This post on pre-judgment interest deals with the basic question: what is the best method by which to calculate a pre-judgment interest rate?
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%.
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.
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.
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.
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.
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.
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.
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. ),  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):
In deciding the appropriate measure of pre-judgment and post-judgment interest, the trial judge agreed with the appellant that it should be awarded the interest rate provided for in the Loan Agreement because, although it only intended to be an interim lender, the breach by the respondent resulted in the appellant becoming a long term lender which resulted in the appellant missing other investment opportunities as the money due to it was not paid and not available for other loans [para 12].
The case was somewhat unique in that Bank of America’s “investments” were in fact bank loans.
Justice Zinn rejected the proposal that the plaintiff’s weighted average cost of capital – which measures the rate of return required by rational investors, given the risks inherent in the company – be used to calculate the discount rate, noting that it was a merely theoretical measure and that it was not reflective of what the plaintfif had actually done (and, presumably, would have done)
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.
I am not aware of any case in which a plaintiff has argued that the defendant has unnecessarily shortened the duration of the litigation.
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:
A judgment in an infringement action is not complete, where the plaintiff elects an accounting of profits, until the profits have been accounted for and the judgment rendered on the report of the person designated to take accounts. The complaint that the referee took more than two years to file his report while pre-judgment interest was accruing overlooked the fact that the respondents had been deprived of that money during that period of time while the appellant had it. Furthermore, compound interest is not a penalty, but a recognition of reality.