This
first post on pre-judgment interest deals with the basic question: what is the best
method by which to calculate a pre-judgment interest rate?
The Law
Pre-judgment
interest is interest that is added to a plaintiff’s monetary award in respect
of past losses suffered prior to the date judgment is pronounced.
Pre-judgment
interest may be awarded by statute. In Ontario, for example, the relevant
legislation is found in sections 127 to 130 of the Courts of Justice Act. The pre-judgment interest rates set out in
those sections are noteworthy in two respects:
·
Rate - the prejudgment
interest rate is based on “the bank rate established by the Bank of Canada as
the minimum rate at which the Bank of Canada makes short-term advances to
Canadian banks”. This is a very low interest rate that reflects very little in
the way of a premium for default risk.
·
Method - the interest is
calculated as simple, not compound, interest. In most commercial contexts,
compound interest applies.
These
peculiarities of the statutory rates were acknowledged by the Supreme Court of
Canada in Bank of America Trust v. Mutual Trust
Co.
2002 SCC 43. That case involved
two lenders who were both party to a contract with a condominium builder. One
of the two lenders (Mutual Trust) failed to fulfill its obligations under the
contract, with the result that the builder was forced into receivership,
resulting in the second lender (Bank of America) suffering losses of both
principal and interest. Bank of America sought to recover its losses from
Mutual Trust.
The
Supreme Court ruled that Bank of America could recover compound interest at the
rate specified in the contract, and was not bound to the interest provisions
set out in the Courts of Justice Act.
It noted that in general, interest is meant to compensate lenders for three
things: (i) the time value of money (i.e. the idea that the ability to spend a
dollar today is worth more than the opportunity to spend that same dollar at a
later date) (ii) risk, and (iii) inflation. Historically, societal attitudes
towards the charging of interest were generally negative, with the result that statutory
pre-judgment interest rates have been set somewhat parsimoniously (or “miserly”,
to quote another case from the Alberta Court of Appeal), and the commercial
reality is that the rates set out in the Courts
of Justice Act and various other statutes do not reflect any element of
risk.
The
Courts of Justice Act does provide
for some flexibility in the granting of pre-judgment interest if can be shown
to be “payable by a right other than under this section”. The Supreme Court
ruled that in certain circumstances, such as breach of contract cases where an
interest rate is clearly stipulated, it may be appropriate to depart from the
statutory prejudgment interest rates, and to award pre-judgment interest as a
head of damage. It noted, at paragraph 55, that “It may be awarded as
consequential damages in other cases but there would be the usual
requirement of proving that damage component” (emphasis added).
While
the case before the Supreme Court at the time was for the breach of a loan
contract (in which the interest rate was explicitly stated), this idea of
awarding interest as an element of damages has been applied in other areas in
which no contractual interest rate had been agreed to. In a recent patent
infringement case, Eli Lilly v. Apotex, 2014
FC 1254 (“Cefaclor”),
the trial judge awarded $31M in damages for the period 1997 to 2000, and approximately
$75M in pre-judgment interest as part of the damages award under the Patent Act, rather than as a prescribed
remedy under the Federal Courts Act.
The
impact of this decision was profound. Although (for example) the pre-judgment
interest prescribed under Ontario’s Courts
of Justice Act for Q1 of 1997 (when
the infringement action was brought) would have been simple interest at 3.3%,
the trial judge awarded interest on Lilly’s lost profits using an average compound
interest rate of approximately 8.5%.
The Theory
Once
one recognises that the statutory rates do not properly reflect either the time
value of money or risk, and that it may be possible in some situations to argue
for compound interest on some other basis, the question becomes, what is the
most appropriate way in which to quantify those factors? How should a
pre-judgment interest rate that is economically “fair” be set?
There
are two ways of conceptualizing pre-judgment interest.
The
first is compensatory, and focuses on the plaintiff’s perspective. Under this
view, pre-judgement interest compensates the plaintiff for not having the
damage award between the time it was harmed until the time damages were
determined.
The
second is restitutionary, and looks at things from the point of view of the
defendant. Pre-judgment interest can be viewed as the amount the defendant must
disgorge to the plaintiff as a result of having, on an interest-free basis,
wrongly held money to which the plaintiff was entitled. This focus on
restitution will make most sense for financial remedies that are explicitly
defendant-focused (e.g. the accounting of profits remedy), but may also be applicable
in other situations, as I discuss further below.
Note
that these two rationales may not yield identical interest rates. For example,
if the plaintiff’s borrowing cost is 6% but the defendant’s is 8%, the benefit
to the defendant of holding the disputed funds in the period prior to trial is
greater than the cost to the defendant in foregoing those funds. Similarly, if
the plaintiff was forced to forego a highly profitable venture as a result of
lack of funds, while the defendant earned a low rate of return while it held
the award, its loss may be greater than the defendant’s gain.
The Options
1.
Plaintiff’s Return on Capital: The Alternative Investment
Theory
This
theory argues that as a result of the wrongdoing and the withholding of an
award that rightfully belonged to the plaintiff, the plaintiff has had to
forego potential investments on which it would have earned a return. It argues
that the appropriate rate of interest should compensate the plaintiff for this
lost opportunity.
This
appears to have been the approach adopted by the court in Cefaclor. The trial judge calculated the interest rate with
reference to the plaintiff’s actual “profit margins”
during the damages period.
(Though
it is not clear from the decision, it is possible that Zinn J. was referring to
the plaintiff’s return on capital not its profit margin. Profit margins are
calculated by taking a firm’s profits and dividing by its revenue; they
say nothing about the profit a firm earns as a percentage of its invested capital.)
This
choice of metric is noteworthy, insofar as it tacitly assumes that as a result
of not having access to the damages award, the plaintiff may have been required
to forego additional profit-making ventures. While this assumption may be valid
for smaller businesses without ready access to capital, it may be less so for
large publicly traded companies such as Eli Lilly, who have ready access to
public debt and equity markets. It does not appear that Eli Lilly was required
by the court to prove that it had in fact been forced to forego any specific
investments as a result of not having access to its lost profits, let alone to
adduce any evidence as to what the profitability of such hypothetical
investments might have been.
There
is another, more subtle, objection that can be raised to the above measure. The
assumption that the plaintiff’s average return on capital is
representative of the return the plaintiff would have generated on the award is
also debatable. Plaintiffs invest in a variety of projects, some with higher
rates of return than others. If the plaintiff can be assumed to be a knowledgeable
economic agent, one might assume that in the absence of funds, the plaintiff
would ration its funds and turn down the least profitable or most risky
projects. The marginal loss of funds would then result in the loss of only
these marginal, below average investment opportunities.
2.
Plaintiff’s Cost of Borrowing: The Alternative Investment
Theory, Light
This theory is similar to
the previous one, but instead of arguing that the plaintiff would have used the
award to invest in another project, it assumes that, at the very least, the
plaintiff would have paid down some of its debt and relieved itself of interest
obligations on that debt.
The advantage of this approach
over the first is largely evidentiary. While it may be very difficult for the
plaintiff to point to investments that it rejected due to insufficient funds –
and not only that, but to also prove the level of profit it would have made
from those investments – it should be easy for the plaintiff to point to
specific bank loans it could have paid off had it had access to capital.
This may be what the
plaintiff could have done, but is it what the plaintiff would have
done? Perhaps, but this is not easy to prove. There are numerous other ways in
which corporations expend their money – reinvestment, dividends, and increased
executive compensation. Many companies have a target debt level, and will not
use every spare dollar to pay down debt the way a conservative middle-aged investor
preparing for retirement would. In short, it is not always easy to determine
what the plaintiff would have done with the money, and insofar as that is the
correct measure of the plaintiff’s damages, using the plaintiff’s cost of
borrowing may also not be appropriate.
3.
Defendant’s Return on Capital: Disgorging the Profit
This is similar to option #1 above, but from
the perspective of the defendant; it looks to disgorge the defendant’s profit
earned from holding the award that rightfully belonged to the plaintiff.
The evidentiary problems with
reconstructing what the plaintiff would have done with the money do not exist
under this option – the defendant’s use of the money, and its profit from that
use, is known. It might be attractive to look at the arrangement in existence
between the damage date and the date of trial as some sort of partnership or
constructive trust, in which the silent and unwilling partner is entitled to
the profit earned on its capital.
Of course, in reality there is no real
equity investment here. If the defendant incurs negative investment returns
during the period between the date of damage and the trial, it is surely no
argument for it to say that the plaintiff should be stuck with those losses on
its share of the capital. It may be unfair to reward the plaintiff with any
profits, while at the same time not exposing it to any of the losses.
4.
Defendant’s Cost of Borrowing: The Coerced Loan Theory
This
is the approach endorsed in an excellent article by two US scholars, Michael
S. Knoll and Jeffrey M. Colon. Knoll and Colon argue that
in wrongfully holding the plaintiff’s money, the defendant has effectively
coerced the plaintiff into loaning it money. They argue that the interest rate
to be charged, retroactively, on such a loan should be equal to the defendant’s
floating cost of unsecured debt.
This was a measure that was advocated by
the plaintiff in Merck & Co., Inc. v. Apotex Inc.,
2013 FC 751
(“lovastatin”), and received favourable comment by Snider J.
as being restitutionary; it is a
sound measure of the defendant’s benefit to be disgorged, in that it measures
what the defendant would otherwise have had to pay in order to borrow an amount
equal to the award.
Less
intuitively, it can also be viewed as a measure of the plaintiff’s loss,
if one considers that the plaintiff has been deprived of the difference between
a market rate of return on lending funds to the defendant (or a firm with a
similar default risk profile). To consider how this is so, consider the
following example:
· Suppose
that Defendant caused the Plaintiff to lose $1M in profits in the year 2000. Damages
will be awarded 10 years later.
· Knoll
and Colon argue that the unpaid judgment in the hands of the defendant is
effectively an unsecured loan from the plaintiff to the defendant. Immediately
following the date of damage, one can think of a notional “asset” (i.e. a loan
receivable) accruing to the Plaintiff in the amount of $1M, and a corresponding
“liability” (a loan payable) accruing to the Defendant’s balance sheet.
· Knoll
and Colon argue that the pre-judgment interest rate should be the rate that
compensates the Plaintiff for a) inflation, b) the time value of money, and c)
the risk that the Defendant will not repay the Plaintiff the $1M.
It is this risk that was actually borne by the plaintiff, and it is this
risk – not the risk of, theoretically, investing in a new factory or technology
– for which the plaintiff should be compensated.
This
is arguably the least speculative measure that can be used to calculate
pre-judgment interest. It looks not at what the plaintiff would have
done with its money, nor at what it could have done, but at what it did.
The plaintiff has lent the defendant money, and the defendant should pay it an
appropriate rate.
Discretion
Section
130(2) of the Ontario Courts of Justice
Act states that in some situations, the court may decide to vary the award
of pre-judgment interest for any number of reasons, including:
(f)
the conduct of any party that tended to shorten or to lengthen unnecessarily
the duration of the proceeding;
This
paragraph is often used by defendants – and often used successfully – to argue
that the award of pre-judgment interest should be reduced on account of the
plaintiff’s role in delaying resolution of the dispute.
From the discussion above, I would hope that it is clear
that this section of the Act is
likely based on a view of pre-judgment interest as somehow punitive in nature,
as opposed to merely compensatory. The economic reality is that the plaintiff
is rarely better off by having its award sit in the hands of the defendant and accrue simple interest at the low rates
set by the Courts of Justice Act. The very fact that the
default pre-judgment interest award will be at a low, simple rate should be
enough to encourage plaintiffs to expedite proceedings to the extent possible,
and further reducing the pre-judgment interest award on these grounds may be redundant.
Conclusion
The
Bank of America decision is more than
ten years old; yet (based on an admittedly non-exhaustive inquiry) there do not
seem to be a large number of cases in which pre-judgment interest has been
awarded based on common law or equitable principles of damages. In many cases,
no doubt, it may not be worth the hassle, although the Cefaclor case certainly presents an extreme situation in which
pursuing the argument was highly profitable to the plaintiff. I hope the above
discussion may prove useful in setting straight some of the conceptual and
evidentiary issues associated with each potential measure.
In Reading & Bates
Construction Co. v. Baker Energy Resources Corp. ( C.A. ), [1995] 1 F.C. 483, the Federal Court of Appeal noted that in an accounting of profits case,
“The awarding of pre-judgment interest should be characterized as deemed
secondary benefits, i.e. deemed earnings on the profits... The awarding of
interest on the contract profits is part of the assessment of the profits that
the plaintiff is entitled to and would have made if they had been paid to him
rather than to the infringer.
Bearing in mind the modern
reality that interest paid or earned on deposits or loans is compound interest
and the need to achieve equity in the accounting of profits, the awarding of
compound pre-judgment interest as deemed earnings on the profits is the rule,
subject to a Court's discretion to mitigate it or to award only simple interest
in appropriate circumstances.”
Interestingly, this is also the
rationale used by the trial judge in Bank of America, namely that (as
summarized by the Supreme Court):
The
case was somewhat unique in that Bank of America’s “investments” were in fact
bank loans.
I should hasten to point out that we
are not speaking here of what is known as “litigation risk”, i.e. the risk the
plaintiff might be unsuccessful in winning its case. Rather, we are referring
to the risk that the defendant might go bankrupt between the date of wrongdoing
and the judgment.
This reality has been recognized by
some courts. For example, the Federal
Court of Appeal noted in Reading & Bates Construction Co. v. Baker Energy
Resources Corp. that:
