In Other Words

Double Your Money

Oxford University Comparative Law Forum, 2004, Online Albert Einstein — who knew a thing or two about numbers — reputedly hailed compound interest as the "greatest mathematical discovery of our time." Consider: If you invest $100 at a simple annual interest rate of 10 percent, you’ll have $110 after 12 months. But invest the same ...

Oxford University Comparative Law Forum,
2004, Online

Albert Einstein — who knew a thing or two about numbers — reputedly hailed compound interest as the "greatest mathematical discovery of our time." Consider: If you invest $100 at a simple annual interest rate of 10 percent, you’ll have $110 after 12 months. But invest the same $100 at the same rate, compounded quarterly, and you wind up with $110.47, because compound interest adds interest on the interest. Over time, compound interest can yield huge financial gains.

Curiously, legislatures and judges around the globe are reluctant to spread the wealth. "In today’s economic world," explains Villanova University law Professor John Y. Gotanda in the online Oxford University Comparative Law Forum, "compound interest, and not simple interest, is the norm in both third-party financing and investment vehicles. Yet, in disputes between transnational contracting parties, simple interest awards are the norm." This seemingly minor discrepancy represents an odd exception to the push toward harmonization and common standards currently under way in the global economy.

Legal verdicts in business disputes often include payments of interest by the losing party. Interest awards are common because claimants suffer not only from whatever profit or value they lose — say, a late loan repayment or an expropriated property — but also from their inability to invest or exploit that lost value. The bias against compound interest awards seems born of a mistaken belief by many courts that such awards are generally prohibited: A U.S. District Court ruled in 2000 that "the prohibition on compound interest was so well settled that it could be considered a principle of customary international law."

Yet Gotanda surveys laws in Europe, Asia, Australia, New Zealand, and the Americas and finds that, when awarding such damages, some nations "prohibit [compound interest], others allow it in certain circumstances, and a number of statutes are silent on the issue." In Italy, for instance, a guilty defendant must pay compound interest only when the two parties had a prior agreement to that effect and when interest is overdue by at least six months. In Belgium, the interest must be overdue by a full year before compound interest is allowed. And in Mexico, compound interest awards are prohibited unless the two parties previously agreed upon it.

Special tribunals resolving transnational commercial disputes typically opt for simple interest awards as well, Gotanda explains. More recently, though, some tribunals have begun awarding compound interest. In 2002, the International Centre for Settlement of Investment Disputes awarded U.K.-based Wena Hotels Ltd. $8.1 million in its claim against Egypt over properties expropriated in 1991, but it added a whopping $11.4 million in compound interest damages. Those 47 extra cents really add up, don’t they?

Gotanda argues that compound interest awards make sense when all parties have previously agreed to it, when the guilty party’s failure caused the claimant to incur compounded financing charges, or when the claimant can prove that it would have earned compound interest on the money owed. And in a global business environment where compound interest prevails, at least one of those conditions will generally hold.

Indeed, it is hard to imagine that this unlikely divergence between business and law will endure. In a globalizing economy, transnational standards are emerging in everything from accounting practices to intellectual property protection. Beginning in 2005, for example, Europe’s publicly traded companies will have to comply with the financial reporting standards issued by the London-based International Accounting Standards Board. This body is also working with U.S. accounting officials to establish a common global "language" for financial reporting.

Moreover, at a time when massive corporate fraud will likely produce major damage awards, the difference between simple and compound interest damages will prove impossible to ignore.

Why have legal practices lagged behind? Gotanda speculates that some laws may linger from eras when disputes were solved quickly, thus minimizing the gap between simple and compound interest. Less convincingly, he wonders if past judges and legislators preferred simple interest because they lacked the computers needed to estimate compound interest. That supposition seems a tad unfair: Economic historians trace the compound interest concept as far back as 2000 B.C., to scribal schools in Sumer and Babylonia. Like compound interest itself, these early thinkers’ influence is felt very much in the long term.

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