law approach to contractual illegality is reflected in the following passage of Parke B. in Cope v. Rowlands (1836), 2 M. & W. 149, 150 E.R. 707 (Ex. Ct.), at p. 710:
[W]here the contract which the plaintiff seeks to enforce, be it express or implied, is expressly or by implication forbidden by the common or statute law, no court will lend its assistance to give it effect. It is equally clear that a contract is void if prohibited by a statute, though the statute inflicts a penalty only, because such a penalty implies a prohibition.
In Cope v. Rowlands, the question surrounded whether an unlicensed broker could recover for the work that he had done for the defendant. The court concluded that the legal requirement (under threat of penalty) that brokers be licensed by the city of London implied a prohibition on work being done by unlicenced brokers. As a consequence, the contract was held to be void ab initio and the unlicensed broker was unable to enforce his claim for payment for the work that had been done. The Court of Appeal for Ontario denied recovery in a similar case involving an electrician seeking to recover for work done without possessing the appropriate class of licence: see Kocotis v. D’Angelo (1957), 13 D.L.R. (2d) 69.
22 The historical common law approach that contracts illegal under statute are void ab initio has been applied by this Court: see, e.g., Bank of Toronto v. Perkins (1883), 8 S.C.R. 603, and more recently, Neider v. Carda of Peace River District Ltd., [1972] S.C.R. 678. However, some time ago Canadian courts began to develop a more flexible approach to statutory illegality in contract, often severing the illegal provisions and enforcing the remainder. For example, in one of the earliest cases dealing with the application of s. 347 of the Code , Mira Design Co. v. Seascape Holdings Ltd., [1982] 4 W.W.R. 97 (B.C.S.C.), Huddart L.J.S.C. held that although the interest provisions of a mortgage were unenforceable, exceeding as they did the maximum effective interest rate permitted under s. 305.1 of the Code (the predecessor to s. 347 ), the contract as a whole should not be held to be void ab initio. Her reasoning, at p. 104, was that although the section makes it an offence to receive interest at an illegal rate, the section did not seek to make associated collateral agreements (such as for the transfer of the real estate or the payment of the principal amount owing on the mortgage) void ab initio:
Most Canadians would agree that the purpose of the Criminal Code is to protect the public by providing for the punishment of behaviour that Parliament considers to be against the public interest. The purpose of s. 305.1 [now s. 347 ] is to punish everyone who enters into an agreement or arrangement to receive interest at a criminal rate. It does not expressly prohibit such behaviour, nor does it declare such an agreement or arrangement to be void. The penalty is severe, and designed to deter persons from making such agreements. It replaces the Small Loans Act, which included a prohibition of such agreements and gave the court the power to reconstruct them. It is designed to protect borrowers. There is no penalty imposed on a person who makes an agreement to pay, or pays, interest at a criminal rate. It is not designed to prevent persons from entering into lending transactions per se.
23 The same approach was taken by the Court of Appeal for Ontario in William E. Thomson Associates Inc. v. Carpenter (1989), 61 D.L.R. (4th) 1. Having considered s. 347 of the Code , the court in that case concluded that where an interest rate provided for in an agreement exceeds the 60 percent statutory maximum, the interest rate provision of the contract may be severed without declaring the whole contract void.
24 In Thomson, at p. 8, Blair J.A. considered the following four factors in deciding between partial enforcement and declaring a contract void ab initio: (i) whether the purpose or the policy of s. 347 would be subverted by severance; (ii) whether the parties entered into the agreement for an illegal purpose or with an evil intention; (iii) the relative bargaining positions of the parties and their conduct in reaching the agreement; and (iv) whether the debtor would be given an unjustified windfall. He did not foreclose the possibility of applying other considerations in other cases, however, and remarked (at p. 12) that whether “a contract tainted by illegality is completely unenforceable depends upon all the circumstances surrounding the contract and the balancing of the considerations discussed above and, in appropriate cases, other considerations”.
25 In Trillium Computer Resources Inc. v. Taiwan Connection Inc. (1993), 11 B.L.R. (2d) 1 (Ont. Ct. (Gen. Div.)), aff’d (1994), 11 B.L.R. (2d) 1 (Ont. Div. Ct.), Conant J. entered summary judgment in favour of the plaintiff who had paid $8,000 interest in consideration of credit extended by the defendant for eight days. In a brief judgment and without addressing the authorities on this point, Conant J. stated, at p. 2:
I am satisfied that an interest rate of over 3,000 % per annum, whether it be for credit and/or compensation for damages and other matters suffered by the Defendant, is a flagrant breach of s. 347 of the Criminal Code of Canada. This, in my view, is illegal and shall be returned to the Plaintiff less the maximum rate of 60% per annum allowed under the Code . [Emphasis added.]
This approach is similar to the one applied by Cullity J. and endorsed by Sharpe J.A. (in dissent at the Court of Appeal) in the present case.
26 In Milani v. Banks (1997), 145 D.L.R. (4th) 55, the Court of Appeal for Ontario applied the contextual approach endorsed by Blair J.A. in Thomson, supra. This case involved a $32,000 loan with a term of 30 days. The contract provided for $3,000 to be kept by the creditor in respect of the costs associated with the loan, and an 18 percent annualized interest rate to be paid on the full principal amount. McKinlay J.A. for the court held, at pp. 59‑60 that:
In this case, the appellant takes the position that the only offensive part of the loan was the $3,000 charge for “fees”, and that if the agreement were left intact apart from that provision, the result would be a fair one in the circumstances. I am inclined to agree with that position . . . .
. . .
I consider this case to be one strongly favouring the position of the appellant. She is clearly not entitled to the $3,000 fee, but I would strike only that provision, and leave the loan otherwise intact as a $32,000 loan with interest at 18% per annum for a thirty day term.
The approach taken by McKinlay J.A. in Milani is reflected in the path taken by Rosenberg J.A. at the Court of Appeal for Ontario in the case at bar. McKinlay J.A. severed one of the “interest” terms (actually attributable to “costs”) from the loan so that the interest rate would be legal, just as Rosenberg J.A. in this case severed the promise to pay interest at four percent per month, calculated daily, payable monthly in arrears, thereby leaving the other charges to amount, cumulatively, to a permissible rate of interest under s. 347 .
C. The Problematic Nature of the Blue-Pencil Test
27 The blue-pencil approach is understood both as a test of the availability of severance to remedy contractual illegality and also as a technique for effecting severance. The blue-pencil approach as a test of the appropriateness of severance requires a consideration of whether an illegal contract can be rendered legal by striking out (i.e., by drawing a line through) the illegal promises in the agreement. The resulting set of legal terms should retain the core of the agreement. If the nature or core of the agreement is disturbed, then on this test the illegal clause in the contract is not a candidate for severance and the entire contract is void. The blue-pencil approach as a technique of effecting severance involves the actual excision of the provisions leading to the illegality, leaving those promises untainted by the illegality to be enforced.
28 The use of the blue-pencil approach to sever one or more provisions from a contract alters the terms of the agreement between the parties. The only agreement that one can say with certainty the parties would have agreed to is the one that they actually entered into. The insistence in the case law that the blue-pencil test derives its validity from refusing to change or add words or provisions to the contract is unconvincing. It is doubtful, for example, that the lenders in cases such as Thomson, supra, or Mira Design, supra, would have entered into the agreements at issue had they been aware ex ante that they would only be entitled to the return of the principal advanced. The change effected by the blue-pencil technique will often fundamentally alter the consideration associated with the bargain and do violence to the intention of the parties. Indeed, in many cases, the application of the blue-pencil approach will provide for an interest-free loan where the parties demonstrated in the agreement a clear intention to charge and pay considerable interest.
29 The blue-pencil test was developed in cases where the courts were considering instruments under seal, where the form of the deed governed and where the intention of the parties was irrelevant. It was therefore important that what remained after severance would be a valid deed:
In the deed form was everything; the actual intention of the parties was immaterial. It was, therefore, natural that in considering the possibility of severance of promises in a deed, the court should be concerned to see that what was left remained a valid deed; there could be no question of implying a promise to take effect if part of the original bargain was illegal. This is the historical origin of what was later called the ‘blue-pencil test’.
(N. S. Marsh, “The Severance of Illegality in Contract” (1948), 64 L.Q.R. 230 and 347, at pp. 351‑52)
Historically, courts were not concerned with the intention of the parties. The artificiality of the blue-pencil test arises from the common law constraints imposed on courts unaided by principles of equity.
30 Courts inescapably make a new bargain for the parties when they use the blue-pencil approach. As Cullity J. remarked, at paras. 35‑36:
The blue-pencil test is, I believe, a relic of a bygone era when the attitude of courts of common law — unassisted by principles of equity — towards the interpretation and enforcement of contracts was more rigid than is the case at the present time. At an early stage in the development of the law relating to illegal promises, severance was held to be justified on the basis of the blue-pencil test alone. As the reasoning in Milani and William E. Thomson demonstrates, we have moved a long way beyond that mechanical approach. Enforcement may be refused in the exercise of the kind of discretionary judgment I have mentioned even where blue-pencil severance is possible.
Despite repeated statements in the cases that the court will not make a new agreement for the parties, that is, of course, exactly what it does w