Aside from settings where the pre-award interest rate is set by contract, tribunals are often guided by the notion of a commercial rate (e.g., “Compensation shall [among other things] include interest at a commercially reasonable rate.”[1]). In these settings, tribunals have several options to choose from. Since 2015, the rate most frequently awarded by tribunals has been LIBOR plus a spread. Among those cases, more than half have applied LIBOR+2%.[2] In this article, we address whether LIBOR+2% is the most appropriate “commercially reasonable rate” or “normal commercial rate” applicable to each case.
It is a central tenet of finance that interest rates vary with the likelihood of default, i.e., with the probability of losses. It follows that a commercially reasonable rate is one that is commensurate with the likelihood of default. We illustrate this relationship between risk and rates below, using credit ratings, which measure the likelihood of default. Figure 1 shows the spread over LIBOR of debts of different corporate ratings, namely AA (in green) and B (in blue), as well as the frequent 2% spread over LIBOR (in orange).
Figure 1: Corporate bond-yield spreads to LIBOR[1]
This figure shows that safer debts (rated AA) pay interest rates well below a 2% spread over LIBOR, whereas riskier debts (rated B) pay interest rates with more than a 2% spread over LIBOR. Different companies and their debts will have different credit ratings, of which the two portrayed in this figure (AA and B), are just two examples. As a result, LIBOR+2% does not represent a commercial reasonable rate associated with either type of company or with the vast majority of commercial situations, but rather, an imperfect middle ground that does not correspond to rates in the real world.
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[1] See, e.g., Free Trade Agreement Between the Government of Canada and the Government of the Republic of Chile (1997).
[2] Tiago Duarte-Silva & Swati Kanoria, “The Importance of Interest in Arbitral Awards,” CRA Insights, 2022.
[3] Bond yield ratings based on index of one- to three-year corporate bond yields across credit ratings. Data from Eikon. As of April 13, 2022, LIBOR was 2.3%, AA corporate bond yields were 2.6%, and B corporate bond yields were 6.8%.
