Legal Blog

Forbear

Financial institutions use sophisticated loan agreements which, for the most part, are bullet-proof. Assuming that a debtor defaults under a loan agreement, is the agreement likely to be interpreted in a manner that would force the creditor to forbear collecting the debt until the occurrence of another event? This was the question with which the court had to grapple in Royal Bank of Canada v. Everest Group Inc., a 2018 decision of the Ontario Superior Court of Justice.

Debt

The bank financed a franchisee to open and operate a restaurant. The franchisee signed loan and security agreements:  a $350,000 small business financing loan, a $5,000 overdraft demand loan facility, a $256,000 variable-rate term facility, a $10,000 Visa facility, and a general security agreement. Two principals signed guarantees limited to $87,000 for the small business loan and $271,000 for the other loans.

The franchisee operated the restaurant for 13 months, investing $2.4 million to acquire and build the franchise. Unfortunately, the restaurant was never profitable and the franchisee exercised its right of rescission under the Arthur Wishart Act. That Act allows a franchisee to rescind a franchise agreement within 2 years if the franchisor failed to deliver a proper disclosure document.

As soon as the franchisee delivered its notice of rescission, the franchisor terminated the franchise agreement and took over the restaurant.

The franchisee notified the bank that it had rescinded the franchise agreement and was claiming $5.6 million in damages from the franchisor. It seemingly thought that the bank would view this as good news. The bank did not. It immediately took the position that the franchisee was in default of its obligations under the various loan agreements and demanded repayment.

Interpretation

The franchisee maintained that the loan agreements and guarantees should be interpreted in light of the bank’s knowledge that it was financing a start-up franchise, which had a two-year right of rescission under the Act. It also submitted that it did not cease to carry on business; rather, instead of a restaurant operation, it was carrying on the business of recovering the substantial investment it made.

The franchisee therefore argued that, having regard to all the circumstances when the loan agreements and guarantees were formed, the judge should interpret the “cease to carry on business” default clauses so as not to penalise the franchisee and prevent it from exercising its statutory rights against the franchisor. With that interpretation, the bank would be forced to wait for its payment until the franchisee’s action against the franchisor was resolved.

Default

The judge had no difficulty to find the franchisee in default of its loan agreements and guarantees, reasoning that:

• The franchisee had insufficient funds to pay the ongoing payments to the bank and had a significant indebtedness to CRA for HST.
• The franchisee had ceased to carry on business operations and that cessation was a material adverse change in operations.
• The franchisee did not provide financial information to the bank as required.
• Although there was some talk about continuing loan payments, nothing happened; the franchisee ceased its payments even before the franchise agreement was terminated and $535,000 was outstanding on the loans.

No Wait

The judge refused to require the bank to forbear exercising its rights. His preamble to that conclusion is worth repeating:

“While I admire the audacity and originality of (the franchisee’s) argument about how a business loan agreement between a sophisticated lender who would be aware of the Arthur Wishart (Franchise Disclosure), 2000 Act should be interpreted, having regard to the actual wording used in the various loan agreements and interpreting them in the context of the surrounding circumstances known to the parties at the time of contracting and in accordance with the canons of contract interpretation, there is no basis for reading into the standard terms a provision that would require RBC to forebear exercising its rights.”

In coming to his conclusion, the judge reasoned as follows:

• Infusing the loan agreements with a restriction on the bank’s rights did not give the loan transaction agreements business efficacy; it would not make common sense for a lender to agree to limit the nature of the events of default.
• It was contrary to common sense for the franchisee to expect that its lender would forbear enforcing security in anticipation that the franchisee would be successful in its action against the franchisor, an action that had yet to be determined (i.e. the franchisee could lose).
• The factual record did not support an allegation that the bank was subjectively or objectively unreasonable in exercising its discretion to enforce its rights under the loan agreements and guarantees; indeed, it was both expected and reasonable.
• The bank was neither subjectively nor objectively unreasonable in declining to await the uncertain outcome of the franchisee’s action against the franchisor before enforcing its rights.

Outcome

The judge granted summary judgment for all indebtedness owed under the loan agreements and against the guarantees to their limits plus costs on a full indemnity basis of $33,400. We assume that loan agreements contained a full indemnity costs provision. “Audacity and originality” may have bought time, but with a significant cost.

Image courtesy of krosseel.

Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.