In a recent decision in this case (which is the latest in a long series of rulings in this matter), the Court of Chancery determined that a director and major shareholder breached its fiduciary duties in connection with the conversion of his debt into equity, which also diluted the minority shareholder. That transaction occurred in March of 2000. The decision which determined that he breached his fiduciary duty was issued in May 2010.
The issue addressed in this short letter ruling is what the appropriate rate of pre-judgment interest should be and in particular whether that rate should be fixed in March of 2000 or whether it should vary with the substantial fluctuation in interest rates over the ensuing years. See Section 2301(a) of Title 6 of the Delaware Code which provides that the legal rate of interest is determined by adding 5% to the Federal Reserve Discount Rate. That Federal Rate in March 2000 was 5.5% and by comparison, in Nov. 2002 it was .75%. When the action was filed in March 2003 it stood at 2.25%. By Dec. 2008 it was .5% and currently is .75% again.
The Court emphasized that the legal rate of interest in a court of equity is a mere guide, and not an inflexible rule. See footnote 10. Thus, the Court has broad discretion to fix the rate of pre-judgment interest based on principles of fairness under the circumstances.
In determining a fair rate of interest, the factors that the Court considered were two-fold. First, the purpose of pre-judgment interest is intended to compensate the petitioner for the loss of the use of its capital during the pendency of the litigation, and secondly, it addresses the benefit the defendant enjoyed during the same period of time.
The monetary amount determined as damages for the breach of fiduciary duty was approximately $300,000. If a fixed rate of interest were used based on the rate of 10.5% in effect at the time of the disputed transaction, the amount that rate would yield, compounded quarterly, would be approximately $562,000, but a variable rate would yield slightly more than $390,000, or a difference of approximately $170,000.
The Court explained that this was not a statutory appraisal action, but the equitable remedy imposed by the Court drew extensively from the case law developed in appraisal jurisprudence. Because the harm suffered by the plaintiff was in the dilution of its shares, the corresponding loss of capital is deserving of fair compensation, but excessive interest would constitute an inequitable windfall.
The point of reference often used by the Courts in this context is what a prudent investor would have realized during the relevant period of time. In this situation, because it is so unlikely that the hypothetical prudent investor would have achieved a 10.5% rate of return over the past decade during which the Federal Discount Rate frequently stood at all-time lows, and the equity markets often encountered turbulence, the Court could not conclude that a fixed rate would be fair. Compare generally Section 262(h) of the DGCL which addresses the applicable rate in appraisal cases. See also footnote 16 which notes that the Dow Jones Industrial Average in March 2000 was slightly over 11,000 but that as of March 2010 the Dow Jones Industrial Average was only approximately 10,800. Additionally, the NASDAQ Composite in March 2000 was slightly under 5,000, but in March 2010 had fallen to approximately 2,400.
Although the defendant argued that the Court of Chancery on some occasions has exercised its discretion to reduce the term over which interest accrues on damage awards, in this situation the Court declined the request and applied the variable rate of interest for the full pre-judgment period. Although this case was filed shortly after the Court determined that it did not fall within the scope of a companion appraisal action, the Court did not fault the plaintiff for the protracted length of the litigation.