There is no dispute that a court has the power to award simple interest. However, the power to award compound interest would be a substantial benefit to the innocent victims of breach of contract.

Supreme Court of Canada gives courts the power to award compound interest on damage awards

By Michael MacKay

Bank of America Canada v. Mutual Trust Co.

Prejudgment and post-judgment interest • Supreme Court of Canada changes common law rule to permit courts to award compound interest on damages where necessary to fully compensate complainant • Section 128(4)(g) of the Ontario Courts of Justice Act includes right to compound interest at common law and in equity

The Supreme Court of Canada recently established that courts have the power to award the payment of compound interest on damages both before (prejudgment) and after (post-judgment) judgment in appropriate cases. The decision is a simple answer to a simple question. However, because of the nature of the legal system, the explanation is complicated.

Simple interest and compound interest are two different methods for calculating interest. The difference between them can be substantial. Simple interest is determined by multiplying the principal amount by the interest rate and the length of time the money is due. For example, a complainant that obtains a judgment for $1 million after four years of litigation, and is awarded simple interest at six per cent a year, would be entitled to $240,000 in prejudgment interest.

With compound interest, the unpaid interest is added to the principal every so often, and the interest for the next period is calculated on that larger amount. The more frequent the compounding, the more quickly the principal grows. On a $1 million judgment for four years at six per cent, the total interest would be roughly $266,769 if compounded semi-annually, and $270,490 (over $30,000 more than simple interest) if compounded monthly.

In this case, the difference between the trial judge’s award of compound interest and the Ontario Court of Appeal’s award of simple interest was roughly $5 million.

There is no dispute that a court has the power to award simple interest. However, the power to award compound interest would be a substantial benefit to the innocent victims of breach of contract.

What Happened

The dispute was between two lenders on a construction project.

In 1987 Reemark was developing a 300 unit condominium in Scarborough. The units were to be sold to investors. In November 1987, Mutual Trust Co. agreed to provide mortgage financing to the individual investors, so they could purchase the units when the project was built. Reemark would receive the mortgage proceeds. This agreement was called the Takeout Mortgage Commitment.

In the meantime, Reemark needed to fund construction. In December 1988, Reemark obtained a construction loan from the Bank of America Canada. Reemark would repay the loan plus interest at prime plus one per cent, compounded monthly.

To give the Bank security for its loan, Reemark and Mutual Trust assigned Reemark’s rights under the Takeout Mortgage Commitment to the Bank. When the project was registered, and the investors could take over their units, Mutual Trust would pay the Bank instead of Reemark, and Reemark’s indebtedness under its construction loan from the Bank would be reduced accordingly.

Unfortunately, by July 1991, the Toronto real estate market had collapsed. Mutual Trust refused to make the required advances. The Bank had to appoint a receiver for the project. The receiver ultimately sold the project for $22.5 million, much less than the Bank had lent Reemark.

The trial judge found that Mutual Trust breached the contract by refusing to make the required advances. He assessed the Bank’s damages at roughly $15 million. On top of that, the judge awarded the Bank pre-judgment interest at the rate set out in the construction loan (prime plus one per cent), compounded monthly, from the date of loss until judgment, and compound post-judgment interest calculated on the same basis from judgment until paid.

His reason for awarding compound interest was that, although the Bank “only intended to be an interim lender, the breach by [Mutual Trust] resulted in the [Bank] becoming a long term lender, which resulted in [the Bank] missing other investment opportunities as the money due to it was not paid and not available for other loans.”

The Ontario Court of Appeal reversed the award of compound interest, saying the courts do not have the power to award compound interest.

The Supreme Court’s Analysis

The Supreme Court said the issue was whether the trial judge had the power to award compound interest, and whether he was correct in doing so. The Court began its analysis by considering whether the courts should award compound interest.

First the Court considered the need to award interest at all. The Court observed that “the value of money decreases with the passage of time” due to inflation and other factors. Since the first principle of contract law is to put the complainant in the position it would have been in had the contract been performed, interest should be paid on damage awards:

To award the [Bank] damages equal to the value of the contract as if it had been performed on time, the court must first determine the dollar value of the promise to the [Bank] at the time the obligation was to have been performed, and then apply the appropriate interest rate and method of calculation to account for the time during which [the Bank] was not paid what was rightfully due. [Emphasis added.]

The real issue was which is the appropriate method of calculation: simple interest or compound interest. Both measure the time value of money. The Supreme Court observed that compound interest was usually more accurate:

Simple interest makes an artificial distinction between money owed as principal and money owed as interest. Compound interest treats a dollar as a dollar and is therefore a more precise measure of the value of possessing money for a period of time. Compound interest is the norm in the banking and financial systems in Canada and the western world….

Thus, while “…not historically available, compound interest is well suited to compensate a [complainant] for the interval between when damages initially arise and when they are finally paid.” To fully compensate a plaintiff for breach of contract, courts should award compound interest in appropriate circumstances.

The critical issue was whether courts could award compound interest — whether they have the jurisdiction (the legal authority) to do so.

The Supreme Court of Canada described ss. 128(1) and 129(1) of the Courts of Justice Act as containing “interest rates and methods of calculation … for which there is no evidence of a more appropriate interest rate and/or method of calculation.” Courts should resort to ss. 128(1) and 129(1), not as a general rule, but only when there is no other appropriate method.

The Ontario Court of Appeal concluded that interest was not payable by another right in this case. The courts’ equitable jurisdiction — their power to do equity when the rules of the common law are unable to do justice between the parties — would have been such a right. Unfortunately, the circumstances here were not congruent with previous cases where other courts awarded compound interest under their equitable jurisdiction.

The Supreme Court concluded that the common law (principles derived from previous court decisions) was also another right referred to in ss. 128 and 129. In addition, in this case the Supreme Court changed the rules of the common law to permit the award of compound interest.

The Supreme Court had previously, in Friedman Equity Developments Inc. v. Final Note Ltd., indicated that it could change common law rules: to keep the common law in step with the evolution of society; to clarify a legal principle; or to resolve an inconsistency.

The Supreme Court concluded that courts should award compound interest to keep the common law in step with the evolution of society, because compound interest is now routine in the business world. Mortgages and many other loans are calculated using compound interest.

As well, it found a conflict between the general principle of damages (full compensation for the complainant) and the common law prohibition against compound interest. The Supreme Court chose to resolve the inconsistency by removing the prohibition. Awards of simple interest would encourage borrowers not to repay their loans — why pay compound interest on a loan if you know the court is only going to make you pay simple interest? The Supreme Court said:

Where the parties have earlier agreed on a compound rate of interest, or there are circumstances warranting it, it seems fair that a court have the power to award compound post-judgment interest as damages to enable the plaintiff to be fully compensated when the award is finally paid.

Although compound interest was not traditionally available at common law, it is, as a result of this decision, now available in Canada. The Supreme Court concluded:

The courts have the jurisdiction to award pre-judgment and post-judgment interest at both common law and equity. Sections 128(4)(g) and 129(5) CJA allow courts to award interest by means of these powers as a substitute for the interest prescribed by those sections. This is such a case.

However, entitlement to compound interest is not automatic. Here the Bank’s entitlement to compound interest was not self-evident because Mutual Trust was not a party to the construction loan that called for compound interest. However, there were other factors: both parties were in the business of lending money at compound interest. The Supreme Court said:

An award of compound pre- and post-judgment interest will generally be limited to breach of contract cases where there is evidence that the parties agreed, knew, or should have known, that the money which is the subject of the dispute would bear compound interest as damages. It may be awarded as consequential damages in other cases but there would be the usual requirement of proving that damage component.

Those who wish to receive compound interest should make it clear in their contracts that compound interest is payable. When a dispute goes into litigation, complainants should provide sufficient evidence that they are entitled to compound interest.

Supreme Court of Canada

Major J.

April 26, 2002