Legal framework

The legal framework governing interest is primarily contained in the Interest Act, 1978, along with Section 34 of the Civil Procedure Code, 1908 (CPC), and section 31(7) of the Arbitration and Conciliation Act, 1996.

These provisions generally allow only simple interest, with section 3(3)(c) of the Interest Act going further and specifically providing that “nothing in this section shall empower the court to award interest upon interest”.

Despite this legislative hindrance, Indian courts have developed a framework allowing compound interest or “interest on interest” under certain conditions.

In Renusagar Power Co. Ltd. v General Electric Co., 1994, the Supreme Court upheld a foreign arbitral award granting compound interest, holding that section 3(3)(c) of the Interest Act does not preclude awarding compound interest under contract, usage or statute as compensatory damages. Post Renusagar, the jurisprudence has evolved towards legitimising compound interest claims in specific circumstances.

In Indian Council for Enviro-Legal Action v Union of India, 2011, the Supreme Court held that while statutes may limit courts to awarding simple interest, compound interest could be awarded in restitution, emphasising the need to prevent unjust enrichment by removing incentives for delay or wrongdoing.

Guided by these considerations, the Supreme Court, in T.N. Generation & Distribution Corpn. Ltd. v PPN Power Generating Co. (P) Ltd., 2014, upheld the finding of the Appellate Tribunal for Electricity that since the respondent’s loans were payable on a compound interest basis, the interest for late payment would also be compounded.

However, in State of Haryana v S.L. Arora and Co., 2010, the Supreme Court took a more restrictive view, holding that unless specifically provided for, interest should be simple – not compound – and that arbitral tribunals lacked a general discretion to award compound interest.

This restrictive approach was overruled in Hyder Consulting (UK) Ltd. v State of Orissa, 2015, which dealt with section 31(7) of the Arbitration Act. The majority held that the term “sum” in the section includes pre-award interest, thereby allowing post-award interest to be calculated on the entire amount, i.e. principal sum and pre-award interest.

The court distinguished this from section 34 of the CPC, which restricts the courts’ power to grant compound interest by specifically using the term “principal sum”. This position was reaffirmed in UHL Power Co. Ltd. v State of H.P., 2022, where the Supreme Court upheld an award granting compound interest.

Latest developments

Despite these strides, the Supreme Court, in above-mentioned D. Khosla & Co. held in August 2024 that courts should not ordinarily grant compound interest. In this case, an arbitral award under the Arbitration Act, 1940 awarded 12% simple interest for the pre-award period and 15% for the post-award period.

The argument that pre-award interest should form part of the principal for post-award interest, thereby compounding the interest, was rejected. The court clarified that neither statute nor contract provided for such interest on interest.

Key takeaway

While Indian courts acknowledge the importance of awarding compound interest in specific instances – particularly within the context of restitution and compensatory damages – the prevailing rule remains that simple interest is ordinarily granted unless compound interest is expressly provided for by statute or contract. Hence, it is crucial for businesses to clearly articulate the nature of interest, whether simple or compound, in their contracts. By doing so, parties can better protect their financial interests and ensure clarity in their contracts.

This article was originally published in Asia Business Law Journal on 12 December 2024 Co-written by: Atika Vaz, Partner; Anumeha Karnatak, Senior Associate; Eeshan Sonak, Associate. Click here for original article.

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