Pre-Judgment Interest, Part III: Property Damage, Profit, and PJI

My practice involves a lot of work for property insurance companies. When damage to property occurs, the property owner may advance a claim against the third party tortfeasor for both the value of the damaged property as well as an ongoing loss of income or profit associated with the damage. While most first party business interruption insurance policies will typically limit any claim for lost profits to a 12-month period from the date of incident, third party claims for lost profits can often extend outside of this period.

In such cases, not only will there be damages claimed for both the physical damage and lost profits; there will also claims for pre-judgment interest. This post looks at how pre-judgment interest should be calculated in such situations.

In my experience, pre-judgment interest is often awarded on the property damage as well as on the lost profits. Is this correct from a financial point of view? Consider that lost profits represent a rate of return that would have been earned on the damaged property. If the plaintiff is already being awarded a rate of return on its lost property, it would seem unfair to also award it with pre-judgment interest on that same asset.

An Example

Consider the following example, which should illustrate this basic point:

• Assume that ABC Corp. (“ABC”) has a single machine, which will cost $1M to replace in Year 5 and would have cost $900,000 to replace in Year 1. 
• The machine allows ABC to generate profits of $100,000 per year (we will ignore taxes for the sake of this example).
• The machine is destroyed in a fire at the beginning of Year 1; the fire was caused by faulty electrical work performed by a subcontractor, and liability is admitted***. Due to lack of funds and other logistical issues, the plaintiff was unable to replace the machine until the end of Year 5; once the machine is replaced, it is not anticipated that ABC will suffer any ongoing adverse effects.

***It is great how financial experts always get to assume liability is a non-issue in their examples, isn’t it? Nothing to it...

It is now the end of Year 5, and the trial has just concluded. The trial judge has awarded the plaintiff the replacement cost of the machine, which is $1M, as well as lost profits of $500,000 representing five years of lost profits.

 

In addition, ABC will likely receive pre-judgment interest (for a five-year period) on the value of the machine, as well as interest on each year’s annual lost profits. Let us assume that the judge has decided to apply a simple interest rate of 5%, based on the rates specified in the Courts of Justice Act for the relevant date of loss.

The award may look something like this: the end result is a damages award of $1.5M and pre-judgment interest of $312,500.

 

But there are two problems with this calculation, both of which will tend to overstate the pre-judgment interest award.

First, the replacement cost of the machine has been calculated in Year 5 dollar terms; the replacement cost in Year 1 was only $900,000, but due to inflation the price of the same machine has increased by around 11%, to $1M. Pre-judgment interest rates include an inflation component; banks (including the Bank of Canada) lend money in the anticipation that inflation will occur, and they need to recover the erosion in the nominal value of the principal as part of their interest payments. If the property damage award already includes an adjustment for inflation, then compensating ABC for inflation a second time (through the pre-judgment interest mechanism) will result in a windfall to ABC.

But there is a second, somewhat less intuitive problem with the award.

Pre-judgment interest is meant to compensate the plaintiff for the loss of return on its assets during the interval between the date of the loss and the trial date. Yet that is precisely what the award for lost profits represents – the loss of the annual return on the machine that would have been earned by ABC. By awarding both pre-judgment interest and lost profits resulting from the destruction of the machine, we are essentially double-counting the plaintiff’s lost returns on its machine.

Both of these problems can be easily illustrated by modeling the plaintiff’s cash flows "but for" the destruction of the machine. The plaintiff would have earned $100,000 per year, which it would have (presumably) reinvested and used to earn additional returns. These additional returns can be modelled with pre-judgment interest (notwithstanding the issues I raised in previous posts, which argue that such rates tend to undercompensate plaintiffs). It is these cash flows that will need to be replaced.

In addition, but for the wrongdoing, the plaintiff would have still had the machine; but now it does not. It therefore needs to receive an amount that will allow it to buy a replacement machine in Year 5; it needs only $1M to replace the asset, not $1M plus interest.



As you can see, our damages award is still $1.5M, but we no longer accrue any additional amounts for pre-judgment interest for the damaged machine; PJI falls from over $312,500 to only $62,500. The combined award will put ABC back in the position it would have been in but for the destruction of its machine.

Conclusion

 

Property damage and lost profits are commonly viewed as two distinct heads of damage, and in some senses they are indeed separate: property damage occurs at a point in time, while lost profits are the consequential result of that physical event.

But failure to recognize the linkages between property damage and lost profits can result in damages assessments that are significantly distorted. There are many senses in which this is true, and I hope to delve into this area in a future post, but the area of pre-judgment interest is one example in which failure to account for these linkages can result in an inflated overall award.

Inflation and Family Law

I was looking through my oldest daughter’s baby book last night and found that we had noted the price of gas at $0.70 per litre; I had noted at the time that this was “really high”! This got me thinking about inflation.

My daughter is 10 years old now, and gasoline has been hovering at between $1.00 and $1.10 in recent weeks here in Toronto. Some of the increase is due to volatile commodity prices, but a large portion of it is due to inflation.

We tend not to think about inflation these days; it is an unspoken part of our everyday lives. A friend of mine recently commented to me that inflation is a modern phenomenon and that in pre-modern societies people simply didn’t have to put up with it. I pointed out to him that a) he’s wrong, there have been four Great Waves since the 13^th century, (to borrow from the title of David Hackett Fischer’s excellent book on the topic), and that b) in modern times there have been periods of significant deflation (most recently during the Great Depression). Here is a graph showing the annual rate of change in the Consumer Price Index in Canada since 1919:

Anyway, as I said, we tend not to think much about inflation. Often, this is a good thing; many people feel good when they receive a 2% raise, and do not like to be reminded that they are just treading water. Deflation, meanwhile, can be crippling for debtors; over 100 years ago, the Democratic presidential candidate, William Jennings Bryan*, famously said that American farmers were being crucified on a “cross of gold” due to a refusal of the government to depreciate its currency.

*It still blows my mind that the Democrats gave Bryan three consecutive kicks at the can as their presidential candidate. Not until Mike Milbury took over the New York Islanders would an organization show such patience with an unsuccessful leader.

Inflation is something that we are comfortable with, so long as it is predictable. It is over 20 years since the Bank of Canada committed itself to fighting inflation, and we tend to assume that things will simply chug along. Yet inflation can cause tremendous distortions in the economy. It can lead to large losses on seemingly safe investments, such as government bonds, as anyone who purchased such bonds in the 1970s will know (or may not know). Payments on bonds are in nominal dollars; when the anticipated real (i.e. inflation-adjusted) value of a dollar declines, bond prices drop as well. If the annual yield on the bond you buy is less than the average rate of inflation over the term of the bond, you will lose money. Here is a look at the average real rate of return for holders of long term Government of Canada Bonds:

You can see that depending on where in the inflationary wave you purchased your bond, you could either make a lot of money, or none at all. (In general, bond yields tended to price in the recent history of inflation; they were lousy at predicting inflation. So, for example, if you bought a bond in 1982 – on the heels of the “stagflation” experienced in the late 1970s – the anticipated inflation built into your bond yield allowed you to make a killing).

Inflation and the Law

So much for the brief economics lesson. How is this relevant to lawyers?

Some areas of law consider inflation. One example is the Income Tax Act. One of the reasons that only 50% of capital gains are included in taxable income (for now) is because for assets that are held over a long period of time, there will have been an inflationary increase in the nominal asset value, which does not really represent incremental income to the asset owner. Tax brackets are also changed every year for this reason. Prejudgment interest is designed to compensate plaintiffs for inflation between the time of injury and trial.

One area of law that does not take inflation into account is family law (at least in Ontario). Consider the following case:

• A couple enters a marriage in the year 2000 with no assets or liabilities, other than a piece of land owned by the wife worth $100,000 (in 2000 dollars).
• Assume that the couple accumulates no additional assets or debts during the course of their marriage – they spend everything they earn, no more and no less. The land just sits there, but it has risen in value due to inflation. Assume that this occurs in a region of the province where inflation in land prices is equal to CPI (i.e. not Toronto). In 2010, assume the land is worth $120,000 (in 2010 dollars).
• In such a case, would there be any equalization payment to reflect the gain in the wife’s net family property? Or would the law recognize that, in real terms, the wife’s property has not appreciated at all?

I presented this scenario to a leading family law practitioner and asked whether it made any sense that an equalization payment would need to be made. He replied that under Ontario’s Family Law Act, any increase in the nominal value of family property, even if due to inflation only, is considered to be an increase and to be part of "net family property". Section 4 of the Act defines "net family property as:

the value of all the property, except property described in subsection (2), that a spouse owns on the valuation date, after deducting,

(a) the spouse’s debts and other liabilities, and

(b) the value of property, other than a matrimonial home, that the spouse owned on the date of the marriage, after deducting the spouse’s debts and other liabilities, other than debts or liabilities related directly to the acquisition or significant improvement of a matrimonial home, calculated as of the date of the marriage;

This issue arises in business valuations as well. As a result of inflation, a business will increase its selling prices (hopefully), its costs will increase, the replacement costs of its assets will increase, and a business that undergoes no fundamental change can find itself worth much more in nominal terms than it was at the date of marriage.

I suppose one could suggest a reading of the Act to the effect that the calculation should be based on real (and not nominal) values; but in my experience in dealing with family law matters, this is typically not argued.

Conclusion

One might ask, is this fair? There has been no real increase in the value of the property, why should the husband get anything? This was my first instinct In thinking about the issue. But I think now that perhaps that question - "is it fair?" - is not the right one to be asking.

Life is not fair. In some marriages, both spouses contribute equally (either to the business or to home life). This is not always the case, however. Rather than trying to assign points, the Family Law Act says simply: we will split the net increase down the middle.  It may not be “fair”, but it is impossible to legislate fairness with anything more than very broad strokes.

Statutory financial remedies will never be perfect. They cannot address all possible cases. The advantage of such relatively cut-and-dried remedies is that they provide a relatively simple system of efficiently adjudicating disputes and allocating money between the parties.

Of course, it does not always work out that way J