The discount rate debate

What is the discount rate?

In cases where lump sum awards are to be made to a pursuer in respect of a future loss, for example future wage loss or future care costs, the fact that the entire lump sum is going to be paid at a point in time well in advance of when it is required has to be considered. Historically, it has always been assumed that a responsible pursuer will invest their lump sum and it will therefore accrue interest. If the interest earned on that lump sum is not taken into account, the pursuer would end up being overcompensated over time. A discount is therefore applied when the lump sum figure is being calculated. Done properly, the pursuer will receive a capital sum at the outset which will be invested, will earn interest in the future, but over time, that capital sum and interest combined will gradually be depleted and run out at a defined point in the future.

Why is it important?

It is a basic principle of our legal system that the law will try to put a pursuer back in the position they would have been in – insofar as money can do so – but for the harmful act. Pursuers should be neither undercompensated nor overcompensated; that much is uncontroversial. Achieving that desired goal in practice, though, is not quite so straightforward.

Speculating about what a person’s lost earnings or care costs will be in the future is a difficult task, and the further into the future one has to look, the more difficult the task in hand becomes. Speculating on what sort of return a pursuer can expect on a lump sum investment over lengthy periods is equally difficult.

In cases involving children, assumptions and calculations might require to be made about what is going to happen over a period of as long as perhaps 60-70 years into the future. In cases involving adults, some pursuers might still be within the education system or working towards a particular profession, while others may already have advanced along a defined and relatively certain career path.

Even in cases involving adults, assumptions and calculations can require to be made for periods of time as long as perhaps 40-50 years into the future in some cases, taking account of an aging population and increasing retirement dates. It is important to get both the lump sum and the discount rate correct if a pursuer is to be appropriately compensated. If the wrong figures are used at the outset, that initial error will be exaggerated year on year. If the wrong figure is used, the reality for the pursuer will likely become that the lump sum they receive at the outset may run out years before it should otherwise have done.

If a pursuer runs out of capital to pay for care costs, they cannot go back to the original wrongdoer (or the wrongdoer’s insurer) seeking an additional payment. Instead, that pursuer would have to fall back on the state. Quite apart from speculating on whether there will be an NHS in 30, 40 or 50+ years’ time, or what standard of care might be available on the NHS that far into the future, as a matter of principle, the taxpayer should not have to pick up the bill for a wrong committed many years beforehand by a defender who undercompensated a pursuer.

In practice, the reality is that the parties to a dispute simply do not come to the table with the objective of trying to calculate “the appropriate level of compensation for a pursuer”. Defenders’ interests lie in resolving claims on the best possible terms for their client, which usually means some figure lower than the appropriate amount and, where opportunities present, a figure significantly below what would otherwise be considered the appropriate amount of compensation. That aside, even if both parties were able to agree on all or most of the material facts and circumstances and the only substantive issue was over what discount rate should be applied, some very different final figures can be produced if different discount rates are used. The larger the lump sum and the longer the period it covers, the more exaggerated the difference becomes. In some cases, it can make a difference of millions of pounds.

Why is it an issue?

In basic terms, the discount rate has become an issue because the default rate that is currently used has not been updated since it was set a decade ago, and the world we live in has changed dramatically in that time.

In the recent case of Tortolano v Ogilvie Construction [2012] CSOH 162 (10 October 2012), Lord Brodie provides a full description of how the rate was set, both in Scotland (2002) and England (2001), and what the position was before those rates were introduced.

The procedural framework is as follows:

1. The Damages Act 1996

“1.–(1) …the court shall… take into account such rate of return (if any) as may from time to time be prescribed by an order made by the Lord Chancellor.

“(2) Subsection (1) above shall not however prevent the court taking a different rate of return into account if any party to the proceedings shows that it is more appropriate in the case in question.”

In Scotland, the Scottish ministers are substituted for the Lord Chancellor, but neither exercised their right to make an order prescribing a rate immediately.

2. Wells v Wells [1999] 1 AC 345

In this case the House of Lords, as it was then known, considered the issue of the discount rate. The court considered that:
(a) the fundamental principle of any compensatory award in personal injury actions is that a pursuer should, so far as it is possible to do, be fully compensated;
(b) a pursuer should not be expected to assume investment risks in order to provide for future losses or expenses; and
(c) the future losses or expenses that are being valued in each case should increase in line with inflation.

On the assumption that a pursuer is not expected to take unreasonable risks on their investment, the court considered that a prudent pursuer would invest in index linked Government securities (ILGS), and set the discount rate, at that time, at 3%. The court made it clear that this rate was to be used as a default rate until such times as a rate was prescribed by either the Lord Chancellor or, as the case may be, the Scottish ministers, unless there was a considerable change in economic circumstances.

3. The Damages (Personal Injury) (Scotland) Order 2002

In February 2002, the Scottish ministers produced an order setting the rate at 2.5%, which became effective immediately. This order followed a similar order made by the Lord Chancellor in 2001 for England. The Scottish ministers published an executive note relative to the making of their order. Within that note was included the passage:

“7. The general approach taken by the Executive is to set a rate which will not need to be frequently changed, barring any major economic changes.”

The general approach adopted by the ministers was consistent with that of the House of Lords. It makes sense that parties should not have to lead evidence or make submissions about an appropriate discount rate in each and every case that comes before the courts. Consistency is important; but if the rate is not reviewed at appropriate intervals, it will inevitably become out of date sooner or later, and the direct effect will be that pursuers would start to be either undercompensated or overcompensated, depending on the return on investments being achieved.

In practice, if there were signs that pursuers were in danger of being over-compensated because rates of return began to increase, it might be suggested that it would not be long before pressure was brought to bear on the Scottish ministers by other government or quasi-government bodies who would benefit from a review of the discount rate. Bear in mind that the Scottish ministers are commonly sued directly, but in addition, they also underwrite the various health boards in some very high value litigations.

4. The next 10 years

Ten years then pass without the rate being reviewed. Global economies were widely affected, some decimated, post-2008. A number of banks and major financial houses collapsed, were taken over or were bailed out by governments. Interest rates went down, stayed down – and similarly, as prudent investors will be aware, the rate of return on investments went down and stayed down.

In Tortolano, the pursuer sought to introduce averments describing in detail how the world has changed since the rate was originally set. The proposed discount rate for general damages was 0% and, because earnings have consistently outpaced inflation, a negative discount rate of -1% was proposed for loss of earnings.

The Ogden tables are not solely based on a 2.5% discount rate. They provide figures covering a range of rates at 0.5% intervals. The range in the sixth edition was 0 to 5% but, interestingly, the seventh edition of the tables was revised to cover the range from minus -2% to 3%.

There is now a significant tension between achieving the objectives identified by the House of Lords in Wells v Wells, chief among them the need to adequately compensate a pursuer, and, on the other hand, the fact that a now out-of-date order made by the Scottish Ministers still exists, specifying a default discount rate of 2.5%. Even senior counsel for the defender in Tortolano appeared to acknowledge that the rate is out of date:

“Mr Hanretty accepted that the statutory formulation was not entirely without difficulty. Section 1(1) required the court to ‘take into account’ the prescribed rate, but where the prescribed rate ‘shall be’ 2.5%, in cases where s 1(1) applied it was difficult to see what scope there was for determining a return on investment other than 2.5% over inflation, irrespective of the current realities of the market.”

The decision in Tortolano

Lord Brodie decided the issue in Tortolano on an interpretation of s 1(2) of the Damages Act (quoted above), with particular emphasis on the passage in italics.

It was argued for the pursuer that “in the case in question” could apply to all cases. Lord Brodie disagreed and held that that construction “fails, in my opinion, to give due weight to the words ‘in the case in question’. These, to my mind, indicate that the jurisdiction conferred by s 1(2) is case specific”.

The Lord Chancellor gave reasons for his decision to set the rate at 2.5% in England in 2001, which was adopted by the Scottish ministers in 2002. Lord Brodie was not persuaded that the fact that some or all of those factors may have changed since the rate was set, justified intervention. In his Lordship’s view, what matters is that “it [is] for the… Scottish ministers to fix the rate, not anyone else”.

The pursuer’s agents in Tortolano sought and were granted leave to appeal to the Inner House on this issue. Dates have already been fixed for the Inner House to deal with this matter on an urgent basis on 18 and 19 December 2012.

What should happen?

In my opinion, the “wrong” that needs to be addressed is that one of the fundamental objectives of the law of damages in Scotland is being undermined by the fact that the Scottish ministers have either failed or refused to review the discount rate since it was originally set. In fact, a cross-jurisdiction consultation on this point commenced in August 2012 and the period for responses from interested parties has now closed. A response is due to be published by 22 January 2013.

It is not right that both sides to a dispute can walk into a court with a copy of the Financial Times or Kemp & Kemp, which would report within it that the rate of return in ILGS does not reflect the prescribed default rate to be used in that courtroom. Parties should be able to rely on the fundamental objective that the court is there to adjudicate on a dispute and to adequately compensate a pursuer. Where a piece of legislation exists which has become out of date and conflicts directly with the role of the court, in my submission, the court should interpret the provisions of that statute in such a fashion that the “wrong” is addressed, particularly when there is an inbuilt discretionary mechanism by which that purpose could be achieved, and even more so when an executive order accompanying the piece of legislation makes specific reference to a rate which was to apply “barring any major economic changes”.

What then should happen?

(1) The consultation on the discount rate is due to publish its finding in the next three months. Ideally, the rate proposed will be uncontroversial and the ministers will act promptly to specify a new default rate. Beyond that, the ministers would do well to review the rate on an annual or at least biennial basis.

(2) The Inner House will hear an urgent appeal in the Tortolano case in December 2012. In practice, the discount rate is extremely important. It can make a difference of hundreds of thousands in some cases and millions in others. Proofs are currently being discharged or split whilst this issue remains unresolved. A queue is forming at court with parties eager to argue that the current default rate of 2.5% is unfair and that some other interpretation than that adopted by Lord Brodie should apply.

(3) In the absence of an effective solution coming either from the ministers themselves or from the Inner House, it would probably only be a matter of time before a pursuer takes the judicial review point discussed by Lord Brodie and challenges the Scottish ministers on their failure to review the rate in the face of the economic changes that have prevailed since the rate was originally set.

This is a very hot topic at the moment. I wait with interest to see how it unfolds.