is equal to the tax rate on the award date.
Prejudgment Period
The prejudgment period ends on the date of the damages award. However, the date on which the prejudgment period begins may depend on the jurisdiction. Some favor the date at which the harm began, and others favor the date of the filing of the claim. Courts may also choose to deny interest for a portion of the prejudgment period.
As between the alternatives, the notion that prejudgment interest is intended to compensate the plaintiff for the defendant's use of its funds supports using the date at which the harm began. This notwithstanding, under the doctrine of laches, courts may deny prejudgment interest to a plaintiff that has unreasonably delayed the filing of its claim. Under this doctrine, a claim will not be enforced or allowed if an undue delay in asserting the claim has prejudiced the opposing party.
Compounding Period
Compounding allows interest to be earned on past interest. To illustrate, prejudgment interest calculated at 10 percent simple interest over five years based on a damages award of $100 equals $50 ($100 X .10 X 5). By comparison, with a 10 percent rate of interest, annual compounding over five years, and an award of $100, prejudgment interest equals $61 ($100 X {(1.10)5 – 1}). In general, the difference between simple and compound prejudgment interest will increase with the length of the prejudgment period, the interest rate, and the number of compounding periods. The proper treatment may depend on the relevant jurisdiction or statute.
Applicable Interest Rate
As with compounding, courts can have considerable latitude in selecting the rate at which prejudgment interest is to be calculated. Among the rates that might be considered are a Treasury bill or Treasury bond rate, the defendant's unsecured borrowing rate, the plaintiff's cost of capital, a rate based on a contractual provision between the parties, or a rate based on a market index. The rate selected will depend in general on the nature of the associated risks and rate of return required as compensation, with the low end likely bounded by Treasury rates and the high end by the rate of return on lost opportunities, perhaps as indicated by a measure of the plaintiff's cost of capital or historical rate of return, if greater.
Risk-free rate.
If it is appropriate to compensate the plaintiff for the time value of money between the date of harm and date of the award, but not for the inherent risk, a risk-free rate may be applicable. This type of rate may be obtained from the rate for a Treasury bill or Treasury bond. This approach treats the damages award as attributable to the appropriation or impairment of an asset by the defendant, the value of which was known on the date of harm. Underlying this methodology is the idea that by depriving the plaintiff of the asset between the date of harm and judgment, the defendant also took from the plaintiff the risks associated with investing in and owning the asset. Accordingly, the plaintiff should not be compensated for risks it did not bear.
Defendant's unsecured borrowing rate.
he use of the defendant's borrowing rate for purposes of calculating prejudgment interest is intended to compensate the plaintiff for the time value of money, as well as the risk that the defendant will default on its obligation to pay the damages award. As with the use of the risk-free rate, this approach (sometimes referred to as the coerced loan theory) treats the damages award as compensation attributable to the appropriation or impairment of an asset by the defendant. However, unlike in the risk-free rate model, the asset is treated as being equivalent to that of a claim or debt obligation owed by the defendant to the plaintiff. This approach is similar to how bankruptcy courts treat legal claims. From this, it follows that the rate required to compensate the plaintiff is the defendant's unsecured borrowing rate. The prime rate, which is the rate of interest charged by banks in the United States to their prime customers, has often been used for this purpose.
Plaintiff's cost of capital.
The theory underlying the use of the plaintiff's cost of capital (meaning the weighted average of its costs of equity and debt) to calculate prejudgment interest is that doing so compensates the plaintiff for the cost of lost opportunities (sometimes referred to as the lost return approach). For example, it could be argued that but for the defendant's harmful conduct, the plaintiff would have otherwise had available and invested the funds from which it was deprived such that it would have realized a return equal to its weighted average cost of capital over the prejudgment period. Similarly, it might be said that the plaintiff would have earned a return on the particular asset appropriated or impaired by the defendant equal to its weighted average cost of capital.
Alternatives theoretically similar (from a lost return perspective) to the plaintiff's weighted average cost of capital include the plaintiff's historical return on equity, its cost of borrowing, and the return on a market index. The basis for using the average of the plaintiff's historical return on equity is that the plaintiff would have invested the funds from which it was deprived in its own business and that the return on equity generated by the business historically best measures the rate of return the plaintiff would have earned. The principle underlying the use of the plaintiff's cost of borrowing is that if the harmful act of the defendant did not preclude the plaintiff from pursuing new investment opportunities, it nevertheless likely caused the plaintiff to increase its level of borrowing. The premise for the use of the return on a market index is that the plaintiff could have itself invested the funds in a diversified market portfolio of stocks or distributed the funds to its shareholders, who would have done so for themselves.
The range of rates that can result in practice is highlighted in the opinion by Judge Wheeler of the U.S. Court of Federal Claims in the class action litigation brought by Star International Co. against the United States following the government bailout of American International Group at the height of the financial crisis. See Starr Int'l Co., Inc. v. United States, 121 Fed. Cl. 428 (Fed. Cl. 2015). The expert for the plaintiff testified that the prejudgment interest rate should be determined by looking at a rate of return on a synthetic portfolio comprising competitors of AIG and that doing so indicated that the prejudgment interest rate should be 7.0 percent for the Credit Agreement Class and 20.1 percent for the Reverse Stock Split Class. Id. at 461.By comparison, the expert for the defendant testified that the plaintiff should not be compensated for risks it did not bear and that a good proxy for a risk-free rate of return would be the one-year Treasury bill or five-year Treasury Inflation Protected Securities (TIPS) rate, which would yield prejudgment interest rates of between 0.5 and 0.3 percent or 2.9 and 3.2 percent. Id. at 462.
Ex Ante and Ex Post Discounting
Finally, the discounting convention and date to which damages are discounted to present value may also have a significant effect on the value of prejudgment interest. Under the ex ante approach, all cash flows (including those occurring between the date of the unlawful act and the date of restitution) are discounted back to the date of the unlawful act using a rate commensurate with the risk of the associated asset. This lump sum is then brought forward to the date of the damages award using the selected prejudgment interest rate. Only information known or knowable as of the date of the harmful act is used. Subsequent events are ignored, including the outcome of litigation, which would convert the analysis to an ex post evaluation.
In contrast, with the ex post method, cash flows projected in the future are discounted to present value as of the date of restitution using a rate appropriate for the risk of the asset, with the date of trial often serving as a proxy. Past cash flows occurring between the date of the harmful act and the date of restitution are not discounted, however. Rather, they are brought forward from the date of the harmful act to the date of restitution by compounding the selected rate of prejudgment interest. All information known or knowable up through the date of trial is relevant.
Conclusion
For these reasons, litigation counsel is well served by understanding the implications of prejudgment interest at the outset of litigation and in the creation of the damages model.
