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Tort Reform and Interest on Damages
by Philip Saunders, Jr., Ph.D.
The Governor's tort reform bill (The Civil Justice Reform Act of 1995, House No. 5232) proposes, among other things, a change in the statutory rate for calculating interest on awards (Mass. Gen. L. Ch. 231, Secs. 6B and 6C). Instead of the present 12 percent, the rate would become the latest "coupon issue yield equivalent" for the 52 week U.S. Treasury bills (House No. 5232, Sec. 13). Using the proposed Treasury bill rate would keep the statutory rate current, instead of the present situation in which the 12 percent fixed rate bears no relationship to prevailing market conditions.
To some extent, House No. 5232 would conform Massachusetts to Federal practice. The 52-week Treasury bill rate is used in most types of Federal cases to calculate post-judgment interest, compounded annually (28 U.S.C.A. Sec. 1961(a) and (b)).
While we are amending the statute, it is worth pausing for a moment and reviewing the rationale for pre- and post-judgment interest.
First, the interest should compensate the plaintiff for the loss of the time value of money. Between the time of the breach or demand in a contract case or of the commencement of the case in a personal injury or property damage action, and the date of payment, the plaintiff loses the use of the money awarded in the judgment.
Second, the interest should be neutral in the sense that it should not affect the conduct of the case. A rate that is too high puts pressure on the defendant to settle. Too low a rate fails to compensate the plaintiff adequately and also gives the defendant little incentive to pay.
Third, determination of the interest should be a relatively simple process.
Fourth, the interest should or should not, depending upon your point of view, compensate the plaintiff for the risk of default on the judgment by the defendant.
There would likely be general agreement on the first three criteria. There would probably not be similar agreement on what the fourth criterion should be. Before examining interest rates that could be used for calculating pre- and post-judgment interest, including the current and proposed statutory rate, it may be useful to elaborate on the issues involved in the fourth criterion.
Not all judgments are equally collectible. The defendant's financial condition may have deteriorated, insurance coverage may be compromised, or the defendant may have diverted assets. The question is, who pays for bearing the default risk.
One school of thought holds that the risk that a judgment may be uncollectible is merely one more litigation risk, like the risk of losing the case. We do not generally compensate the plaintiff for having borne any other litigation risk, so why compensate the plaintiff for bearing the risk of default. Under this view it is only necessary to compensate the plaintiff for the time value of money. Therefore, a risk-free rate of interest, such as a U.S. Treasury obligation rate, is appropriate.
A second school holds that it is appropriate to compensate the plaintiff for bearing the risk of default. Plaintiff's are in fact compensated periodically for bearing some of the litigation risk. For example, in some cases courts award attorneys' fees, the principle cost for which the plaintiff typically is at risk. Attorneys' fees may be awarded in breach of contract cases where the contract provides for fees and in 93A actions here in Massachusetts. Also, there is a suspicion that juries occasionally gross up awards to give the plaintiff a desired amount net of contingency fees. This is ex post compensation. It is reimbursement of expense after the outcome of the litigation is known. It is only partial reimbursement of the risk borne, for it does not take account of the probability that the plaintiff might have lost the case. Nevertheless, it does provide precedent for having the defendant pay some of the cost of bearing litigation risk.
Following this second line of thought, the way to compensate the plaintiff for bearing at least some of the risk of default is to compute pre- and post- judgment interest at the defendant's borrowing rate. The borrowing rate includes not only the cost of money for the particular maturity at the risk free rate but also a premium to compensate the lender, in this case the plaintiff, for the possibility that the borrower, in this case the defendant, may not pay timely.
Using the borrowing rate implicitly assumes that the judgment is not so large relative to the defendant's means that no one would lend the defendant such a sum. If the defendant were a company and could only raise the money with a combination of debt and equity, the appropriate rate would be the defendant's weighted average cost of capital at the margin, in other words the weighted average cost of the incremental money being raised. Of course some judgments are so large relative to the defendant's ability to pay that there may be no meaningful rate that compensates the plaintiff for the risk of default.
At this point in the discussion, we have three possible rates for the calculation of pre- and post-judgment interest: a fixed rate; a Treasury rate; and the defendant's borrowing rate.
All three rates compensate the plaintiff for the time value of money, in most circumstances. The one exception would be the occasions, such as occurred in 1980, 1981, and 1982, when the Treasury rate at several maturities, was above 12 percent. On those occasions the plaintiff was not being adequately compensated, especially since the statutory rate at the time was 10 percent. Both the recent Treasury rate, as proposed, and the defendant's borrowing rate would be an improvement over a fixed rate from the point of view of accurately compensating for loss of the time value of money.
Both the Treasury rate and the defendant's borrowing rate would also be an improvement over a fixed rate from the point of view of neutrality with respect to conduct of the case. Under a fixed-rate system the plaintiff in most cases will receive either too much or too little interest to compensate him or her for the costs incurred and the risks borne, and the defendant will pay too little or too much for the benefit gained from the use of the money.
For example, the current 12 percent rate was written into the law in 1982, a year in which one-year U.S. Treasury obligations averaged over 12 percent. Since then, one-year Treasuries have dropped below 3 percent, in 1994, and are now back up to over 5 percent. The relatively high, 12 percent, rate has the advantage of encouraging prompt payment once the judgment has been entered. However, the rate also puts more pressure on the defendant than the plaintiff to settle and has made a judgment in a lawsuit one of the better investments available, assuming that the judgment and the interest are ultimately collectible.
On the neutrality criteria, the defendant's borrowing rate is to be preferred to the Treasury rate. A judgment earning interest, and simple interest not even compound interest at that, at the Treasury rate is the cheapest money that any individual or company can borrow. The low cost of money gives the defendant a disincentive to settle or pay.
As to simplicity, the fixed rate wins hands down and the Treasury rate is not far behind. A 20-year history of the equivalent coupon issue yield of the 52-week Treasury bill rate is updated and published after every change and distributed to the clerks of the Federal courts (U.S. Dept. of the Treasury, Bureau of the Public Debt, "52-Week T-Bill Rate Table of Changes"). Using the defendant's borrowing rate is clearly more complex, but the complexity need not be faced in most cases. The statute could be written to make the statutory rate a default rate, to be applied in the absence of a determination by the trial judge to use some other rate of interest. The determination would only be made if either plaintiff or defense raises the issue.
For the run-of-the-mine personal injury, wrongful death, or property damage case, the distinction between the risks of default by the U.S. Treasury and by the defendant does not have great practical significance. The ultimate payor is usually an insurance company, so the risk of default is minimal. It makes relatively little difference whether the Treasury rate or a rate appropriate for the insurer's policy obligations is used.
Also, in small cases, especially those with relatively short periods for which interest is due, the distinction between risk of Treasury default and the risk of default by the defendant may not have great practical significance. The amounts of additional interest due, if the defendant's borrowing rate is used, are not great.
For the above reasons, the use of the Treasury rate for calculating interest on damages is not likely to present a significant problem and therefore is not likely to be raised by either party in the great majority of cases. However, when either party thinks that the U.S Treasury rate is inappropriate and that enough is at stake to make the point worth arguing, he or she could have the right to plead for an alternative rate. As long as the default rate is a Treasury rate the proponent will typically be the plaintiff. It would be the proponent's burden to demonstrate that risk of default by the defendant was significantly greater than a risk of default by the U.S. Government and to propose and explain an alternative rate, presumably an estimate of the defendant's borrowing rate. Determination of the rate would then be up to the trial judge.
Finally, we come to the question of whether plaintiffs should be compensated for bearing the risk of default. Plaintiffs will prefer compensation and therefore the option of using the defendant's borrowing rate. Defendants will prefer the Treasury rate.
Economic theory points in the direction of using the defendant's borrowing rate. Economic efficiency is achieved by allocating resources to the uses with the highest incremental returns. The market mechanism allocates resources, in this case money, which represents a claim on resources, by selling to the highest bidder. To the extent that anyone, in this case the defendant, is able to borrow at a subsidized rate, he or she may borrow more and longer than he or she would have otherwise. The money will be put to a less productive use than it would be without the subsidy. Resources will be misallocated.
A related economic issues is transaction costs. Even though pleas to the court in favor of using a rate specific to a case might be relatively infrequent, they would make those trials in which the question is raised more protracted and costly. The costs will reduce the gains in efficiency achieved through appropriate allocation resources. Since, as discussed above, the issue would be likely to be raised only in cases where a substantial amount was at stake, the net gain in efficiency would presumably still be positive, but whether that would be true in practice is an empirical question.
Misallocation is undesirable but common. Our economy is rife with subsidies, direct and indirect, and resources are misallocated regularly. Whether subsidy of the defendant by allowing him or her to borrow at the Treasury rate and allocation to the plaintiff of all the cost of bearing the risk of default are desirable is, ultimately, a question of equity in the broad sense and of public policy.
If one believes that the plaintiff should bear the risk of judgment default, the Governor's proposal is on balance correct. If, however, one believes that the defendant should bear some of the risk of default, then allowing the court the option to direct that pre- and post-judgment interest be computed at the defendant's borrowing rate would be a better proposal.
First published in Massachusetts Lawyers Weekly, Jan. 15, 1996.
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