Two royalties purchased by an investor were held not to exceed the criminal rate of interest. The case of Hybrid Financial Ltd. v. Flow Capital Corp., 160 O.R. (3d) 122, 2022 ONSC 892, illustrates a financial arrangement that is more an equity investment than a debt or credit transaction.
In the Hybrid case, an Ontario company that carried on a sales and distribution business involved in the provision of capital market services, investor relations, asset management and shareholder services was indebted to a chartered bank. Because the bank debt was secured by the personal guarantee of the company’s owner who did not want to carry a personal guarantee, the company searched for an alternative form of financing. The owner approached an investor corporation that provided growth capital for businesses across North America and the United Kingdom with a view to securing financing that would allow the company to pay off the bank debt and not require the owner to give a personal guarantee. The investor agreed to provide $750,000 in capital to the company, and in exchange, the investor acquired two royalties which were essentially revenue generating assets, subject to a buyout option exercisable by the company.
The company was obliged to make a minimum monthly royalty payment for the first two years of the term, and thereafter the monthly royalty payment was to be the greater of a set amount or an amount tied to the company’s revenues based on a trailing 12-month revenue figure. There was no obligation on the company to repay the $750,000 provided by the investor, since the company had a buyout option to repurchase the royalties once it had made royalty payments totalling at least $750,000. The company eventually gave notice of its right to exercise the buyout option when it had paid an aggregate of $828,205 in monthly royalty payments. Following the notice, the parties engaged in a dispute over the valuation of the buyout option, and the company ceased to provide the required financial disclosure and the royalty payments. The company then applied to the Ontario Superior Court seeking an order that the financial formula stipulated in the agreement relating to the buyout of the royalties by the company exceeded the criminal rate of interest under section 347 of the Criminal Code.
In dismissing the application, the Court found that the financial transaction reflected in the agreement was not captured by section 347 because it was a hybrid transaction that was predominantly more akin to an equity transaction than a debt or credit transaction. The Court concluded that the agreement “chosen by two sophisticated corporate entities through negotiations aided by lawyers, lacks most of the hallmarks of a loan, debt or credit facility”.
The Court cited [at para. 91] the following examples of the agreement reflecting an equity transaction: the agreement was styled as a Royalty Purchase Agreement; the subject royalties were described throughout as a “purchase” not a loan; the royalty payments after the second year of the agreement were tied to the company’s revenues; the buyout amount for the royalties was tied to the company’s net equity value; potential third parties that could contribute to further royalty purchases were described as “investors”; the investor was provided with an opportunity to purchase more royalties from the company (to a maximum amount) and this opportunity was called a “potential investment”; and there was no provision requiring the repayment of any amount of fixed debt.
The Court [at para. 93] continued:
As stated by the courts, in today’s commercial environment, parties are entering into creative financing agreements to permit the movement of capital to risky ventures beyond the constraints of conventional debt financing. This Royalty Agreement reflects a creative financing hybrid arrangement that features the potential of a high or low return for [the investor] Flow (or even no return if [the company] Hybrid ceases business) depending on the success of Hybrid.
In discussing the company’s argument that section 347 of the Criminal Code applied to render the amount of the royalty payments illegal, the Court explained [at para. 94] as follows:
Section 347 of the Code was not intended to capture creative commercial financing arrangements including hybrid agreements in which the true nature of the agreement is more akin to an equity arrangement and not a loan arrangement. Here, the royalties were sold by a sophisticated corporate entity, aided by lawyers, as a revenue generating asset that could be bought back, to allow it to retire a bank debt. The royalty payments are not incidental to a debt repayment scheme. Section 347 of the Criminal Code was not intended to foreclose creative financing commercial arrangements between sophisticated parties negotiating on a level playing field. There is no suggestion that [the company] Hybrid was in dire straits and had nowhere to turn for financing other than [the investor] Flow. Hybrid had secured financing in the form of a traditional debt/loan from a bank. It wanted a different type of financial arrangement and that is what it bargained for. It cannot now resile from that arrangement because it is more successful than it anticipated it would be when it entered into the Royalty Agreement.
In light of the foregoing, the Hybrid case illustrates an attempt by a company to use the criminal interest rate prohibition in the Criminal Code to avoid payment of amounts agreed upon in a financing arrangement. By agreeing to use a structure that came with the risks as well as the rewards of an equity transaction, the company couldn’t complain later on that it had not bargained for a better result.
Private Company Law 