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In a recent paper, we propose a principled approach for government bailouts of critical/systemic firms who find themselves in COVID-19-induced financial distress. We also demonstrate why bankruptcy is the wrong tool to address the problems of these types of firms.

The current pandemic threatens lives and livelihoods across the world. A key difference compared to previous market shocks is that lockdowns and related measures have, in certain instances, made it impossible for businesses to conduct their operations. This has resulted in a very specific type of distress, one that bankruptcy is not in the best position to address effectively. If there are no revenues, the design of bankruptcy laws makes them an inadequate tool—and the sheer volume of companies going through the process may put severe stress on the system. As has been demonstrated in another paper, the difficulties that the vast majority of companies are encountering may be better solved using different tools: bailouts, bail-ins or a combination thereof, deployed by the government in wide-ranging statutory schemes.

However, these schemes may not adequately address the issues of all companies; and the preservation of some of them—those that we refer to as critical/systemic—may be of such significant value to society that more intense assistance from the government is justified. We engage with the characteristics of firms that should be considered critical/systemic and the principles that should guide ad hoc rescues of those companies by the government.

Firms are critical/systemic if their failure imposes significant negative externalities on the economy (or, conversely, their preservation generates significant positive externalities) or if they provide the public with an ‘infrastructure’ not otherwise provided by the private sector. If firms are critical/systemic, the government should have the ability to bail them out, going beyond applicable statutory schemes and ensuring that the relevant externalities are considered when deciding whether to keep these companies as going concerns. Bankruptcy is process which seeks to accommodate and reschedule the conflicting rights of private financial stakeholders of distressed firms. It is typically not designed to vindicate public considerations involved in the assessment of such externalities.

Government bailouts, however, should be governed by principles, as any government intervention in the economy, and its associated efficiency and distributional effects must be considered with care. The guiding principles that we propose and elaborate on are (i) proportionality, (ii) efficiency, (iii) equity and (iv) transparency. The application of these principles should ensure that, if the government takes ownership of a private firm through an ad hoc bailout, this is a tool of last resort, and not more than temporary—and that the pre-distress investors properly contribute to the necessary measures.

Horst Eidenmüller is a Statutory Professor of Commercial Law at the University of Oxford.

Javier Paz Valbuena is a DPhil in Law candidate at the University of Oxford.