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Lenders and Lending Lawyers – Don’t Get Tripped Up By The “Clog”

 

Be Careful When Combining a Mortgage with an Option to Purchase

Lenders and their lawyers should be aware that the prohibition against “clogs on the equity of redemption” may become an issue in any transaction that includes a mortgage and an associated option to purchase in favour of the mortgagee.  The prohibition is an equitable principle, first established in England in the 17th Century in the context of strict usury laws and predominantly unregulated lending practices.  The prohibition voids any agreement, provision or device (including an option to purchase) that is part of a mortgage transaction and that has the effect of making the mortgage irredeemable.

Under Section 2 of the Law and Equity Act (British Columbia), all early civil laws of England (subject to legislative modifications and local circumstances) form part of the law of B.C.  Although the clogging rule is not expressly addressed in the Act, recent cases confirm that the clogging rule will be considered and potentially applied by the court, as applicable, in cases where a mortgagee also obtains an option to purchase.

Recent Consideration in British Columbia

The background to the prohibition against clogs is set out in the following excerpt from the B.C. Supreme Court’s decision in Gupta v. 0856716 B.C. Ltd., 2012 BCSC 1407:

“[t]he prohibition against the clog and the issues that arise are described by Harvey J., in 400091 British Columbia Ltd. v. Copper Beach Estates Ltd., 25 R.P.R. (2d) 189, 1992 CarswellBC 668 at paras. 9 and 10:

[9]  The policy behind the rule is discussed by the Supreme Court of Canada in Wilson v. Ward, [1930] 2 D.L.R. 433 at 441:

It has long been settled that equity will not allow a mortgagee to enter into a contract with the mortgagor, at the time of the loan, for the absolute purchase of the subject of the mortgage for a specific sum in case of default in payment of the mortgage money at the appointed time.  The rule had its origin in the Ecclesiastical Courts.  In the Court of Chancery, it was a rule of policy based upon a recognition of the disposition of money lenders to use their power of dictating the form of a security transaction, in order to shape it in such a way as to make it possible to “wrest the estate out of the hands of the mortgagor”.

[10]  In my view, the courts are loathe to permit mortgagees to dictate terms of a loan in a way that is oppressive to the mortgagor’s right to redeem his or her property. …”

In the Gupta case, the Court confirmed that an option to purchase taken at the time of the loan by a mortgagee from his mortgagor is a clog on the equity of redemption and unenforceable.  However, the Court also held that, in order to fall within the prohibition, the option to purchase must be part of the mortgage transaction, and that the entirety of the transaction must be examined without restricting the analysis to the form of the documentation, and that the mere existence of an option to purchase together with a mortgage does not necessarily create a clog on the equity of redemption.  If the option was a collateral agreement, and not taken as additional security for the mortgage, the option is valid, if on the totality of the transaction it cannot be regarded as unfair or unconscionable (Di Castri at 6-26).

Although the Court in Gupta confirmed the continued applicability of the rule against clogs, it ultimately found that the transaction in question did not offend the rule.  The Court highlighted the following facts:  the borrower offered to provide the option to purchase as an inducement for a loan which the lender had initially declined to provide; although the mortgage securing the loan and the option to purchase were included in one agreement, the option did not refer to the security being provided for the loan and was not triggered by a loan default; and there was equal bargaining power between the parties, both of whom were familiar with commercial undertakings.  Relying on the foregoing and looking at the substance of the subject deal, the Court held that the option to purchase in the Gupta case was enforceable.

Conclusion

Following the Gupta decision, in order to assess the enforceability of an option to purchase granted to a mortgagee in association with a mortgage, it is no longer sufficient to consider the form of the documents and/or examine whether the option interferes with the exercise of a redemption right.  An option taken at the time of granting of a mortgage may still, on the totality of the considerations, be valid.  Conversely, an option that is not taken as additional security for a loan may still offend the clogging principle if, considering the transaction as a whole, the option is unfair or unconscionable.  Typically, unconscionability may be found in circumstances where there is unfair or offensive conduct and/or a harsh or unconscionable substantive result.


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TERRA LAW CORPORATION

Our office is located in Vancouver, B.C. but we represent clients involved in transactions and projects throughout British Columbia. Terra Law focuses on representing individuals and businesses in complex commercial real estate transactions, financings and developments.


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