Unsurprisingly, one meaningful factor influencing whether pre-petition claims are pursued as part of a debtor’s bankruptcy case (or as part of a confirmed plan) is the amount of recoverable damages. In order for a bankruptcy estate to expend resources or attract contingency counsel to prosecute a meritorious claim, the potential recovery must be worth the effort and time. When assessing recoverable damages, numerous questions generally come to mind: (i) what are the damages; (ii) what evidence is needed to prove the damages; (iii) are the damages collectible; (iv) who is liable for the damages; and (v) is there a material choice-of-law issue. Another possible component of damages is prejudgment interest. While prejudgment interest is commonly included in the standard damage recital for a pleading, it may not get much substantive attention before a judgment is on the horizon. Prejudgment interest should not be overlooked as an important component of claims held by a bankruptcy estate.
Upon the filing of a voluntary petition under the federal Bankruptcy Code, a bankruptcy estate is created for the benefit of the debtor’s creditors. That estate comprises “property of the estate,” which includes pre-petition causes of action that the debtor could have pursued prior to the bankruptcy. In some instances, these pre-petition claims represent a significant potential source of recovery for the debtor’s unsecured creditors. The debtor’s pre-petition claims may have laid dormant for a variety of reasons. For example, a financially distressed debtor may have lacked the resources to initiate litigation or was preoccupied with salvaging its business. On the other hand, a debtor may not have had the practical motivation to seek legal redress against insiders or contractual counterparties. A bankruptcy can appreciably change this landscape by introducing parties who have statutory duties (a trustee) or are motived (creditors) to pursue pre-petition state law claims on behalf of the debtor’s creditors.
If a cause of action expires under applicable statutes of limitations before the petition date, there is no cause of action to become property of the debtor’s estate. When the claim is viable as of the petition date and becomes property of the estate, the trustee generally may commence a civil action before the later of the end of the applicable limitation period or two years after the voluntary petition date. 11 U.S.C. § 108(a). Thus, if the applicable limitations period for a pre-petition cause of action expired the day after the petition date, a trustee would have almost two years to commence an action without a limitation preclusion. Depending on the applicable non-bankruptcy law, the debtor’s claim may have accrued, for limitations purposes, several years before the petition date. By extension, prejudgment interest may have been accruing several years prior to the petition date, as well.
Prejudgment interest is interest that accrues on the amount of a judgment or legal award from a prior date in time, such as the date of the loss, the date the claim accrued, or the date the complaint was filed, up to a date certain, usually the date on which final judgment is entered. Prejudgment interest is often reserved for liquidated damages. Most states have codified statutory schemes (or constitutional provisions) that govern the availability of, and rate for, prejudgment interest, including causes of action (or types of damages) for which prejudgment interest is unavailable. For example, some states preclude prejudgment interest for damages arising from bodily injury. In some instances, prejudgment interest is mandated by statute; in others, the award is subject to judicial discretion. Prejudgment interest can serve a variety of purposes. Sometimes it is considered remedial, serving primarily to compensate the prevailing party for the delay in receiving money damages, the loss of the use of money that was rightfully owed, or the true costs of damages incurred (or a combination of these). Another purpose can be to encourage prompt and early settlements and compensate litigants for the expense of bringing the action. Prejudgment interest may also be viewed under the larger umbrella as something awarded to promote fairness and equity.
Variety exists among the states when it comes to prejudgment interest. Not only can the rate of prejudgment interest widely vary, but state law can meaningfully differ regarding the types of claims or damages for which a litigant can seek prejudgment interest, when prejudgment interest begins to accrue, whether prejudgment interest is simple or compound, and whether contractual prejudgment interest rates are enforceable. In many states, the prejudgment interest rate has no connection to, and is appreciably higher than, the market interest rate. The intricacies of every state’s prejudgment interest law are outside the purview of this article, but a few examples will make the point. These examples are as of February 4, 2020.
If a court is applying federal law, there is no general prejudgment interest statutory scheme. Rather, the award of prejudgment interest is generally a matter left to the discretion of the trial court, absent some federal statute to the contrary. DRCK, LLC v. Chong (In re Chong), 523 B.R. 236, 253 (Bankr. D. Colo. 2014) (applying federal law, but awarding prejudgment interest at Colorado rate).
No math degree is needed to appreciate how, depending on the applicable law, prejudgment interest can equal or exceed a liquidated damages amount. Take, for example, a breach of contract action that accrues in May 2015 with liquidated damages of $1 million. The debtor plaintiff files for Chapter 11 bankruptcy in May 2018 (with the applicable limitation period expiring right after the petition date), a bankruptcy trustee is appointed and brings an adversary proceeding in May 2020, and the trustee obtains judgment in May 2022 for the full liquidated damages. Prejudgment interest at 9 percent per annum, compounded annually over 7 years equals about $828,000. Imagine if the limitation period is longer and the litigation drags on a few more years. Using the $1 million damage claim at 9 percent prejudgment interest compounding annually for 10 years, prejudgment interest now totals $1.36 million—more than the underlying damages. Make a few adjustments and a different picture is painted. If you change the prior scenario to simple interest, prejudgment interest adds up to $630,000 (7 years) and $900,000 (10 years). If you change the interest rate to 5 percent (compounded annually), prejudgment interest adds up to $407,000 over 7 years and $628,000 over 10 years.
While the examples above may be extreme, they underscore how the facts and applicable law can make a substantial difference in a prejudgment interest recovery.
Speaking of applicable law—that brings us to the choice-of-law analysis in bankruptcy cases for state law causes of action (assuming the causes of action are brought in an adversary proceeding). Under the Supreme Court’s framework set out in Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938), and its progeny, substantive issues of state law claims asserted in federal court are determined under state law, while procedural issues are determined under federal law. As a general matter, federal courts siting in diversity jurisdiction apply the choice-of-law rules of the forum state to determine which state law applies. Klaxon Co. v. Stentor Elec. Mfg. Co., 313 U.S. 487, 496 (1941), superseded by statute on other grounds. The meeting of state and federal law in bankruptcy cases can raise complex jurisdictional and choice-of-law issues. In the bankruptcy context, some bankruptcy courts have extended Klaxon to state law questions arising in bankruptcy cases (generally or only absent a significant federal interest), while other courts have applied federal common-law choice-of-law rules. Rent-Rite Superkegs W., Ltd. v. World Bus. Lenders, LLC (In re Rent-Rite Superkegs W., Ltd.), 603 B.R. 41, 70 (Bankr. D. Colo. 2019). The Supreme Court has not directly addressed this issue.
If prejudgment interest is considered a substantive component of damages, then a judicial determination as to the applicable substantive state law for the state law claim may control the applicable prejudgment interest law. It is important, then, to understand at the onset of the case whether there is a material choice-of-law issue (including over a contractual choice-of-law provision) for the applicable state substantive law. Take a breach of contract action, for example. It may be that, between State A and State B, the applicable breach of contract law is not significantly different, but the prejudgment interest statutory schemes (or common-law rules) vastly differ. Understanding this distinction from the beginning can shape the positions taken and arguments made during the course of the litigation. On the other hand, if prejudgment interest is considered procedural, then the forum state’s prejudgment interest may control. It is also possible that an argument is made for the bankruptcy court to apply federal prejudgment interest law.
With respect to cases in which the prejudgment interest amount reaches a high figure, there may be constitutional challenges, depending on how large the prejudgment interest component becomes in comparison with the pecuniary damages. However, some courts have not been receptive to due process violation claims to statutory prejudgment interest rates. Citibank, N.A. v. Barclays Bank, PLC, 28 F. Supp. 3d 174, 184 (S.D.N.Y. 2013); Concord Gen. Mut. Ins. Co. v. Gritman, 146 A.3d 882, 892 (Vt. 2016).
Depending on the applicable law and the relevant time period covered, prejudgment interest can amount to a significant portion of a damage recovery or be a nonevent. The availability and potential amount of prejudgment interest should be assessed when evaluating estimated recoveries for state law causes of action that became property of the debtor’s estate. Prejudgment interest should also be factored in when performing a choice-of-law analysis as to state law causes of action to ensure that any position taken throughout the course of litigation is made with an understanding of any interplay between the applicable substantive law and prejudgment interest. In bankruptcy cases in which unsecured creditors are rarely paid in full, every penny counts. Evaluating prejudgment interest at the beginning helps to ensure no pennies are lost.
