COVID-19 has significantly disrupted the conduct of business around the globe. In jurisdictions that impose one or more ‘lockdowns’, multiple sectors of the real economy must endure prolonged periods of reduced trading or even total shutdowns. The resulting revenue losses will—absent some intervention by the state, or voluntary accommodation from creditors and counterparties—push many businesses to default on debts as they fall due. In a new working paper, we consider how policymakers should respond to the emergence of such a cohort of newly defaulting debtors. Our conclusion is that, even in jurisdictions with an insolvency framework that functioned well in pre-pandemic times, policymakers should consider routes to delivering relief outside this framework, rather than risk distorting this framework to accommodate the peculiar features of COVID-19 distress.
The starting point for our analysis is the basic proposition that it is not only businesses that have borrowed (ie those with external debt finance) that are at risk of defaulting during a period of COVID-19 related trading disruption. Even a business with no financial creditors will typically have fixed costs that accrue periodically under executory contracts (for example, the obligation to pay wages under a contract of service, or to pay rent under a lease). Such obligations are met out of turnover, but in the absence of turnover they will continue to accrue, and once accrued constitute a debt that exposes the business to default risk. Revenue losses from COVID-19 related trading disruption can, then, push a business with little or no debt into a state of financial distress with all its associated costs, including the risk that the assets of the business will be subject to a forced sale at a ‘fire-sale’ price.
As we emphasise in our paper, the initial revenue losses associated with a period of trading shutdown are irrecoverable. But if these initial losses are left to lie where they fall, their effects will be amplified by the costs of financial distress for all businesses in adversely affected sectors that do not have sufficient cash (equity) to absorb the initial loss. These costs, which are additional to the initial, unavoidable revenue loss, mean that the losses in adversely affected sectors and the gains in sectors that do better during a period of shutdown (for example, online video conferencing providers) do not net out to zero. While policymakers cannot recover the initial loss, they can act to minimise the amplification effect by how they treat the cohort of newly defaulting debtors.
In jurisdictions in which there is already a well-functioning reorganisation procedure that is capable of preventing fire-sales and restoring the debtor to solvency, the temptation may be to subject the newly defaulting cohort to treatment by the prevailing, pre-pandemic law. In the paper, we argue that this temptation should be resisted. This is not only because there are significant costs associated with using many such procedures, and it is plain that such costs should not be inflicted on the subset of the cohort that can reasonably expect to again achieve a turnover exceeding costs (including the costs of servicing any debt) on the expiration of lockdown restrictions. Nor is it simply because of concerns about institutional capacity (the ability of the system to treat a large cohort of businesses that have become distressed simultaneously), though clearly this is also a serious concern.
In addition to these factors, we argue that reorganisation procedures are likely to be, by design, ill-suited to the treatment of COVID-19 distress. Such procedures are typically aimed at reducing the debt burden of a business that, absent the requirement to service such debt, would be able to achieve a turnover that exceeds operating costs. But in COVID-19 conditions, some debtors will be distressed only because they cannot meet (fixed) operating costs. Such debtors will not be well-served by a procedure that is geared towards restructuring financial debt (of which there may be none), and which assumes the debtor can continue to pay rent and other liabilities periodically accruing during the procedure (it cannot, because it cannot presently generate sales). Reorganisation law may, of course, be changed—either by the legislature or by the courts, through their interpretation of the statutory provisions—to adapt to the particular features of COVID-19 distress. But that is likely to produce a reorganisation law that works far less well in post-COVID conditions, with associated (adverse) implications for the cost and availability of credit for all businesses. Avoiding such distortions is a major concern of our paper.
If relief is not to be delivered through reorganisation law, how are debtors to be insulated from the costs of financial distress, including the risk of fire-sale outcomes? In the paper we explore two alternatives routes to relief—bail-ins (mandatory orders to creditors or counterparties to forgive), and bail-outs (offers to assume the debtor’s liabilities, or a class thereof). We compare bail-ins and bail-outs to the delivery of relief through reorganisation law (“bankruptcy”) along a range of dimensions. With the exception of cross-border effects (where bankruptcy is potentially superior to bail-ins, though not bail-outs) we find few advantages in relying on the prevailing insolvency law framework, however well-functioning in normal conditions. By comparison with use of this framework, the alternative routes to relief require few legal resources, are more readily tailored to the particular features of COVID-19 distress, and, crucially, are less likely to produce an unduly ‘debtor-friendly’ reorganisation law that persists into good times.
In theory, states could relieve debtors by offering to assume debts (a bail-out), ordering a one-time forgiveness of debts (a bail-in), or (perhaps more plausibly) by some combination of the two. How should states decide which route to take? Plainly, this will be highly context-specific: some states will have greater capacity to assume private liabilities than others; some creditors and counterparties will be better positioned than others to take on the loss under a mandatory forgiveness scheme. It is, however, possible to articulate some principles that appear likely to be of general relevance, and we do so in tentative terms in the final part of the paper.
We suggest that relief should be proportionate, in the sense that it should not go beyond that reasonably thought necessary to minimise the amplification of the economic shock caused by periods of trading shutdowns (Principle 1). In choosing between forms of relief, and in designing the terms of relief, states should seek to minimise distortions to efficient private bargains and private law rules, especially the prevailing debtor-creditor law (Principle 2). Transfers should be from the less financially constrained to the more financially constrained companies and individuals, taking loss absorbing and risk bearing capacity into account (Principle 3). Policies should attempt to achieve a good ‘fit’ with the existing institutional infrastructure in a particular jurisdiction (Principle 4). Finally, a transparent process for determining the allocation of pandemic-induced costs should be established, to minimise the risks of damage to the legitimacy of the state in the post-crisis period (Principle 5).
Kristin van Zwieten is Clifford Chance Associate Professor of Law and Finance at the University of Oxford.
Horst Eidenmüller is Statutory Professor of Commercial Law at the University of Oxford.
Oren Sussman is Reader in Finance at Saïd Business School, University of Oxford.