Copyright (c) 1983 American Bar Association

The Business Lawyer

 

November, 1983

 

39 Bus. Law. 129

 

 

Opportunity Cost: A Measure of Prejudgment Interest

 

John C. Keir * and Robin C. Keir **

 

* Mr. Keir is a member of the Pennsylvania bar and is an attorney in the Philadelphia District Attorney's Office.

** Ms. Keir is an economist with the Philadelphia Saving Fund Society.

Editor's note: G. Emmett Smith of the New York and Texas bars and C. Steven LeBaron of the Pennsylvania bar served as reviewers for this article. 

 

In Pennsylvania and many other jurisdictions, awards of prejudgment interest do not reflect current economic reality.  The rate of interest is arbitrary in an environment of highly volatile rates; it is fixed at an unreasonably low level; and it is simple interest in a financial system where the most conservative investments compound regularly.  These deficiencies in awards of prejudgment interest result in inadequate compensation in virtually all kinds of actions at law.  Consequently, the rules affecting the choice of interest rates to compensate injured parties are outdated and inappropriate.

From ancient times, there have been attempts to define a just rate of interest.  These attempts often centered on moral issues and failed to take into account the economic reason for charging interest -- opportunity cost.  In this paper, we propose a system of awarding interest based on the concept of opportunity cost; interest should be awarded, not as a punishment, but because the plaintiff has suffered a real loss from deprivation of use of funds.  Such a system would eliminate the real inequity involved in awards made under the present rules.

 

HISTORY

Historically, attitudes toward interest tended to focus on moral issues to the exclusion of more mundane economics.  Since in early societies the needy rather than the merchants borrowed money, the moral duty of charity overshadowed the investment potential for money, and interest was generally considered immoral.  Originally the word usury referred to the taking of any interest on loans, as opposed to its modern meaning, the charging of an exorbitant rate.

The writers of the Old Testament were more concerned with the well-being of the Jewish community and the ethics of charity than with an economic understanding of interest.  The fact that interest could not be charged within the Jewish community but could be taken from strangers shows that interest was not considered an unmitigated evil.

The ancient Greeks, too, only considered the social effects of interest on their community.  They had no legal prohibition against interest, only regulation of the rate.  n1 Greek philosophers were generally opposed to interest, and neither Plato nor Aristotle allowed interest in their ideal states because of the potential disruption of the community by pitting rich against poor.  Aristotle went further than Plato in analyzing the function of money and the concept of interest.  Aristotle posited that usury was unnatural, for money was a barren metal and could not reproduce.  Transactions involving usury, therefore, violated justice because such exchanges were not of equal sums.

n1 T. Divine, Interest 11 (1959).

Roman law allowed charging interest for all but a few hundred years of the Roman Empire.  n2 Nonetheless, both Plutarch and Seneca used Aristotle's argument that money was a barren metal, although according to Seneca and Roman law, if a debtor did not repay a loan on time, his obligation was increased.

n2 Id. at 20.

St. Thomas Aquinas and the Scholastics based their approaches on rational philosophy.  They attempted to base their argument more on commutative justice, i.e., exchange of equals, than on moral issues.  They agreed with Aristotle that the borrower and lender were exchanging two present values.  Aquinas taught that there was no reason for money to carry a premium, but where the borrower was to use the money for certain secondary employments, such as a deposit for a pledge or guarantee, then the lender might charge for the loan.  n3 Otherwise, Aquinas ignored the time value of money.

n3 J. Shumpeter, History of Economic Analysis 105 (1966).

The Calvinists sought to give an intrinsic justification for money.  They believed that both the borrower and the lender gained from a loan, so a charge for the use of money was proper.  They interpreted the scriptures as only prohibiting usury that did not allow for charity.  The Reformation Protestants also were favorably disposed toward the charging of interest, and numerous Protestant businessmon depended on lending money at interest for their livelihood.

By the 1700s, the concept of usury had evolved into its present meaning.  Adam Smith wrote in the Wealth of Nations: "As something everywhere can be made by the use of money, something ought everywhere be paid for the use of it." n4

n4 T. Divine, Interest 101 (1959) (quoting A. Smith, Wealth of Nations Bk. II, ch.4).

In this century, modern macroeconomic theory has furthered our knowledge of the functioning of interest considerably by ignoring the moral effects of interest and by attempting to describe how interest rates are determined in a free market.  Modern theorists hold that in such free markets, an equilibrium rate of interest equates the supply and demand for money.  For each money supply and income level, the equilibrium occurs when the sum of the transactions and speculative demands for money equal the actual supply of money.  n5

n5 E. Shapiro, Macroeconomic Analysis 299 (3d ed. 1974).  The concept of a natural rate of interest or "the rate of interest at which the demand for loan capital and the supply of savings exactly agree" was introduced by Knut Wicksell, a Swedish economist in K. Wicksell, Interest and Prices (1898), quoted in P. Wonnecott, Macroeconomics 198 n.2 (1974).

Interest rates allocate limited funds in the most efficient manner among those who have the greatest need or greatest use for such funds.  Thus, interest is dignified by modern theory as a regulator and a measure of demand for money and is no longer viewed as an indicator of greed.

Also, according to modern theory, transactions that involve payments of interest are the only kind that allow for an equal exchange of values in the Aristotelian sense.  Such transactions compensate for opportunity cost, a concept discussed in detail below.

The courts should consider the substantial contribution of modern economists and financial theorists in determining an equitable interest rate.  These modern financial concepts form the underlying assumptions for this paper.

 

THE PROBLEM OF INADEQUATE INTEREST

The law of prejudgment interest awards in litigation has not changed to reflect changes in modern economic theory, nor has it changed to reflect modern conditions, especially historically high interest rates.  The ancient and medieval prejudices against the charging of interest linger in the confusion and neglect found in the law of prejudgment interest.  n6 Without a clear rationale or distinction of cases, courts may refuse interest, n7 make it discretionary, n8 or declare it a matter of right.  n9 Courts may consider the issue of interest as guided exclusively by statute, n10 by common law, n11 or by equitable principles.  n12 More frequently, the issue of interest is simply ignored or handled perfunctorily.  n13 Adequate rules of prejudgment interest awards are simply lacking.  Among the problems of prejudgment interest, inadequacy of the interest awarded is a particularly egregious failing.

n6 See Davis Cattle Co., Inc. v. Great W. Sugar Co., 393 F. Supp. 1165, 1181-82 (D. Colo. 1975), quoting State Trust & Savings Bank v. Hermosa Land & Cattle Co., 30 N.M. 566, 240 p.469 (1925), aff'd, 544 F. 2d 436 (10th Cir. 1976), cert. denied, 429 U.S. 1094 (1977). Notes, Recovery of Prejudgment Interest on an Unliquidated State Claim Arising Within the Sixth Circuit, 46 Cin. L. Rev. 151 (1977).

n7 See National Acceptance Co. v. Virginia Capital Bank, 498 F. Supp. 1078, 1087 (E.D. Va. 1980); Girard Trust Corn Exchange Bank v. Brinks, Inc., 422 Pa. 48, 57, 220 A.2d 827, 832 (1966). See also Ryan v. Ford Motor Co., 334 F. Supp. 674 (E.D. Mich. 1971).

n8 See Coastland Corp. v. Third Nat'l. Mortgage Co., 611 F.2d 969, 980 (4th Cir. 1979); United States v. Bethlehem Steel Corp., 113 F.2d 301, 308 (3d Cir. 1940); Citizens Nat'l Gas Co., v. Richards, 130 Pa. 37, 18 A. 600 (1889); Railroad Co. v. Gesner, 20 Pa. 240 (1853). See also Williston on Contracts §  1413 at 622 (3d ed.); Cutten v. Allied Van Lines, Inc., 349 F. Supp. 907, 912-13 (C.D. Calif. 1972), aff'd, 514 F.2d 1196 (9th Cir. 1975); Glazer v. Glazer, 278 F. Supp. 476, 487 (E.D. La. 1968); Southern New England Contracting Co. v. State, 165 Conn. 644, 664-65, 345 A.2d 550, 560 (1974).

n9 Palmgreen v. Palmer's Garage, 383 Pa. 105, 108, 117 A.2d 721, 722 (1955); City of Allegheny v. Campbell, 107 Pa. 530, 535 (1884). Colonial Refrigerated Transp., Inc. v. Mitchell, 403 F.2d 541, 554-55 (5th Cir. 1968).

n10 47 C.J.S., Interest & Usury, §  6 at 25, §  6b at 30-31.  See Laudenberger v. Port Auth., 496 Pa. 52, 59-60, 436 A.2d 147, 154 (1981); Brophy v. Prudential Ins. Co. of Am., 246 App. Div. 871, 285 N.Y.S. 36 (1936), aff'd, 271 N.Y. 644, 3 N.E.2d 464 (1936).

n11 City of Allegheny v. Campbell, 107 Pa. 530, 535 (1884); 45 Am. Jur. 2d, Interest and Usury §  34 at 39; Louisiana & Arkansas Ry. Co. v. Export Drum Co., Inc., 359 F.2d 311, 317 (5th Cir. 1966).

n12 See United States v. Bethlehem Steel Corp., 113 F.2d 301, 308 (3d Cir. 1940). Aviation Assoc. of Puerto Rico v. Dixon Co., 333 F. Supp. 982, 986-87 (M.D. Pa. 1971). 47 C.J.S., Interest & Usury, §  6 at 29.  See generally Comment, Allowance of "Interest" on Unliquidated Tort Damages in Pennsylvania, 75 Dick. L. Rev. 79 (1970) (extensive discussion of the confusion over awards of prejudgment interest in Pennsylvania).

n13 Nedd v. United Mine Workers of Am., 488 F. Supp. 1208, 1215 n.6 (M.D. Pa. 1980).

The rate of interest allowed by courts for damages as part of the verdict is generally the legal rate set by statute.  n14 In breach of contract cases, however, courts frequently apply a rate of interest agreed upon by the parties rather than the legal rate.  n15 Where there is no agreement as to interest or, where there is an agreement to pay interest but no agreement as to the rate, courts award interest at the legal rate.  n16 The legal rate is fixed and is traditionally in the range of six percent simple interest per annum.  n17

n14 See, e.g., Formigli Corp. v. Fox, 348 F. Supp. 629, 648 (E.D. Pa. 1972); Aviation Assoc. of Puerto Rico v. Dixon Co., 333 F. Supp. 982, 987 (M.D. Pa. 1971); 22 Am. Jur. 2d, Damages §  182 at 260.

n15 In re Realty Associates Sec. Corp, 163 F.2d 387 (2d Cir 1947), cert denied, 68 S. Ct. 218 (1947); 22 Am. Jur. 2d, Damages §  182 at 261.

n16 See Pa. Stat. Ann. tit. 41, § §  201, 202 (Purdon 1974).  See also C. McCormack, Damages §  52 (1935).

n17 Pa. Stat. Ann. tit. 41, §  201 (Purdon 1974) (6% Pennsylvania); Cal. Civ. Code §  1916-1 (West 1954) (7% California); Mass. Gen. Laws Ann. ch. 107, §  3 (West 1958) (6% Massachusetts); Ind. Code Ann. §  24-4.6-1-102 and 103 (Burns 1982) (8% Indiana).

Although the legal rate is set by statute, the application of the legal rate to prejudgment damages is not mandated by statute.  n18 Preverdict interest is a measure of damages of judicial creation.  n19 After the verdict and entry of judgment, an award accrues interest at a rate fixed by statute, n20 but before the verdict, the award of interest is based on court-made rules just as are other items of damages in the substantive law of compensation.  n21

n18 Some states have enacted statutes providing for preverdict interest in certain cases.  See Colo. Rev. Stat. §  13-21-101 (1974); D.C. Code Ann. §  15-109 (1973); Kan Stat. Ann. §  16-201 (Supp. 1980); La. Rev. Stat. Ann. §  13: 4203 (West 1968); Mich. Comp. Laws Ann. §  600.6013 (Supp. 1980); N.H. Rev. Stat. Ann. §  524: 1-b (1974); N.Y. Civ. Prac. Law §  5001 (McKinney 1963); N.C. Gen. Stat. §  24-7 (1965); N.D. Cent. Code § §  32-03-04, 05 (1976 and Supp. 1977); Okla. Stat Ann. tit. 12, §  727 (2) (West Supp. 1980); R.I. Gen Laws §  9-21-10 (Supp. 1977); S.D. Codified Laws Ann. §  21-1-11 (1979); Tex. Rev. Civ. Stat. Ann. art. 5069-1.03 (Vernon Supp. 1980).  By rule, courts have provided for preverdict interest.  See N.J.R. 4:42-11(b) and Pa. R. Civ. P., No. 238, 42 Pa. Cons. Stat. Ann. (Purdon).

n19 See Davis Cattle Co. v. Great W. Sugar Co., 393 F. Supp. 1165, 1189 (D. Colo. 1975), aff'd, 544 F.2d 436 (10th Cir. 1976), cert. denied, 429 U.S. 1094 (1977); Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 384 F. Supp. 507, 527 (S.D.N.Y. 1974) aff'd on this issue, 516 F.2d 172, 190-91 (2d Cir. 1975) rev'd on other grounds, 430 U.S. 1 (1977); Busick v. Levine, 63 N.J. 351, 358-59, 307 A.2d 571, 574 appeal dismissed, 414 U.S. 1106 (1973). See also Note supra note 6 at 153; 25 C.J.S., Damages §  51 at 790.

n20 E.g., 42 Pa. Cons. Stat. §  8101; N.Y. Civ. Prac. Law §  5003, 5004 (McKinney 1963 & West Supp. 1982).  In federal court, 28 U.S.C. §  1961 formerly allowed interest at the rate allowed by state law.  This statute was recently changed to provide for interest based upon the yield of Treasury bills.  See 28 U.S.C. §  1961, amended by Pub. L. No. 97-164, tit. III, pt. B, §  302(a) 96 Stat. 55 (Apr. 2, 1982).

n21 See Busick v. Levine, 63 N.J. at 358-59, 307 A.2d at 574.

Since statutes generally do not restrict courts to awarding prejudgment interest on the basis of the legal rate, courts could award higher or lower rates.  In fact, courts have found occasions not to award the legal rate.  Where the prevailing interest rates are below the legal rate, so the plaintiff would not have borrowed or invested at that legal rate, courts have reduced the interest award to take into account the state of the money market.  n22 Interestingly, courts have been reluctant to make awards of interest in excess of the legal rate when money markets exceed the legal rate.  n23 The legal rate is said to be the maximum rate, so while there is flexibility below the legal rate, there is no flexibility above the rate.

n22 Montgomery Ward & Co. v. Collins Estate Inc. 268 F.2d 830, 839 (4th Cir. 1959); E.I. DuPont De Nemours & Co. v. Lyles & Lang Constr. Co., 219 F.2d 328, 342 (4th Cir. 1955); Chesapeake & Ohio Ry. Co. v. Elk Ref. Co., 186 F.2d 30, 35 (4th Cir. 1950); Speed v. Transamerica Corp., 135 F. Supp. 176, 199 (D. Del. 1955), modified on other grounds, 135 F.2d 369, 374 (3d Cir. 1956); Austrian v. Williams, 103 F. Supp. 64, 118-19 (S.D.N.Y. 1952); In re Keener's Estate, 413 Pa. 267, 270, 196 A.2d 321, 322 (1964); In re Kenin's Trust Estate, 343 Pa. 549, 564, 23 A.2d 837, 844-45 (1942).

n23 See, e.g., Formigli Corp. v. Fox, 348 F. Supp. 629, 648 (E.D. Pa. 1972) (the court refused to take judicial notice of interest rates in the money markets even though courts had previously done so).  See cases cited at note 22 supra. The view that Pennsylvania law permits awards of interest rates only up to the maximum legal rate was rejected in Peterson v. Crown Fin. Corp., 661 F.2d 287, 296 (3d Cir. 1981).

Logically, the varying of prejudgment interest to reflect money market rates only when these interest rates are below the legal rate is indefensible.  By refusing to award interest above the legal rate, courts ignore the fundamental principle of damages that compensation be adequate and full.  By awarding interest, courts attempt to make an injured party whole and to restore him to the position he would have occupied.  n24 Interest is allowed in order that the damages will be adequate in light of the delay in payment.  n25

n24 Louisiana & Ark. Ry. Co. v. Export Drum Co., 359 F.2d 311, 317 (5th Cir. 1966); E. I. DuPont De Nemours & Co. v. Lyles & Lang Constr. Co., 219 F.2d 328, 341-42 (4th Cir. 1955); see also Notes, supra note 6; Williston on Contracts §  1412 at 621 (3d ed.); 25 C.J.S., Damages §  50 at 790.

n25 Miller v. Robertson, 266 U.S. 243, 257 (1924); E.M. Fleishmann Lumber Corp. v. Resources Corp. Int'l, 114 F. Supp. 843, 844-45 (D. Del. 1953); Annot., 36 A.L.R. 2d 337, 345 (1954).

Adequate compensation cannot be awarded to a plaintiff in times of high interest rates if he receives less than the amount he would have received by investing the recovery during the delay.  Courts must be willing to adjust prejudgment interest to reflect money market conditions even when they rise above the legal rate in order to be faithful to the concept of full compensation commensurate with the loss.

One may argue that courts are prohibited by usury laws from awarding interest above the legal rate.  While the legal rate of interest has coincided with interest limits imposed by usury statutes, usury limits are not generally applicable to the portion of a court's damage award comprised of the interest damages.  n26 Indeed, it would be strange to argue that an award of interest by a court of law would be in violation of usury laws.  n27 Certainly, the dangers of extortion or of oppression, which the legislature presumably sought to eliminate by a usury statute, are not at stake in a judicial award of damages.

n26 See e.g., Busick v. Levine, 63 N.J. at 358-59, 307 A.2d at 574. The usury law in Pennsylvania was reenacted as a part of Act 6, Jan. 30, 1974, P.L. 13, No. 6 (Pa. Stat. Ann. tit. 41 §  101 et seq. (Purdon 1974)).  The legislative history indicates no consideration of the effect of the usury law and of the legal rate of interest upon preverdict interest awards.  The amendments to Act 6 in 1978 reveal a legislative intent to exempt from usury law obligations of principal amount over $50,000 and business loans over $10,000 (41 P.S. §  301 (f) (Purdon)).  The amendments could be construed as a basis for awarding preverdict interest above 6% per annum in business litigation and suits over $50,000.  See also D. Siegel, Supplementary Practice Commentaries, N.Y. Civ. Prac. Law §  5004 (Supp. 1982).

n27 See also Notes, supra note 6, at 167; Comment, supra note 12, at 90.

For example, the mechanical application of the legal rate of interest to damage awards has little support from the language or history of the Pennsylvania statute enacting it.  The legal rate of interest was enacted in Pennsylvania in 1858 as part of the usury law.  n28 It was reenacted in 1974 as part of Act 6, n29 which in addition to setting the usury limits focused to a large extent on residential mortgage interest rates.  The legislative history reveals no independent consideration of the statutory sections setting the legal rate.  n30 Consequently, there is no basis for concluding that the legislature considered the effect or lack of effect of its actions on awards of prejudgment interest.  Nor is there any indication of a continuation of policy or, given changed circumstances, a change in policy in the enactment of the same rate of legal interest in 1858 or in 1974.

n28 Pa. Stat. Ann. tit. 41 §  3 (May 28, 1858) P.L. 662 §  1 (1971) (West Supp. 1983-84).

n29 41 Pa. Cons. Stat. Ann. § §  201, 202 (West Supp. 1983-84).

n30 See Pa. Legislative Journal -- Senate 1332 (Jan. 15, 1974). Legislative Journal -- House 3269 (Jan. 30, 1974), Pa. Legislative Journal -- House 2604 (June 30, 1970) (remarks of Rep. Spencer) ("the purpose of the usury law was to keep lenders from exploiting those who are not sophisticated in the borrowing field").

In the ten-year period from 1850 to 1860, yields for government securities averaged less than four and one-half percent, n31 municipal bond yields in New England were approximately five percent, n32 commercial paper averaged eight and one-half percent, n33 and short term money market rates were a little over six percent.  n34 For the next hundred years thereafter, interest rates stayed below this level.  n35

n31 S. Homer, A History of Interest Rates 287 (1963).

n32 Id.

n33 Id. at 318-19.

n34 Id.

n35 Id. at 336, 337.

Yields on treasury bills, commercial paper, corporate bonds, and the prime rate had all moved above seven percent when, in 1974, the legislature provided in Act 6 for a floating residential mortgage rate but retained, with limited exceptions, the traditional usury rate of six percent.  After 1974 interest rates declined for a time but then moved up to new highs.  In 1979 three-month treasury bills yielded an average of 10.04%, short-term prime commercial paper yielded 10.91%, prime rate averaged 12.67%, and Moody's AAA-rated corporate bonds yielded an average of 9.63%.  n36 Rates proceeded upward, and in 1981 three-month treasury bills were yielding an average of 14.08%, prime commercial paper averaged 14.76%, prime rate was 18.87%, and Moody's AAA-rated corporate bonds averaged 14.17%.  n37 No change in the legal rate during this time meant prejudgment interest stayed at the unrealistically low level of six percent and interest awards became less and less the full and fair compensation of delay damages.

n36 Merrill Lynch Economics data base.

n37 Merrill Lynch Economics data base.

A legal rate of interest that bore some relation to reality in 1858 no longer even approximated the value of money.  While in 1858 the legal rate was substantially above most of the safest investments, such as government securities, the situation was reversed in 1974.  The legislature made no change, apparently still believing it was protecting the unsophisticated borrower from usury, n38 not realizing that the same unsophisticated borrowers when injured were being deprived of full and fair compensation.  Moreover, the courts, which could have been expected to recognize and appreciate the problem, did not show the flexibility and movement available to them.  The court-applied prejudgment interest rate remained under the control of a usury statute written by the legislature to deal with entirely different problems.

n38 See supra note 30.

 

PREJUDGMENT INTEREST

In contract and tort actions, interest has been recognized as a component of compensatory damages to be included in the verdict and judgment.  n39 An award of interest is to compensate for the loss of use of money during the delay from the time the cause of action arose until the verdict.  n40 Such interest is sometimes called moratory interest.  n41

n39 Note, Developments in the Law -- Damages, 61 Harv. L. Rev. 113, 136-38 (1947); Annot., 36 A.L.R. 2d 337, 345 (1954). Interest has been awarded in Pennsylvania in several cases.  See e.g., City of Allegheny v. Campbell, 107 Pa. 530, 535 (1884); Delaware, Lack. & W. R.R. v. Burson, 61 Pa. 369, 380-81 (1869). Compensation for delay of which the rate of interest affords the measure has been distinguished from "interest as such" or "interest eo nomine," but practically, there is no difference.  See generally Comment, supra note 12.

n40 C. McCormack, Damages §  50 at 205 (1935).  Interest awarded as compensation for delay is not the only context in which an injured party may seek interest damages.  Interest may also be an item of direct or consequential damages.  See Draft Systems Inc. v. Rimar Mfg., Inc., 524 F. Supp. 1049, 1054 (E.D. Pa. 1981); Chatlos Systems, Inc. v. National Cash Register Corp., 479 F. Supp. 738, 744 & n.5 (D.N.J. 1979); Diversified Environments, Inc. v. Olivetti Corp., 461 F. Supp. 286, 292 (M.D. Pa. 1978); Carl Beasley Ford, Inc. v. Burroughs Corp., 361 F. Supp. 325, 334 (E.D. Pa. 1973). Interest charges are also sometimes an alternative measure of consequential damages instead of loss of use, rental value, or loss of profits.  For example, if the plaintiff's claim is for a defective product or machine, he may seek recovery either for the rental value of a replacement machine, for loss of use of the machine, or for loss of profits while deprived of the machine.  Instead, however, the plaintiff may finance purchase of a replacement and recover the interest charges.  See D. Dobbs, Handbook on the Law of Remedies §  3.5 at 168 (1973).  See also Hussey Metals Div. v. Lectromelt Furnace Div., 417 F. Supp. 964, 969 (W.D. Pa. 1976) (prejudgment interest denied because inextricably intertwined with lost profits); Tampa Elec. Co. v. Stone & Webster Eng'g Corp., 367 F. Supp. 27, 36 (M.D. Fla. 1973) (interest on cost of repairs allowed with lost profits); Chesapeake & Ohio R.R. v. Elk Ref. Co., 186 F.2d 30, 33-35 (4th Cir. 1950) (award for loss of use substituted for interest on repair costs).

n41 Davis Cattle Co., Inc. v. Great W. Sugar Co., 393 F. Supp. 1165, 1188 (D. Colo. 1975), aff'd, 544 F.2d 436 (10th Cir. 1976), cert. denied, 429 U.S. 1094 (1977); Parker v. Brinson Constr. Co., 78 So. 2d 873, 874 (1955).

Awards of prejudgment interest have been justified both on the basis that the injured party has not had use of the money and on the basis that the wrongdoer has had use of money owed during the delay before trial.  n42 The defendant has presumably had the earning capacity of money at his disposal so that he will be unjustly enriched unless interest is awarded.  n43 Interest is included in the award to prevent a wrongdoer from benefiting from the delay.  n44 While the delay may not be the fault of either party, the defendant is clearly receiving a benefit from the delay by having use of the money.  What the defendant does with the money may be significant, n45 but even if he does nothing with it or if identification of particular uses or investments is impossible, the use value can be imputed.

n42 Davis Cattle Co. 393 F. Supp. at 1193-95; Notes, supra note 6, at 154-55.

n43 See, e.g., Nedd v. United Mine Workers of Am., 488 F. Supp. 1208, 1220 (M.D. Pa. 1980). See also Note, Recent Developments -- Prejudgment Interest as Damages: New Application of an Old Theory, 15 Stan. L. Rev. 107, 109 (1962).

n44 Nedd, 488 F. Supp. at 1220-21; D. Dobbs, Handbook on the Law of Remedies, §  3.5 at 169 (1973).

n45 Nedd, 488 F. Supp. at 1222.

Unjust enrichment is a principle of equity particularly developed in trust and fiduciary law.  n46 A trustee should not benefit from his misuse of funds and is required to remit any earnings of profits from the trust funds administered.  For a trustee, the fact of his actually receiving funds is clear and his benefit from use of the funds undeniable.  Less clear is the situation of the tortfeasor who receives nothing and makes no identifiable investment with the money due the injured party.  The notion of unjust enrichment has not been applied generally to the problem of the imputed use value and the time value of money.  In addition, although the unjust enrichment theory provides some justification for award of prejudgment interest, it does not always provide a good measure of those damages in actions at law, because the benefits to the defendant may be negligible or unprovable.

n46 See infra notes 89-92, and accompanying discussion.

An award of interest for damages for delay has been frequently viewed as punitive.  n47 In this view, the delay in payment of a claim requires an economic punishment to deter and to penalize such behavior in litigation.  The other side of the coin is that an injured party may be deprived of interest and punished where he contributed to delay.  n48 A plaintiff making unreasonable demands is deprived of interest on the basis that he required the defendant to litigate to protect himself and that the delay was his own doing.  n49

n47 See generally Note, supra note 43.

n48 E.M. Fleishmann Lumber Corp. v. Resources Corp. Int'l, 114 F. Supp. 843, 845 (D. Del. 1953); Marrazzo v. Scranton Nehi Bottling Co. 438 Pa. 72, 263 A.2d 336, 338 (1970).

n49 Marrazzo v. Scranton Nehi Bottling Co., 438 Pa. 72, 263 A.2d 336 (1970); English Wipple Sailyard Ltd. v. Yawl Ardent, 459 F. Supp. 866, 880 (W.D. Pa. 1978).

Awarding or not awarding interest as punishment is difficult to reconcile with the aim of full and adequate compensation.  n50 If interest is compensation, then there is no logical basis for using such an award as a form of punishment and no actual punishment results from such an award.  n51 There is no symmetry in depriving an injured party of compensation as a result of his unreasonable demands, but requiring a defendant to pay no more than full compensation for his unreasonableness.  A rule that would be more consistent with the law of damages would allow interest, as in the case of any other compensation, on the basis of the wrong done, not the course of litigation.  n52 If punishment is to be meted out for dilatory behavior, it should be done by separate and evenhanded rules, thereby preserving the integrity of the law of compensatory damages.  n53

n50 In Socony Mobil Oil Co. v. Texas Coastal & Int'l, Inc. 559 F.2d 1008 (5th Cir. 1977), an admiralty case, the court said, "Prejudgment interest is not awarded as a penalty, but is in the nature of compensation for the use of funds." Id. at 1014 (citation omitted).  Accord, Sanders v. John Nuveen & Co., Inc. 524 F.2d 1064, 1075 (7th Cir. 1975).

n51 See Sanders 524 F.2d at 1075 ("[T]he imposition of prejudgment interest is in its origin a form of compensation, not a penalty").

n52 See C. McCormack, Damages §  57a at 119 (1935).  As Professor McCormack argues, the injured party loses the value of the detained money measured by the interest, regardless of who is morally responsible for the delay.  The view was adopted in Speed v. Transamerica Corp., 235 F.2d 369, (3d Cir. 1956), where the court revised the district court's reduction of interest, because delays, however caused, harmed only plaintiffs.  Id. at 374.

n53 In Pennsylvania, rule 238, Pa. R. Civ. P. (effective Apr. 16, 1979), attempted to correct part of the deficiency in compensation for delay, but the rule incorporated an element of punishment in the event a party was unreasonable in rejecting settlement.  Since compensation and punishment are combined, this rule does not accomplish either goal fully.  Separate rules would make the objectives and means clearer and the ends more likely to be achieved.

Inflation has also been suggested as a justification of prejudgment interest.  n54 Because inflation reduces the purchasing power of an award, prejudgment interest offsets this loss.  While most jurisdictions do not allow compensatory damages for inflation, the need to deal with economic reality has been recognized.  n55 Reluctance to increase damages to preserve the purchasing power of an award may stem from concerns that a jury already adjusts automatically for inflation in its award or that in many cases the jury award is so subjective and discretionary that adjusting for inflation would only compound the lack of clear direction and principle in jury awards.

n54 Nedd, 488 F. Supp. at 1222-23; Fox v. Kane-Miller Corp., 398 F. Supp. 609, 651 (D. Md. 1975), aff'd in part and remanded on other grounds, 542 F.2d 915 (4th Cir. 1976).

n55 Pfeifer v. Jones & Laughlin Steel Corp., 678 F.2d 453 (3rd Cir. 1982); Kaczkowski v. Bolubasz, 491 Pa. 561, 421 A.2d 1027 (1980); Beaulieu v. Elliott, 434 P.2d 665, 670-72 (Alaska 1967); Willmore v. Hertz Corp., 437 F.2d 357, 359-60 (6th Cir. 1971). See also Dobbs, Handbook on the Law of Remedies §  3.5 at 179 (1973).

Similar arguments have been made against awarding interest for delay damages in personal injury claims.  The award of money damages for pain and mental anguish was considered so imprecise and so completely arbitrary, subjective, and discretionary with the jury as to prevent a defendant from making payment in advance of trial.  n56 Since the defendant did not know what amount to pay, the argument was that he should not be charged interest.  Inherent in this argument was the notion that interest should only be added as a punishment for wrongfully withholding money and not just to compensate for the delay in recovery.  Courts also frequently have refused to allow damages for delay and have refused to adjust awards for inflation on the basis that the jury award is presumed comprehensive.  n57 The addition of delay damages in the personal injury case is deemed unnecessary, because the jury presumably took the delay into account, just as it presumably took inflation into account.

n56 W.D. Rubright Co. v. International Harvester Co., 358 F. Supp. 1388, 1395 (W.D. Pa. 1973). But some legislatures have reversed this refusal to award interest in personal injury suits.  See supra note 18.  In addition, the rule has been criticized.  See McCormack, Damages §  56 at 227 (1935).  There is no good reason to withhold damages for delay merely out of dissatisfaction with juries.  An award after five years' delay is still a lesser sum than the same award at the time of injury.

n57 Robert C. Herd & Co. v. Krawill Mach. Corp., 256 F.2d 946, 952 (4th Cir. 1958), aff'd, 359 U.S. 297 (1959).

Speculation whether a jury allowed for delay damages or for inflation is unnecessary and untenable.  Consideration of the time elapsed from the incidence of the harm until trial may be and properly is considered in determining damages, even in personal injury claims.  n58 Delay damages are compensatory and should be the right of any injured party.  The proper solution is to make the right to interest damages explicit for the jury rather than a latent factor that may or may not enter into their deliberations.  Our jury system depends upon courts giving explicit instructions for jurors to follow in their deliberations, not upon assumptions as to their awards.  The jury should be instructed on the right to interest, the standard for its award, and the rate applicable.  Such an explicit approach leaves no room for speculation, omission, or duplication of damages.

n58 See Restatement (Second) of Torts §  913.

(1) Except when the plaintiff can and does elect the restitutional measure of recovery, he is entitled to interest upon the amount found due

(a) for the taking or detention of land, chattels or other subjects of property, or the destruction of any legally protected interest in them, when the valuation can be ascertained from established market prices, from the time adopted for their valuation to the time of judgment, or

(b) except as stated in Subsection (2), for other harms to pecuniary interests from the time of judgment, if the payment of interest is required to avoid an injustice.

(2) Interest is not allowed upon an amount found due for bodily harm, for emotional distress or for injury to reputation, but the time that has elapsed between the harm and the trial can be considered in determining the amount of damages.

 

Id. (emphasis supplied).

 

INTEREST AND INFLATION

Modern economics allows us now to adopt an explicit approach to delay damages and to adjustments for inflation.  By awarding prejudgment interest on the basis of money market conditions, courts and jurors can by one calculation efficiently and fairly compensate both for delay and loss of purchasing power of money.  Delay damages may and should be awarded for the entire loss resulting from the injured party not receiving his recovery at the time of injury.

Modern economic theory has revealed the integral relation between the inflation rate and interest rates.  n59 In a free market, interest rates are partially determined by the anticipated rate of inflation.  Lenders try to charge a rate that they believe will compensate them for inflation.  Borrowers are willing to pay this rate if they believe that the potential inflation of their earnings will more than compensate them for their interest expense.  These interactions help determine the equilibrium rate of interest.

n59 In Kaczkowski the court adopted the total offset method which recognizes inflation as the approximate equivalent of the legal rate of interest for purposes of discounting awards for future losses.  The court explicitly recognized that the interest and inflation rate are related:

Future inflation rates and future interest rates do not exist in a vacuum, but co-vary significantly.  Inflation: A Survey, 85 Econ. J. 741, 788 (1975).  It can be stated with assurance that present interest rates depend at least in part upon expectations of future inflation.  The mechanism for the adjustment was explained by economist W. E. Gibson:

When inflation becomes expected, lenders expect the real value of their principal and interest payments to be depreciated and borrowers expect to be able to repay loans with money for which less real value must be sacrificed than before expectations changed.  Thus at any level of market interest rates the quantity of loans supplied decreases while the quantity demanded increases.  Both forces increase nominal interest rates.

Gibson, Interest Rates and Inflationary Expectations: New Evidence, 62 Am. Econ. Rev. 854, 855 (1972).

Modern Interest theory commends the accuracy of the total-offset method:

[W]hen prices are rising, the rate of interest tends to be high but not so high as it should be to compensate for the rise; and when prices are falling, the rate of interest tends to be low, but not so low as it should be to compensate for the fall.

Id. at 1037 (quoting I. Fisher, The Theory of Interest 43 (1930)).

A related concept in economic theory is the real rate of interest.  The real rate of interest gives a measure of a lender's return after accounting for any loss of purchasing power.  The real rate of interest is the difference between the market rate and the inflation rate.  Lenders naturally want to be compensated for the possibility that inflation will have reduced their real rate of interest by eroding the purchasing power of the money returned.  For example, if in a given year the rate of inflation is ten percent, a bank charging a fifteen-percent rate has only received a real rate of interest of five percent at the end of the year.

Although expectations about inflation determine interest rate, the expectations are not held with certainty.  Moreover, the higher the rate of inflation, the more uncertainty is likely to exist about its variability.  n60 Consequently, investors will not always be compensated for the effects of inflation, given that sometimes the inflation rate will exceed the money rate.

n60 P. Wonnecutt, Macroeconomics 301 (1974).

A possible inadequacy in money market rates compensating for inflation should not deter courts from using these rates for awards of prejudgment interest.  If the injured party had been awarded compensation at the time of injury, he could only have invested at the current market rates.  The injured party is in no worse position by receiving a market rate of interest than he would have been had he received the compensation without delay.  According to the opportunity cost methodology, the investor should only be compensated for the rate which he could have received in the market.

 

SOME RECENT CASE LAW

Courts have not been unsympathetic to the problem of losses resulting from passage of time and from a plaintiff's inability to use the money found justly due, which losses are greatly in excess of the legal rate of interest.  In the case of Davis Cattle Co., Inc. v. Great Western Sugar Co., n61 the court awarded moratory interest in a breach of contract case and computed the interest at the rate of 11.5%.  The court determined that the rate of moratory interest was not limited to the statutory legal rate and should be measured by the benefits accruing to the defendant from not paying its contractual obligation.  n62 Since the evidence established that defendant had obtained a credit line of financing at 11.5%, the benefit to defendant was the 11.5% in interest it saved by withholding payment.  n63 The court held that the statutory rate of interest was applicable in the absence of proof of the benefit to the defendant, but where there was proof of benefits, as in this case, fairness permitted an award of interest measured by the benefits.  n64

n61 Davis Cattle Co., Inc. v. Great W. Sugar Co., 393 F. Supp. 1165 (D. Colo. 1975), aff'd, 544 F.2d 436 (10th Cir. 1976), cert, denied, 429 U.S. 1094.

n62 393 F. Supp. at 1194.

n63 Id. at 1194-95.

n64 Id.

The result in Davis Cattle Co. is particularly felicitous, but the rationale requires some refinement.  An award of damages at law is generally based on the loss to the plaintiff rather than on the benefit to the defendant.  In actions at equity or for restitution, consideration of the benefits is appropriate in fashioning a fair result.  n65 Davis Cattle Co. was not an equity action, nor was it an action for restitution, yet the court relied on precedents and principles of restitution and equity as well as other precedents at law.  n66 Properly, the court should have declared the true measure of delay damages to have been the loss to the plaintiff, rather than benefits to the defendant.

n65 Peterson v. Crown Fin. Corp., 661 F.2d 287 (3rd Cir. 1981). See also infra discussion at notes 90-98.

n66 The case relied on most heavily, Bankers Trust Co. v. International Trust Co., 108 Colo. 15, 113 P.2d 656 (1941) is essentially an action in restitution, and the court freely cites from the law of restitution.

The court in Davis Cattle Co. was not presented with evidence of the loss caused to the representative plaintiff or to the class of plaintiffs.  Obviously, such proof would have been time consuming and difficult for a whole class of plaintiffs.  Since class actions developec as essentially equitable actions to effect justice among a large number of parties, the court may have put on its equity hat in this case.  The simplicity of the rule requiring proof only of the benefits to the one or two defendants rather than proof of losses to a large class was more than justified in terms of judicial economy and fairness in such a class action.  As a rule to be followed in other cases, however, the Davis Cattle Co. opinion may be misleading and inappropriate.

Certainly, there may be cases where proof of the benefits obtained by a defendant by delay may be the only proof available or may be more easily presented than proof of the plaintiff's losses.  Such evidence should be considered by a court where necessary to effect justice between the parties.  The general rule, however, should not be swallowed by these exceptional cases.  In general, damages for delay should be based on the plaintiff's losses, and evidence of these losses should be presented and admitted in the same manner as other proof of loss.  In some cases, it is conceivable that the facts of the benefits to defendant may even be evidence of the delay losses to the plaintiff.

The importance of Davis Cattle Co. is in the judicial recognition that proof of delay damages will permit an award of interest in excess of the statutory legal rate.  The decision leaves open the question of adequate proof of these delay damages.  The court did not discuss the possibility of taking judicial notice of money markets or of admitting expert testimony on investment opportunities.  As noted above, courts have previously taken judicial notice of the state of money markets n67 and might do so again.  Testimony by economists and financial experts would also appear particularly appropriate.  If courts can take notice of money markets and can listen to expert testimony, then evidence of delay damages and awards of interest above the legal rate should be possible in virtually every action at law.  If the rule of Davis Cattle Co. permitting proof of delay damages can be applied to all actions at law, then plaintiffs should no longer be deprived of full and fair compensation for the delay in their recovery.

n67 See supra note 22.  See also United States v. 97.19 Acres, More or Less, 511 F. Supp. 565, 568-69 (D. Md. 1981) (where court took judicial notice of various rates published in Federal Reserve Bulletins); City of Cleveland, Ohio v. Federal Power Comm'n, 525 F.2d 845, 850 n.38 (D.C. Cir. 1976) ("it is well settled that courts will take judicial notice of current rate of interest on normal borrowing . . .").

A decision basing the rate of interest on the plaintiff's losses and awarding a recovery above the legal rate is found in M.B.A.F.B. Federal Credit Union v. Cumis Insurance Society, Inc. n68 The court awarded interest at the rate of ten percent on the basis of testimony that the plaintiff credit union was being paid six percent on its invested surplus funds and was charging twelve percent on its large loans.  n69 The court also noted that during the period involved, interest rates in the state had seldom been below ten percent.  n70 Apparently, the court approximated a weighted calculation of the interest that the plaintiff credit union would have expected to earn on its money.  While six percent was an historic rate on invested funds, the credit union was lending money at twelve percent at the time of trial.  The court must have concluded, with some justification, that if the money had been awarded at the time of loss, the credit union would have earned closer to the twelve percent rate.  While, strictly speaking, the court did not have precise and definite facts as to the interest loss, the evidence was sufficient for the weighted average approach.  The result was further bolstered by the court's taking notice of local interest rates.

n68 407 F. Supp. 794 (D.S.C. 1981).

n69 Id. at 799.

n70 Id.

The weighted average approach to calculating the loss due to delay seems to be applicable to a wide range of cases.  Each business entity has an historical rate of interest for borrowing or lending that would provide the basis for such an approach.  Individuals also frequently have investments or loans that would establish their losses from delay.  Courts should be receptive to this kind of evidence of actual losses to effect truly compensatory interest awards.

 

BEYOND THE LEGAL RATE

In admiralty practice, courts have allowed prejudgment interest based on a flexible standard of fairness and adequate compensation for the loss rather than on the arbitrary legal rate.  n71 The formal procedure in cases in admiralty is to award prejudgment interest, and the principle restitutis in integrum favors an award in the absence of exceptional circumstances.  n72 The award and rate of interest are at the discretion of the court.  n73 The court should consider all of the circumstances and may take into account the legal rate, prevailing rates of interest, the actual cost to the plaintiff of borrowing money, n74 and return on invested or borrowed capital.  n75 The fair rate of interest in admiralty, therefore, is frequently not the legal rate.  n76

n71 Sabine Towing & Transp. Co; Inc. v. Zapata Ugland Drilling, Inc., 553 F.2d 489, 491 (5th Cir. 1977).

n72 Slater v. Texaco, Inc., 506 F. Supp. 1099, 1116 (D. Del. 1981).

n73 Id.  See also Annot., 36 A.L.R. 337, 346-47, 359 (1954).

n74 Id.  See also Federal Barge Lines, Inc. v. Republic Marine, Inc., 472 F. Supp. 371, 373, (E.D. Mo. 1979); Sabine Towing & Transp. Co., Inc. v. Zapata Ugland Drilling, Inc., 553 F.2d 489, 491 (5th Cir. 1977).

n75 In re Bankers Trust Co., 658 F.2d 103, 112 (3rd Cir. 1981).

n76 See supra notes 72-75.

Just as admiralty actions are not governed by state law nor by state statutory rates of interest, actions brought under federal statutes would appear not to be governed by a state statutory legal rate of interest.  In securities fraud actions under section 16(b) and rule 10b-5, federal law governs and the federal standard is one of fairness.  n77 The distinction between liquidated and unliquidated claims is not followed in federal securities actions for awards of prejudgment interest.  n78 Although the case law is sparse, the federal standard of fairness would appear to be a flexible measure based on equitable considerations, not confined to a state legal rate, n79 nor to a strict theory of compensation for money withheld.  n80 Thus, a federal court may properly award interest at a rate to reflect what money would have earned had defendants not violated the securities laws.  n81 A federal court may also take into consideration the state of the money markets and the rate charged by banks for the use of money.  n82 More commonly, however, in both diversity and federal question cases, federal courts award prejudgment interest based on the legal rate of the forum state.  n83

n77 Blau v. Lehman, 368 U.S. 403, 414 (1962); Huddleston v. Herman & MacLean, 640 F.2d 534, 560 (5th Cir. 1981); Chris-Craft Indus. Inc. v. Piper Aircraft Corp., 516 F.2d 172, 191 (2d Cir. 1975), rev'd on other grounds, 430 U.S. 1 (1977); Occidental Life Ins. Co. v. Pat Ryan Assoc. Inc., 496 F.2d 1255, 1268-69 (4th Cir. 1974), cert. denied, 419 U.S. 1023, Wessel v. Buhler, 437 F.2d 279, 284 (9th Cir. 1971); Sharp v. Coopers & Lybrand, 491 F. Supp. 55, 57-58 (E.D. Pa. 1980) (the court also outlined factors to be considered in an award of interest in a securities action).

n78 Sharp v. Coopers & Lybrand, 491 F. Supp. 55, 57 (E.D. Pa. 1980); Cutten v. Allied Van Lines, Inc., 349 F. Supp. 907 (C.D. Cal. 1972).

n79 See supra note 77.  See also M.B.A.F.B. Fed. Credit Union v. Cumis Ins. Soc'y, Inc., 407 F. Supp. 794, 798 (D.S.C. 1981).

n80 Blau v. Lehman, 368 U.S. 403, 414 (1962); Fox v. Kane-Miller Corp. 398 F. Supp. 609, 650 (D. Md. 1975). Federal courts, like the state courts, look all too often to "equitable considerations" for reasons to deny a plaintiff interest.  Delay in filing suit, in making demand, or in bringing the matter to trial are all excuses to deny interest.  Since delay is harmful to a plaintiff, as discussed supra, note 55 there is no reason to use "equitable considerations" to deny a compensatory award and reach inequitable results.

n81 Sanders v. John Nuveen & Co., Inc., 524 F.2d 1064, 1075 (7th Cir. 1975).

n82 Employer-Teamsters v. Weatherall Concerete, Inc., 468 F. Supp. 1167, 1171 (S.D. W. Va. 1979). The award of prejudgment interest may have been on the basis of federal law or general law of trusts.  The court treated the case as one of breach of contract, suggesting that the award was not based on the law of trusts.  See also Nedd v. United Mine Workers of Am., 488 F. Supp. 1208 (M.D. Pa. 1980), where the court reviewed precedents of federal law and state trust law but refused an award of prejudgment interest on equitable grounds.  See also M.B.A.F.B. Fed. Credit Union v. Cumis Ins. Soc'y, Inc., 507 F. Supp. 794, 798-99 (D.S.C. 1981).

n83 Christ-Craft Indus., Inc. v. Piper Aircraft Corp., 516 F.2d 172, 191 (2d Cir. 1975); Formigli Corp. v. Fox, 348 F. Supp. 629, 648 (E.D. Pa. 1982); Aviation Assoc. of Puerto Rico v. Dixon Co., 333 F. Supp. 982, 987 (M.D. Pa. 1971). See also Crawford v. Roadway Express, Inc. 485 F. Supp. 914, 925 (W.D. La. 1980) (interest award of 7% on back pay award for employment discrimination under Title VII).

In condemnation cases, courts have included in just compensation under eminent domain an amount of interest from the time of the taking until final judgment.  The interest has been calculated on rates above the six percent specified in the Declaration of Taking Act n84 or the legal rate.  The courts have looked to interest rates on debt obligations of the United States, n85 on Moody's AAA long-term corporate bonds, n86 and on mixtures of securities.  n87 Courts have taken judicial notice of these interest rates and have made determinations of varying rates applicable to different time periods for computing an interest award.  n88 There seems to be no reason why courts computing interest awards in other cases cannot take judicial notice of various indices of interest rates as have the courts in condemnation cases.  Judicial notice is appropriate, because rates are not subject to reasonable dispute and are generally known and capable of accurate and ready determination from reliable sources.  n89

n84 40 U.S.C. §  258a (1976).

n85 United States v. Blankinship, 543 F.2d 1272, 1276 (9th Cir. 1976)

n86 Miller v. United States, 620 F.2d 812, 838 (Ct. Cl. 1980); Pitcairn v. United States, 547 F.2d 1106 (Ct. Cl. 1976) cert. denied, 434 U.S. 1052 (1978).

n87 United States v. 429.59 Acres of Land, 612 F.2d 459, 464-65 (9th Cir. 1980). See also United States v. 97.19 Acres, More or Less, 511 F. Supp. 565, 569 (D. Md. 1981).

n88 97.19 Acres, More or Less, 511 F. Supp. at 569.

n89 See Fed. R. Evid. rule 201, 18 U.S.C.A.:

(b) Kinds of facts. A judicially noticed fact must be one not subject to reasonable dispute in that it is either (1) generally known within the territorial jurisdiction of the trial court or (2) capable of accurate and ready determination by resort to sources whose accuracy cannot reasonably be questioned.

 

EQUITY, RESTITUTION, AND UNJUST ENRICHMENT

In actions at equity, courts have exercised more discretion in fixing prejudgment interest rates above the legal rate.  n90 Actions that are based on equitable principles or on theories historically associated with courts of equity will allow more flexible interest awards.  n91 Claims based upon unjust enrichment or restitution, rather than compensation or damages, permit an award of prejudgment interest above the legal rate and also an award of compound interest.  n92 Interest rates may be adjusted upward or downward as economic realities and fairness require.  n93

n90 C. McCormack, Damages §  59 at 231 (1935).

n91 Peterson v. Crown Fin. Corp., 661 F.2d 287, 295 (3d Cir. 1981).

n92 Id. at 297. Sack v. Feinman, 489 Pa. 152, 413 A.2d 1059, 1065 (1980).

n93 Peterson v. Crown Fin. Corp., 661 F.2d 287, 296 (3d Cir. 1981).

The focus of unjust enrichment and restitution is on the benefits obtained or accruing to the wrongdoer.  Consequently, a trustee is chargeable with interest actually received by him on trust funds even if the legal rate is lower.  n94 If a trustee actually receives compound interest or uses funds in his own business, he is ordinarily chargeable with compound interest.  n95 A trustee may be chargeable for interest which a prudent investor could have obtained even when the rate is above the legal rate.  n96 A creditor collecting funds improperly may be required to make restitution with interest at money market rates.  n97

n94 Restatement (Second) Trusts §  207 comment a.

n95 Id. §  207 comment d.

n96 Rollins Envtl. Serv. Inc. v. WSMW Indus. Inc., Del. Super. Ct., 426 A.2d 1363 (1980).

n97 Peterson v. Crown Fin. Corp., 661 F.2d 287, 296 (3d Cir. 1981).

A trustee may also be chargeable with interest above the legal rate as a result of mismanagement where no benefits accrue to the trustee.  n98 Mortgage foreclosure being an equitable proceeding may also result in an award of interest based on the mortgage markets rather than on the legal rate.  n99

n98 First Nat'l Bank of Paris v. Haynes, 614 S.W.2d 605, 610 (Tex. Civ. App. 1981).

n99 In re Hartsdale Assoc., 452 F. Supp. 67, 69 (S.D.N.Y. 1978).

 

COMPOUND INTEREST

The ancient and medieval prejudices against interest are no more evident in the law of prejudgment interest than in the area of compound interest.  Judicial hostility to compounding interest in actions at law is virtually uniform.  In the absence of an agreement and sometimes despite an agreement to the contrary, courts refuse to award interest on interest or to compound interest.  n100 Compound interest is probably seen as a penalty and not as compensatory.  n101 The possibility of accumulation by compounding apparently is of some concern to courts.  n102 An obvious concern also is the limitation contained in the legal rate of interest itself, which is set at a simple rate.  Compounding increases the effective rate of interest above the legal rate contrary to the statutory limit, therefore, contrary to the usury law.  Naturally, courts that are reluctant to award rates of interest above the legal rate will be reluctant to overrule themselves indirectly by compounding interest.

n100 Fox v. Kane-Miller Corp., 398 F. Supp. 609, 652 (D. Md. 1975); Speed v. Transamerica Corp., 135 F. Supp. 176, 199 (D. Del. 1955), modified on other grounds, 235 F.2d 369 (3d Cir. 1956); 25 C.J.S. Damages §  52c; Restatement (Second) Torts §  913, comment b; 47 C.J.S. Interest and Usury §  6c.

n101 See Speed v. Transamerica Corp., 135 F. Supp. 176, 199 (D. Del. 1955).

n102 C. McCormack, Damages 211 (1935).

Contrary to most court decisions, compound interest is appropriate and necessary to make a judicial award of delay damages fully compensatory.  Compound interest can be earned on a wide variety of investments and must be paid on a wide variety of obligations.  An injured party could and most likely would receive compound interest were he to receive his damages at the time of injury and to invest them until the time of trial.  The lost investment opportunity merits compensation.

By refusing to allow compound interest on damages awards, courts encourage delay in litigation.  A defendant can invest the money at compound rates and expect to pay only simple interest.  The defendant has no incentive to pay the claim as long as he expects to earn more than he will have to pay.  Thus, as a matter of policy, compound interest should be awarded to equalize the advantages and disadvantages of delay.

 

A FAIR AND REASONABLE RATE

George Bernard Shaw, on reaching his ninetieth birthday, was asked how he liked being ninety.  He is reputed to have said, "It's fine when you consider the alternative." n103

n103 Quoted in R. Lipsey & P. Steiner, Economics 195 (4th ed. 1975).

The value of the funds withheld from an individual is the principal amount plus the opportunity cost.  According to economic theory, opportunity cost is the benefit that is forgone when a resource is not used in its next best alternative.  An individual who is not in possession of money that is rightfully his must forgo potential investment gains or even incur otherwise unnecessary borrowing cost.  Borrowing costs are considered measures of opportunity cost in that money which goes to pay interest cannot be used to purchase another resource.

The primary opportunity cost of delayed receipt of money can best be explained in terms of the time value of money.  Compound interest takes this time value into account explicitly.  When interest rates are high, the potential appreciation of a sum of money can be enormous since the basic equation is exponential with regard to time.

That is,

FV = PV (1 + r)t

where:

FV = future value of a sum of money

PV = present or beginning value of a sum of money

r = the rate at which interest is compounded

t = the number of periods for which interest is compounded n104

n104 For example, at an interest rate of 10% $100 would compound in the following manner:

Year

PV

X

(1+r)

=

FV

1

$100

 

1.10

 

$110

2

$110

 

1.10

 

$121

3

$121

 

1.10

 

$133

4

$133

 

1.10

 

$146

 

To illustrate the significance of this equation, consider an investment of $1000 at a ten percent rate of interest.  The future value would be $1100 after one year and $1210 after two years.  Thus, a person deprived of $1000 would actually have lost $1210 after two years.

An award of prejudgment interest based on opportunity cost must take into consideration the investments and returns available to an injured party.  An injured party who lost $1000 and could have obtained a return on investment of ten percent will under an opportunity cost approach receive $1210 after two years.  Another injured party who establishes a return on investment of twenty percent will receive $1440 after two years.

Since opportunity cost varies from entity to entity and from person to person, a fixed rate can no longer be set for interest awards.  Instead, in each case, courts should evaluate various opportunity costs and, from a range of rates, select the rate actually to be awarded for delay damages.  The appropriate range of rates and the indicia of opportunity costs differ markedly for individuals and business entities.  These two categories require separate discussion.

 

OPPORTUNITY COST FOR BUSINESS ENTITIES

For business firms, one way that the opportunity cost of not having been paid damages will be reflected is in the cost to the firm of borrowing money.  The cost of borrowing or cost of capital usually corresponds to the firm's estimation of its future profits.  According to financial theory, a firm should invest in projects until the point that the marginal return on the next project equals the marginal cost of capital.  Simply, in making its capital budgeting decisions, a firm will not undertake a project for which the return is less than the cost of financing.

In the case of detained payments, the cost of capital may underestimate real costs.  To understand this point, we should first examine the determination of the marginal cost of capital.  Since the rate to be arrived at is a decision-making rate for future investments, historical costs are not relevant.

To obtain the marginal cost of capital, a weighted average is calculated of the various types of financing available to the firm.  The weights are expressed as fractions representing the actual financing mix which is assumed to be optimal.  One component of marginal cost is the after-tax cost of new debt.  The cost of new debt is calculated as follows:

CD=r (1-T), where

CD = cost of new debt

r = interest rate on new debt

T = tax rate

 

Note that a multiple of the tax rate is subtracted because interest payments are tax deductible.

Another component of marginal cost is the cost of preferred stock.  The cost of preferred stock, CP, is the minimum rate of return required by investors so that the price of the common will not decline.  The formula for calculating the cost of preferred stock is as follows:

CP = preferred yield / 1-flotation costs, where preferred yield = preferred dividend / price of preferred

The third component of the marginal cost of capital is the cost of new common stock, CC, calculated by the following formula:

CC = dividend yield / 1-flotation costs + expected growth, where

dividend yield = dividend / price of common stock

expected growth = (return on investment) X (retention rate of profits)

Finally, there is a cost of retained earning, CE.  This cost is similar to the cost of new stock except there are no flotation costs.  That is:

CE = dividends / initial price + expected growth

Normally, the firm's capital structure is assumed to be optimal.  This capital structure is very much a function of factors external to the firm, primarily attitudes of the firm's investors and creditors.  Consider a firm with a debt-to-equity ratio of .60, which ratio is on the high side for the firm's industry.  Nonetheless, the firm finds that at this level its cost of capital is minimized.  A fire burns down the firm's largest plant, but a legal dispute delays payment of the firm's just claim.  The firm must rebuild the plant as soon as possible, so it begins to seek funds.  However, both creditors and investors begin to perceive the increasing risk of further leverage.  This perceived risk tends to raise the cost of future financing.

Another factor to consider in the computation of the marginal cost of capital is the effect of actions by the firm to reduce this cost.  While the marginal cost of capital is constant over a range, it will finally begin to rise.  The rule is probably gradual because a firm typically will make adjustments in debt, will issue an assortment of securities, will retain more earnings, and so on, as the firm approaches the limit of its ability to generate equity funds.  n105 Thus, the cost of capital as typically calculated can very likely underestimate the true cost of delayed receipt of funds.  Consequently, cost of capital serves as a minimum measure of opportunity cost for a business entity.

n105 Weston & Brigham, Managerial Finance 625-26 (7th ed. 1981).

The firm's historical return on investment should provide an upper bound to the range of interest awards for delay damages.  Return on investment is an important measure of opportunity cost, because return on investment is profit forgone by the firm as a result of not having funds to invest.  For a profit-making enterprise, one can generally assume that the historical return on investment exceeds the average cost of capital.  Otherwise, the firm would soon be out of business.

Return on investment is usually measured by the ratio of net income to total assets.  Some economists add back interest expense to net income to arrive at a number which represents returns to both creditors and stockholders.  However, simple net income has the more common usage.

Just as a weighted approach may be used for calculating the cost of capital, courts may adopt a weighted or average historical return on investment.  If the firm is able to show high returns on some investments but low returns on others, courts may realistically weight these returns according to the amount of investment and the period of time over which the return is obtained.  Experts will be invaluable to courts and to juries in developing these weighted averages from the firm's financial records.  Expert testimony should be allowed, just as such testimony is allowed in other cases of economic loss.

Courts can justifiably award delay damages to a business entity on the basis of either the average cost of capital or the average historical return on investment.  The particular facts of a case or the availability of evidence may determine whether one or the other measures is used.  If no proof can be or is supplied of either measure, a business entity would seem to be entitled to, and courts could take judicial notice of, the average return on mutual funds.

The mutual fund rate is usually above the treasury bill rate and reflects the generally greater risk taking in investment by business entities.  By establishing a right to recover damages, the injured firm will in essence have established at least a loss of investment opportunity during the delay before trial.  While the firm may not be able to establish an ability to borrow, and thus a right to the prime lending rate or higher, the firm certainly could have invested the funds.  The mutual fund rate will approximate the lost investment opportunity.

 

OPPORTUNITY COST FOR INDIVIDUALS

As with the approach suggested for a firm, a range of awards of delay damages encompasses the wide variety of potential claims of the individual.  The endpoints will differ from those of the business entity to take into account the differences in opportunity cost.

The minimum boundary should correspond to the rate on a low-risk instrument that is both liquid and available to most individuals.  This minimum boundary could be approximated by the average rate of money market funds.  A three-month treasury bill rate is less affordable to most individuals but is a somewhat less risky investment than is a money market fund.  By taking on more risk, the individual can substantially increase his return.  There is little reason to believe that an individual would not take greater risks; therefore, this higher rate of return should be taken into account when setting the upper boundary.

Generally, the upper bound should not exceed the greater of the average return on mutual funds, including dividends, or the individual's average historical return on investment.  The rate of return on a mutual fund seems a fair upper bound, because an individual would have little credibility in claiming that he would have invested in the highest yielding stock or most profitable investment.  The average return to the professional investor should, therefore, provide a good yardstick.  However, if the plaintiff can prove that either before the damages arose or during the delay in obtaining compensation he has consistently surpassed these averages in his personal investments, the courts should consider using this historical return on investment just as they should for a corporation.

If the court is satisfied that the individual was forced by the defendant's wrongdoing to borrow at a higher rate of interest, compensation should be awarded at that rate.  Compensation at the loan rate should be awarded on a weighted average approach where each loan is given weight according to the dollar value of the loan.  The compensation rate could, of course, also be calculated in advance and presented by expert testimony in the same manner as other calculations of lost income or lost profits.  Plaintiff's counsel may also request additional compensation for any further costs incurred such as impairment of credit, including bankruptcy.

 

ADVANTAGES AND PROBLEMS OF PROPOSAL

The proposal for awards of prejudgment interest is that they be awarded on the basis of opportunity cost.  A static approach is inadequate to deal with the dynamics of interest fluctuation.  Even a rate tied to one security, such as a treasury bill, is too simplistic for the differing situations of injured parties seeking relief.  The interest rate appropriate to business is not so readily applied to individuals.  For these reasons, the proposed rule is that prejudgment interest be awarded within a range which for businesses would be a minimum of the cost of acquiring capital and, if higher, a maximum of the historical return on investment.  For individuals, awards should range from a minimum of the yield on money market investments or treasury bills and, if higher, should have a maximum of either the individual's cost of borrowing, his historical return on investment, or the average rate earned on mutual funds.

This proposed rule is obviously and considerably different from the current general rule of awarding six percent simple interest.  Whether the proposed change should be adopted will depend upon an analysis of the advantages and disadvantages of such a rule over the current one.

 

PROBLEMS

At the outset, one can readily perceive that the proposed rule would be more difficult for courts to administer.  First, it makes calculations considerably more complex.  Second, it provides greater variety in the basis for calculations of awards.  Third, it would typically require at trial additional proof by the plaintiff of his borrowing or investment.  Concomitantly, the defendant would be entitled to and likely to seek additional pretrial discovery of the plaintiff's borrowing and investment.  In some situations, individuals might object to revealing these personal financial facts.

Difficulty in accomplishing a fair result is never an adequate excuse for refusing to try to effect justice.  There will frequently be a trade-off between the ease of calculation and the provision of full and fair compensation.  Presumably, the judicial system was established to accomplish the latter.

A significant amount of the additional work required by the proposed rule would fall upon the injured party, who must establish his losses.  The added burden is in keeping with the added benefit to be obtained.  The plaintiff would still be free to relinquish his right to prove a higher rate of interest and to accept the minimum rate.  Thus, a plaintiff unwilling to provide personal information in discovery could always settle for the minimum end of the range, i.e., in the case of individuals, the treasury bill rate.

Another disadvantage of the proposal is that decisions would not be as predictable as for a static simple rate of interest.  However, awards would not be entirely unpredictable and could be determined within a close range.  Certainly, the historical rates of return and borrowing can be determined in advance of trial.  The rule would require a judicial determination differing very little from those already required in cases of economic loss.  Indeed, as pointed out previously, courts of admiralty and cases of condemnation already frequently require interest rate determinations similar to the ones that would be required under this rule.

A further disadvantage is the potential for fraudulent evidence.  For example, an individual or a firm may take out an unnecessary loan simply to establish a high cost of borrowing.  While courts may have difficulty distinguishing the necessary from the unnecessary loan, the problem might in part be avoided by adopting a weighting approach, establishing an average interest rate based upon the size and age of the loans.  Moreover, the danger of contrived loans may be exaggerated, because a plaintiff would in most cases recover only the amount he actually paid in interest.  If the plaintiff can expect merely to break even and may run the risk of not being paid as much interest as he paid on the loan, there would be no incentive to borrow without cause.

 

ADVANTAGES

One important advantage of the proposal is that it would no longer encourage delay and would make settlement more likely.  Since anyone can easily earn more than the six percent statutory legal rate, it is obvious that the defendant stands to gain by holding a case up in prolonged litigation.  By basing awards on the plaintiff's opportunity cost, the court could narrow the margin between the legal rate of interest and actual return on investment.  Under the proposal, there would likewise be no advantage to dilatory action by the plaintiff since he would only be awarded that which he otherwise could have earned himself.

The proposed rule is efficient in that it would simultaneously provide compensation for delay and for loss of purchasing power cause by inflation.  The opportunity cost of money measures both at once.  The efficiency of the rule is inherent in the nature and determination of the equilibrium rate of interest described above.  Even where inflation and interest rates diverge, in most cases the injured party is only entitled to that which he could have earned in the market.

The principal advantage of the proposed rule is that it more accurately approximates a full and fair compensation for delay damages.  Since the purpose of prejudgment interest is to provide compensation for delay, the proposed rule is more effective in accomplishing the purpose intended.  A rule that approaches more accurately fair compensation for injury is desirable in making courts appear responsive and realistic rather than unconcerned and removed.  A rule that provides the intended compensation is also more consistent with the purpose of the rule, rather than paying only lip service to full and fair compensation.

 

SUMMARY

The present rules of prejudgment interest are unsatisfactory, inflexible, and unrealistic.  A fairer and more just rule would provide for a rate varying according to the opportunity cost to the injured party.  For corporations and businesses, the opportunity cost can be calculated within a range where the minimum award would be the firm's cost of capital and maximum awards would be based on its historical rate of return, if higher.  For an individual plaintiff, the opportunity cost would be at the rate of a low-risk and liquid instrument such as a money market fund share or treasury bill and, if higher, the maximum rate would be the greater of the individual's historical return on investment or the average yield of a mutual fund including dividends.  Further, the rates should be compounded to reflect the true opportunity cost.

An additional reason for the proposed flexible and varying rates for prejudgment interest is that they will in most circumstances simultaneously incorporate the inflation adjustment necessary for full and fair compensation.  Courts can solve two problems of compensatory law by one measure of opportunity cost in awarding delay damages.