United States: A Subject Of Interest: Pre-Award Interest Rates In International Arbitration

Last Updated: July 22 2015
Article by Dan Harris, Richard Caldwell and M. Alexis Maniatis

Different pre-award interest rates can have a significant impact on damages awards. The potential impact of different pre-award interest rates goes up as the legal process rumbles on. For instance, suppose that it took five years to obtain a damages award. A 10% pre-award interest rate would turn a $100 million claim into $160 million of damages, whereas a 2% pre-award interest rate would turn the claim into only $110 million.1

However, pre-award interest was considered "a vastly under-pleaded area" during a recent Global Arbitration Review (GAR) meeting.2 The recent GAR discussion revealed that the economics behind the choice of pre-award interest are not always well understood. In this article, we discuss the economic principles that should underlie the choice of a pre-award interest rate and draw out several implications.

WHAT IS INTEREST FOR?

Once the tribunal has found for the claimant, the respondent usually owes the claimant money. Hence the claimant becomes a lender or creditor, and the respondent is a borrower. Interest compensates lenders (claimants) for two things: 1) the time value of money and 2) risk. A dollar today is worth more than a dollar tomorrow because we could simply deposit the dollar in the bank and earn a deposit rate.3 To motivate a loan to someone else, we need the loan to generate a return at least as good as we could obtain on a deposit at the bank.

At the same time, a safe dollar is worth more than a risky dollar. Any loan involves the risk that the borrower will not repay the full amount due. The larger the risk, the higher the corresponding interest rate needed to compensate.4 Put differently, no rational investor would lend to a risky prospect at 5%, if they could lend to a safe prospect at 10%.

These simple observations provide the economic framework for any discussion of pre-award interest and carry important implications:

  1. It is the riskiness of borrowers/respondents that determines interest rates. Interest rates compensate lenders for the risks associated with borrower default, not for the risks or costs associated with a lender's own capital raising activities.
  2. Interest rates reflect the actual risks born by lenders/claimants. Interest rates do not compensate lenders for the returns available to them on hypothetical projects with a different risk profile to the actual borrower.

PRE-AWARD INTEREST IN ARBITRATION

The fundamental question for pre-award interest is: what should it compensate claimants for?

Tribunals should at least compensate claimants for the time value of money. Otherwise, violators would end up benefiting from the delay inherent in the legal process, and claimants could never be made whole. Claimants would be subject to the erosion of the dollar value of their claims by inflation during litigation and the attendant delay in compensation, with no ability to obtain even the interest compensation normally obtained by risk-free assets.

A return on a "risk-free" asset will compensate the claimant for the time value of money. Government debt is usually taken as the best proxy for a risk-free asset, but one must exercise care with this assumption. US or German government debt is as close to risk-free as we are likely to see in the real world, but the debt of many Eurozone States currently attracts substantial risk premia. Even interest rate benchmarks like LIBOR or EURIBOR have at times been affected by concerns about counterparty default.

The term of the debt is another question – in other words, what is the duration of the government bond from which we should derive an interest rate? The US Treasury issues debt with terms varying from 30 days to 30 years, and these different issues attract different interest rates. Short-term bills attract lower interest rates, while long-term rates compensate investors for the likely path of interest rates and the risk that inflation and interest rates turn out different from expectations. Determining the most appropriate choice will depend on the inflation risk that the tribunal thinks the claimant should be awarded for, which in turn will depend on the legal and fact pattern of the case.

A broader view of pre-award compensation is also possible. In addition to the time value of money, pre-award interest could also compensate claimants for payment risks attached to the respondent. During the course of the litigation, there is always a risk that a respondent might default and go bankrupt, long before the claimant could obtain an award and collect on damages.

Under this view, a claimant in effect becomes a "forced lender" to a respondent, and deserves some compensation for the associated payment risks borne during the course of the litigation. Indeed, claimants at least deserve compensation in line with other lenders to the respondent.5 Otherwise, they would be forced to bear the risk of a respondent default during the arbitration process without receiving offsetting compensation.

The broader "forced loan" perspective has the added benefit of giving the respondent incentives to behave efficiently. If respondents paid a lower pre-award interest rate than on their other debt, then they could obtain cheaper financing through improper conduct than by borrowing through normal channels. Respondents would have an incentive to drag out legal proceedings as long as possible, to continue profiting from the cheap loan from claimants.6 Ensuring that respondents pay the full costs of the forced loan also ensures that they will take appropriate precautions to avoid the situation that led to the award in the first place.7

The risk of a respondent's default is distinct from the claimant's chance of a successful legal outcome. The legal process exposes claimants to the risk that their claim may be denied. Claimants and litigation funders logically take such chances into account when deciding whether or not to pursue claims. However, granting pre-award interest at the respondent's borrowing cost does not compensate for the risk of an unsuccessful legal outcome. It simply compensates for the risk that respondents may not be able to pay even when found liable.

Whether a tribunal adopts the narrow risk-free or broader forced loan perspectives ultimately comes down to legal considerations. The narrow "risk-free" view presumes that respondents' liability arises only at the moment awards are rendered,8 and treats the risk of a respondent payment default as one more of the many risks associated with the litigation process for which the claimant is not compensated. Under this theory, the risk that a respondent fails financially prior to an award is viewed as part of the risk of arbitration rather than a financial risk. The broader "forced loan" view compensates the claimant for the risk of a respondent payment default, consistent with the idea that the amount owed was a forced loan made at the time of the breach.

HIGH PRE-AWARD INTEREST RATES?

The GAR discussion on pre-award interest raised an alternative argument, which we paraphrase here: "The breach deprived the claimant of the ability to undertake alternative investments, which would have generated returns, close to the (high) equity return actually achieved by the claimant on other activities. Respondents should provide compensation for such foregone investment returns." This argument is simple, intuitive, and wrong.

Recall that interest rates depend on the risks attached to the borrower of the funds, and that they are linked to the extent of risks run. The use of a claimant's return on alternative investments would sever the fundamental links between the pre-award interest rate, the borrower and the extent of risks the claimant bore during the arbitration.

The claimant's return on an alternative investment has nothing to do with the respondent, even though interest rates should relate to borrowers/respondents. At the same time, the claimant never undertook the alternative investments nor did it run the associated risks, yet pre-award interest at the claimant's return would provide compensation on the presumption that the claimant did and that the investments turned out as expected.

Put another way, the claimant may have hoped to earn higher rates of return on alternative investments. But we will never know, since the claimant never undertook the alternative investment or ran the associated risks. Like anything else, the alternative investments could have gone well or poorly, and the claimants could have gained or lost money. By depriving the claimants of the ability to undertake the alternative investments, the violations have deprived the claimants of both the chance to win and the chance to lose. Pre-award interest at the claimant's cost of capital would compensate the claimants for a favourable outcome to the alternative investment, while ignoring the chances that they could have lost.

Moreover, if the alternative project was really so fantastic, then the claimant should have been able to find sources of funding for it other than the amounts owed by respondent. To claim that the respondent's tardiness in paying up has deprived the claimant of an investment opportunity asks us to believe that there are no other sources of funding – a situation that is rarely likely to occur.

This brings us to the limits of what pre-award interest can compensate for. In real life, violations may have undermined the claimant's ability to pursue other valuable investment opportunities, and forced them to lend money to respondents instead. Even if pre-award interest at the respondent's borrowing rate gave a fair return for the risks actually run during the arbitration process – the risks of a respondent default – it would still not compensate the claimant for the loss of freedom to invest their money as they would have wished. It is the return that the claimant deserves, but not the return that they want. However, quantifying and compensating for this "inconvenience" would be difficult from an economic perspective, since the damage depends on the claimant's risk preferences, which are not observable. But whatever the correct compensation for this inconvenience, the claimant's cost of capital is unlikely to give the right answer.

CONCLUSIONS

The pre-award interest can lead to very significant differences to the final award, yet the debates on interest often reveal misunderstandings about the economic fundamentals.

In arbitration, the claimant takes the role of a lender to the respondent, who is the borrower or debtor. Interest rates compensate the lender for the time value of money, and also for the risk that the borrower might default on the loan. Hence, it is the riskiness or creditworthiness of the borrower or respondent that should determine the pre-award interest rate.

Whether a tribunal decides to compensate the claimant only for the time value of money, or also for the risk of respondent default, is ultimately a legal issue. It depends on whether the damages are viewed as a "forced loan" from the claimant that arose at the moment of breach, or whether the liability only arose as of the award date.

Regardless of which perspective the tribunal adopts, the final choice of pre-award interest will require careful economic consideration with respct to the choice of market data used, and any adjustment that may be required. The claimant's expected return on alternative investments is not an appropriate pre-award rate. The tribunal should not reward the claimant for a risk that they never took. This perspective fails to compensate the claimant for the inconvenience of being forced to lend to the respondent, but quantifying such compensation will rely on judgement as much as economics.

Footnotes

1. We assume interest is componded annually in these examples.

2. See GAR 12 May 2015; An unexpected interest in interest.

3. The time value of money also reflects the impact of inflation. In the presence of inflation, the purchasing power of a dollar declines over time. If a lender foregoes the use of her money today, then she must be compensated for the expected decline in purchasing power during the term of the loan.

4. For a more detailed discussion of the economic role of pre-award interest see Gotanda, John Yukio; Compound Interest in International Disputes. Law and Policy in International Business, Vol. 34 (2003), pp. 397-398.

5. For more on the "forced creditor theory" see Epstein, Roy J.; Prejudgment Interest Rates in Patent Cases: Don't Compound an Error. IPL Newsletter, Vol. 24, No. 2 (2006), p. 9.

6. For further discussion on this point see Sénéchal, Thierry J. and John Y. Gotanda; Interest as Damages. Columbia Journal of Transnational Law, Vol. 47, No. 3 (2009), p. 496. Available at SSRN: http://ssrn.com/abstract=1116384

7. Knoll, Michael S.; A Primer on Prejudgment Interest. Texas Law Review, Vol. 75 (1996), p. 296.

8. See, for example, Franklin M. Fisher and R. Craig Romaine; Janis Joplin's Yearbook and the Theory of Damages. Journal of Accounting, Auditing & Finance, Vol. 5, Nos. 1/2 (1990), pp. 145-157.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions