"I realise that some of my criticisms may be mistaken; but to refuse to criticize judgements for fear of being mistaken is to abandon criticism altogether... If any of my criticisms are found to be correct, the cause is served; and if any are found to be incorrect the very process of finding out my mistakes must lead to the discovery of the right reasons, or better reasons than I have been able to give, and the cause is served just as well."

-Mr. HM Seervai, Preface to the 1st ed., Constitutional Law of India.

Thursday, June 3, 2010

Interest Rate under the Indian Arbitration and Conciliation Act, 1996

In this blog, we had three posts on the consultation paper (CP) released by the Ministry of Law and Justice (Ministry) proposing to amend the law of arbitration in India. One was a guest post that gave a descriptive analysis of what the CP was all about. The other two posts (which can be found here and here) were on the suggestions of the Ministry regarding the applicability of Part I of the Arbitration and Conciliation Act, 1996 to international commercial arbitrations held outside India. The aim of this post is to analyse the proposal relating to the rate of interest [readers may please note that we have not dealt with the CP in the same order as the CP does; For example, the aspect relating to the applicability of Part I of the Act was designated as (A) in the CP and the proposal relating to interest rate is (E) in the CP. Nevertheless, we will try to cover all the aspects of the CP].

Article 31(7) of the Act provides:

"(a) Unless otherwise agreed by the parties, where and in so far as an arbitral award is for the payment of money, the arbitral tribunal may include in the sum for which the award is made interest, at such rate as it deems reasonable, on the whole or any part of the money, for the whole or any part of the period between the date on which the cause of action arose and the date on which the award is made.

(b) A sum directed to be paid by an arbitral award shall, unless the award otherwise directs, carry interest at the rate of eighteen percentum per annum from the date of the award to the date of payment

The rate of interest, by default, has been fixed at 18% per annum. The parties could, however, agree to the contrary, providing for a different interest rate.

The CP proposes that since the said 18% per annum rate of interest in this economic scenario is too harsh, the interest rate ought to be linked to the interest rate fixed by the Reserve Bank of India (RBI). Hence, the CP seeks to modify S 31(7)(b) as follows:

'(b) A sum directed to be paid by arbitral award shall carry interest at the rate of one percent higher then the current rate of interest from the date of award to the date of payment.

Explanation- The expression “Current rate of interest” shall have same meaning as assigned to it under clause (b) of Section 2 of the Interest Act, 1978.

S 2(b) of the Interest Act, 1978 reads as follows:

'(b) "current rate of interest" means the highest of the maximum rates at which interest may be paid on different classes of deposits (other than those maintained in savings account or those maintained by charitable or religious institutions) by different classes of scheduled banks in accordance with the directions given or issued to banking companies generally by the Reserve Bank of India under the Banking Regulation Act, 1949 (10 of 1949).

Explanation.-- In this clause, "scheduled bank" means a bank, not being a co-operative bank, transacting any business authorised by the Banking Regulation Act, 1949 (10 of 1949);

As per the RBI’s website, the Prime Lending Rates (PLR) of different banks are between 11-12%. This article in Business Standard describes the Benchmark Prime Lending Rates of various Indian Banks.

Effectively, the Ministry proposes to fix the interest rate at around 12%. The only justification it provides is the 'present economic scenario'. We are not sure whether this is an adequate justification. Three points are worth noting here. One, at the time when the CP was released (April 2010), the Indian economy had already started recovering (so did many countries in the world). Two, the amendments proposed are far-reaching amendments, meant to extend the longevity and usefulness of the Act. From this perspective, I am not sure if this provision has to be amended on the basis of a temporary phenomenon like economic crisis. What would happen once the economic crisis is over? cessante ratione legis cessat ipsa lex. Three, what was the basis of fixing the interest rate at 18% in Section 31(7)(b)? The CP does not discuss the reason for the law as it exists.

The point which we are making in this post is that before the said provision is amended as per the Ministry’s proposal, the following must be examined:
  1. What was the basis for S 31(7)(b) to fix interest rates at 18%?
  2. Why is the new proposal to fix it at the PLR?
  3. Prudent basis/ bases for fixing interest rates must be determined and then incorporated in the Act.
Interest is the payment which would an entity would be entitled to (over and above the principal)* , had the principal amount been available to it for its use from a particular point of time in the past. The question is how is this sum to be determined? In general, an entity would be entitled to an interest rate which is equivalent to the interest rate which it would have obtained had it invested the principal amount in the least risky investment available in the market. However, the problem arises when an entity would have used the particular amount to obtain returns at a percentage that is far higher than the interest rate which the least risky investment would give. The ideal solution in such a case would be to link the interest rate to the performance of the entity. This would be the correct compensation that an entity would be entitled to had it been in possession of that principal amount.

We do not pretend to be experts on aspects relating to finance. However, readers may spare some time and read this well-researched thirty page (including end notes) article titled ‘Interest as Damages’ by Sénéchal and Gotanda, 47 Colum. J. Transnat'l L. 491 (2009). The authors have posted a draft of the said article in SSRN (though I am not sure if both are identical) which you can download from here. The authors discuss, inter alia, the bases on which interest rates should be determined and come to a conclusion that interest rates in respect of publicly traded corporations should be calculated by referring to the weighted average cost of capital and for privately held firms, interest ought to be calculated by adding up a risk–free rate (which is theoretically impossible) and risk premium.

* Added after posting

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