India’s low interest rate regime in litigation

Any judicial adjudication takes time. When claims are finally settled, the successful party has to be compensated for the time value of money. Otherwise, the party is not put in the same position as if the legal harm had not been done. This requires a successful party recovering interest on the monetary claim.

How much interest is the successful party entitled to? The law and the courts must answer this question. There are four possible ways of doing this. (i) Leave it to the discretion of the courts; (ii) calculate the cost of capital of the parties; (iii) enforce a rate agreed to between the parties; or (iv) fix a reference rate in the statute. Each method has its advantages and disadvantages. While discretion of the courts and statutory rates are easier to implement, they do not reflect the cost of delayed payment to the successful plaintiff. This is done when the court awards the opportunity cost of money to the successful party. However, this method is difficult and prone to variation. It may not be feasible to calculate the opportunity cost of a party accurately.

India follows a mixed approach to determine the rate of interest. In some cases, it specifies the rates and leaves it to the discretion of courts in others. The treatment varies depending on whether the case is a general suit or is governed by specialised legislation. Due to multiple laws that were enacted at different points of time, India has ended up with a complicated legislative framework for calculating interest rates. Compounding this problem has been the judicial approach. Jurisprudence on this complicated legal framework is divergent and devoid of underlying economic philosophy. Poor legislative drafting has been interpreted in ways that lead to unpredictable results.

The rate for most civil disputes in India was last amended in 1976. Since then, economic conditions of India have changed. This has resulted in a scenario where interest granted by courts have become less and less in line with market rates. Overall, both the legislative framework and its judicial interpretation have favored paying lower interest rates than what would be the reasonable cost of capital. This consistent practice of awarding lower interest rates has economic consequences. It generates perverse incentives for litigants.

Since the time the legislation was last amended, India went through multiple economic upheavals. The risk-free rate of return doubled and then went down again. However, the courts continue to award substantially lower interest rates. If the interest rate awarded by the courts is lower than the cost of borrowing for the losing defendant, it can create an incentive to drag out litigation. Every year that a losing defendant is able to delay the eventual judgment, she makes a notional profit. This profit is the difference between the rate at which the party can borrow from the market and the rate awarded by the court at the end of the litigation.

The problem of awarding low interest rates is further compounded by the uncertainty in the rate that the court will finally award. Indian jurisprudence shows that there is no predictability in whether interest will be awarded, at what rate it will be awarded, and for what period? Courts frequently change the statutory provision through interpretation, and even overrule interest rates agreed to by the parties. This causes uncertainty in contracts. Parties are unable to foresee the damages that will be awarded if the commitments under the contract are not honored. Such uncertainty leads to less contracting, or contracting being limited between parties who trust each other, or excessive capital being locked up in guarantees.

This has important consequences. India’s slow judiciary and poor record in contract enforcement have recently gained prominence. However, most solutions offered for the problem revolve around increasing the size and capacity of the judiciary. We think that perverse incentives caused by awarding low interest rates and lack of certainty about interest being awarded may contribute to the delay. If this is the case, then increasing the number of judges will not solve the problem. India needs substantial legal changes in awarding interest to successful parties in litigation. Such rates should reflect the economic reality of India and consider the cost of borrowing for average litigants. They should also consider the opportunity cost of money for successful litigants. The law should be a general principle and not be dependent on the nature of the litigation.

This paper contributes to the literature on analyzing perverse incentives and unintended consequences created by law. Our findings are similar to which shows that laws may have unintended consequences. Starting from, who argued that minimum wage legislation had the opposite effect of reducing income, there is growing literature showing that legislation has consequences unforeseen by the creators, including precisely the opposite outcome. This paper argues that in addition to the perverse incentive to extend litigation, interest laws in India may be contributing to the problem of judicial delays. In the lines of, judicial delays in India may be a product of incentives rather than a shortage of judges.

Karan Gulati is researcher at Symbiosis Law School and Shubho Roy is researcher at University of Chicago. This paper was presented at the APU-NIPFP workshop Strengthening the Republic #1, January 11, 2020.