E. Severance

• Author: John D. McCamus
• Profession: Professor of Law. Osgoode Hall Law School, York University
• Pages: 483-493

Page 483

In cases where a provision of an agreement has been found to be illegal, the doctrine of severance may enable a court to excise the offending provision from the agreement and permit each party to enforce the remainder of its terms that are untouched by the illegality. As with other aspects of illegality doctrine, a determination as to whether or not a particular contractual provision is severable in this sense may rest on a subtle analysis of the policy factors underlying the rule offended by the provision and the particular contractual setting. In essence, the test for determining whether a particular provision is severable is twofold. First, it must be considered whether, as a practical matter, the remainder of the agreement, after excision of the offending term, constitutes an agreement that can sensibly be enforced. Second, it must be determined whether the nature of the illegality is such that enforcement of the remainder of the agreement would be inconsistent with the policy considerations underlying the rule that renders the provision illegal and unenforceable. Under traditional doctrine, there is, however, a further requirement. It must be possible to effect the excision of a term only by deletion of words from the agreement. This, the so-called blue-pencil test, had the consequence that although courts could delete a provision or parts of a provision from the agreement, they could not revise or add to the terms of an agreement and, so it was said, "make the agreement for the parties." Under this approach, then, courts could delete provisions only in the metaphorical sense of drawing a line through them. As we shall see, however, the Supreme Court of Canada²⁷¹has, in recent years, departed from this traditional view and has adopted a concept

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of "notional severance" under which a provision might, in effect, be rewritten so as to avoid conflict with the rule that rendered the original version of the provision unenforceable.

In determining whether, as a practical matter, the offending provision can be severed from the remainder of the agreement, it must be considered whether the offending provisions "are in substance so connected with the others as to form an indivisible whole which cannot be taken to pieces without altering its nature."²⁷²Thus, for example, in a case involving a service station lease containing an unenforceable provision requiring the lessee to purchase gasoline exclusively from the lessor oil company, the Privy Council held that this requirement was an indispensable part of the arrangement and that the "tie" could not be severed from the lease so as to enable the lessee to remain in possession of the premises and conduct the business by purchasing its gasoline supplies from other sources.²⁷³Further, where the offending provisions essentially amount to the whole consideration provided by one party, it would not be sensible to sever the offending provisions and enforce what thus becomes an essentially one-sided arrangement.²⁷⁴

Assuming that the offending provisions can be deleted from the agreement without impermissibly affecting the nature of the agreement, the second branch of the test requires a determination as to whether the nature of the illegality is such that the entire agreement is tainted. In a colourful illustration of the point offered by an Australian judge, one would not expect a court to sever and enforce the remaining provisions contained in an agreement that provided for the carrying out of an assassination.²⁷⁵Less dramatically, a line of cases holds, for example, that agreements entered into for the purpose of defrauding the revenue authorities will not be subject to severance.²⁷⁶

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Canadian courts have considered and refined the doctrine of severance in a series of cases arising from the criminal rate of interest provisions of the Canadian Criminal Code.²⁷⁷Section 347 of the Code prohibits the entering into of agreements to receive interest at a rate that exceeds 60 percent per annum. The provision further defines the concept of "interest" expansively to include "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"²⁷⁸paid or payable with respect to the advancing of credit. This provision was included in the Criminal Code as a feature of the legislation repealing the federal Small Loans Act.²⁷⁹The latter legislation had been originally inspired by the apparent need to regulate small consumer loans at a time when banks and other financial institutions had not substantially entered the consumer loan market. The legislation was thought to be unnecessary, however, once banks and other responsible lenders had entered the consumer market at competitive lending rates. At the same time, however, it was thought desirable to provide the law enforcement community with a means to deal with non-market loan-sharking activities and for this purpose, section 347 was introduced into the Criminal Code.²⁸⁰The provision was drafted, however, without any evident awareness of commercial practices in the context of high-risk, especially short-term, commercial loans. Accordingly, although the provision appears to have been rarely invoked against actual loan sharks, the expansiveness of the provisions²⁸¹has captured numerous commercial lending transactions entered into by sophisticated commercial parties, often acting on the basis of professional advice.²⁸²

The facts of a leading case, William E. Thomson Associates Inc. v. Carpenter,²⁸³neatly illustrate the problem. The plaintiff investment

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banker had entered into an arrangement to provide interim financing to a corporation experiencing financial difficulties in order to provide a period of time during which the borrower’s affairs could be put in order with a view to attracting conventional financing. In due course, the borrower proved to be unable to arrange a refinancing and defaulted on the loan. Accordingly, the lender sought to enforce guarantees executed by two directors of the borrower. The guarantors defended the claim on the basis that the interest charges contravened section 347. The various charges associated with the interim financing, including interest charges, a facility fee and reimbursement of the plaintiff’s legal fees and other costs, were all considered to be interest within the meaning of section 347 and cumulatively amounted to an annual rate in excess of 60 percent. Accordingly, both the loan and the associated guarantees constituted illegal transactions and were unenforceable. The problem in such cases is not that the lender might be prosecuted under the Code for commission of the section 347 offence. This eventuality is most unlikely.²⁸⁴Rather, the problem is that borrowers in such circumstances will take the position that as the entire transaction is unlawful, neither the interest nor the principal must be paid to the lender with resulting enrichment of the borrower at the lender’s expense. The net and, presumably, unintended effect of section 347 in this context, then, is to increase the risk of this kind of financing and, we may assume, reduce its availability. For obvious reasons, however, considerable attention has been focused in these cases on the question of the severability of the unlawful interest provisions.

Initially, Canadian courts sought to distinguish between transactions in which the interest provisions could be considered to be collateral to the primary purpose of the transaction, in which case the interest provisions were severable,²⁸⁵and those in which the interest yield was said to be the central purpose of the transaction, in which case the provisions could not be severed.²⁸⁶More recently, however, Canadian courts have accepted that the interest provisions in these cases are severable even in a straightforward lending context where the very point of the transaction from the lender’s perspective is to earn

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interest. In such cases, the lender is at least entitled to a return of the principal.²⁸⁷As well, in cases where the criminal rate of interest stipulated in the agreement contains a number of components, courts have adopted the view that provisions relating to particular components can be deleted to the point at...