Reforming the law on compound interest

United Kingdom

The Law Commission has recently published its Consultation Paper on compound interest. It has proposed that “compound interest be made available in all money judgments and [that] unless there are good reasons to the contrary this should be awarded at prescribed rates as a matter of course.

In the light of the Commission’s paper, it seems that now is an opportune time to examine the current legal position on the award of interest and the Law Commission’s proposals.

Following general principles, interest cannot be awarded for a period earlier than the accrual of the action (Section 35A Supreme Court Act 1981 (as amended)). Following the House of Lords decision in Nykredit v Edward Erdman (unreported) in November 1997, the date from which interest should be awarded is the date at which the party suffered its full allowable loss. This date may, therefore, be later than the accrual of the cause of action.

When considering an award of interest in the context of a construction dispute we find that if an employer fails to pay sums due under the building contract the contractor can consider the recovery of interest under one of the following:

  • an express term of the contract may provide for the payment of either simple or compound interest at a quantified rate (for example Clause 60(7) of the ICE Conditions of Contract (6th Edition))

  • an express term of the contract which does not provide for the payment of interest as such but which has been construed as giving the contractor a right to what is, in effect, an interest payment (for example “direct loss and/or expense discussed below)

  • The Late Payment of Commercial Debts (Interest) Act 1998, which, in the absence of a substantial contractual remedy for late payment, implies a term into the contract whereby the non-defaulting party has a statutory right to simple interest on unpaid debts

  • through a Court Judgment (Section 35A Supreme Court Act 1981 (as amended)) or Arbitration Award (Section 49 Arbitration Act 1996)

  • damages.

Express term of the contract providing for the payment of interest

The parties may have provided in the contract for a right to claim either simple or compound interest in which case the non-defaulting party will seek to enforce that term.

Direct loss and/or expense

The Court held in F.D. Minter v Welsh Health Technical Services Organisation [1980] 13 BLR1that a contractual right to “direct loss and expense under a 1963 JCT Standard Form of Building Contract included a right to be paid “finance charges (compound interest paid or foregone) on other primary loss and expense. This case in principle should also apply to other forms of contract which provide for the recovery of claims based on actual loss or cost, including the ICE Conditions of Contract.

The Late Payment of Commercial Debts (Interest) Act 1998

The Late Payment of Commercial Debts (Interest) Act 1998 enables businesses of all sizes and the public sector to claim interest on commercial debts. Simple interest is payable from the day following the date or the end of the period of payment fixed in the contract. Where no date or period is fixed, interest will run from 30 days following receipt of the issue, or receipt or acceptance of the goods. The rate of interest is currently 8% above the Bank of England’s official dealing rate.

Section 35A Supreme Court Act 1981 and Section 49 Arbitration Act 1996

If a claim is successfully litigated, section 35A Supreme Court Act 1981 (as amended) provides for a limited right to simple interest on the award. The Judge has discretion whether to award interest at all and at what rate, to what part of the award, and for what period.

However, section 49 Arbitration Act 1996 provides that in the absence of any agreements between parties, the Tribunal may award either simple or compound interest. The parties may still exclude the possibility of an award of compound interest when agreeing the powers of the Tribunal.

One of the reasons that reform is proposed is to remove the anomaly between these two forums of dispute resolution.

Damages

The rule established by the House of Lords in the case of London Chatham and Dover Railway Company v South Eastern Railway Company [1893] AC429and reiterated in the President of India v La Pintanda Compania Navigacion SA [1985] AC104is that the law does not permit the recovery of interest as general damages where the only breach alleged is lateness in making payment.

However, where special damage can be established within the second limb of Hadley v Baxendale [1854] 9 Exch341 (that is, cases where the party in breach had notice of the special loss likely to be incurred by the claimant upon a breach and could be said to have contracted with that loss in contemplation) then interest, either compound or simple, can be recovered as special damages. Consequently, by pleading the actual outlay of interest incurred it is possible to recover the actual sum lost.

Reform

The current position is, as can be seen from the above, unsatisfactory. Whether simple or compound interest will be awarded can depend on the forum for dispute resolution and/or in the way in which a case is pleaded. Consequently the arguments for developing greater uniformity have gathered strength and have resulted in the Law Commission’s proposal that compound interest be made available in all money judgments.

The Commission has suggested that a compound interest rate be set by reference to the Bank base rate at a level designed to reflect market investment rates or the mortgage rate payable by private individuals. However, the more appropriate rate may be by reference to borrowing rates available to businesses since it is argued that claimants are more likely to be businesses which will have borrowed at such rates to compensate for the money owed.

It is submitted that the obvious reason for any reform is that the introduction of compound interest will reflect economic reality. If the claimant should have received money earlier, it has either missed an opportunity to invest the money or has had to borrow to cover loss. Such an opportunity to invest, or necessary borrowing, carries compound interest consequences.

It is also suggested that compound interest will encourage early payment or encourage defendants to bring about the early resolution of proceedings. Whether this is true is debatable. These arguments were also behind the introduction of the Late Payment of Commercial Debt Act 1998 but we find that some businesses are still reluctant to bring claims for late payment against those on whom they rely for repeat business.

Those against the principle of awarding compound interest point out that at present the rates of simple interest awarded are higher than commercial rates of interest and that this goes towards offsetting the effect of not awarding compound interest. Whether the end result of a claim will be satisfactory will depend on the length of time it takes to dispose of a case, in some cases a claimant will be under compensated for their loss if it is disposed of quickly whereas an order for compound interest in a long running case has the potential for significant over compensation.

There will always be those who object to change, but the Law Commission has recognised that it is time to reform the law. The current legal position is unsatisfactory. Dispute resolution procedures on this issue are anomalous and economic reality is not reflected. The Law Commission has put forward its proposals for change and now there is an opportunity to achieve a greater level of certainty and uniformity on this issue. Will this opportunity be taken? Only time will tell.

For further information please contact Alex Smith at alex.smith@cms-cmck.com or on +44 (0)20 7367 3480.