Towards a Principled Approach for Bailouts of COVID-distressed Critical/Systemic Firms
By
By
Horst Eidenmüller[1]* & Javier Paz Valbuena[2]**[3]ψ
In this Article, 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 these firms’ problems.
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. 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. The bankruptcy process is not designed to vindicate such public considerations.
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.
The COVID-19 pandemic threatens lives and livelihoods across the world. The necessary healthcare measures adopted by governments across the globe, from social distancing to strict lockdowns, disrupt the business models of a large number of companies.[4] Scholars on both sides of the Atlantic have gone to significant lengths to establish the best way to meet the challenge of massive numbers of businesses simultaneously in distress across vast parts of the economy.[5] Policymakers are committing public rescue funds to assist struggling firms on an unprecedented scale.[6] However, irrespective of how well constructed and implemented the general policy response may be, it will not be sufficient in all cases.
Since the outbreak of the COVID-19 pandemic, a number of companies have emerged as potential candidates for special treatment by their respective governments in an attempt to keep them operating outside bankruptcy.[7] We have already witnessed headline-grabbing bailouts, such as the German government’s rescue of flag carrier Lufthansa[8] and tour operator TUI,[9] France’s assistance to Eurostar[10] and Renault[11] (and carmakers generally),[12] and the U.S. Treasury’s bailout of defense contractor YRC Worldwide.[13] Similar ad hoc bailouts will undoubtedly follow as the economic impact of the COVID-19 pandemic continues to slash the financial resources of companies across the globe. At the same time, given the magnitude of public funds involved, government interventions will increasingly come under enhanced scrutiny, such as with Franco-Dutch airline Air France-KLM.[14]
We will refer to a narrow subset of businesses, such as the ones mentioned in the previous paragraph, as “critical/systemic.” Arguably, these businesses, if financially distressed, warrant an ad hoc, tailored response—both because their situation cannot be effectively remedied with all-encompassing measures and general stimuli to the economy and because their particular characteristics call for such a heightened effort.
This Article intends to make two key contributions in this respect. The first is to explain why it is not a good idea to let critical/systemic businesses go through bankruptcy proceedings. The key point here is that the bankruptcy process is not designed to take into account the positive or negative externalities typically associated with the continued operation or liquidation of critical/systemic firms. The second intended contribution is to detail the principles that should be followed when implementing alternative proceedings designed to deal with the distress of those critical/systemic businesses, which we will generally refer to as “non-statutory, ad hoc bailouts.”
We begin in Part II by explaining why the current wave of COVID-distressed firms is special, and why bankruptcy laws may not be the right tool to deal with these firms. We subscribe to the view that the appropriate way to manage the cohort of distressed businesses resulting from the pandemic is primarily through statutory schemes of government-led bailouts or government-mandated bail-ins.[15] In Part III we discuss which characteristics are required for a business to be considered critical/systemic and thus be a potential subject of a “non-statutory, ad hoc bailout” as well as why those characteristics make bankruptcy an especially poor tool to deal with this type of businesses. Part IV then builds on the concept of non-statutory, ad hoc bailouts and the characteristics of critical/systemic businesses to establish the guiding principles for the implementation of such bailouts. These are public interventions with public money to pursue public objectives. It is crucial that the rights of everyone involved (from the shareholders of the companies to the governments and the taxpayers) are properly safeguarded and the intervention does not have unintended and adverse consequences for public welfare.
With every shock or crisis, there is always the temptation to justify what is unique about it and why our past models do not work. Yet most of the time, there is nothing that new.[16] However, the COVID-19 pandemic has indeed created a quite peculiar situation for many businesses. The public health measures adopted by governments across the globe have resulted in a very specific situation affecting vast numbers of businesses across most industries: economically viable and financially sound businesses have seen their revenues evaporate overnight.[17] In addition, these circumstances often combine with other issues pre-dating the COVID-19 pandemic, such as very high levels of debt in the capital structures of companies across both sides of the Atlantic[18] and a tally of “zombie” companies[19] far exceeding that seen during the Great Recession.[20]
Bankruptcy law is a useful tool to reorganize businesses in normal times, whether in the growing or contracting phase of a regular business cycle.[21] The bankruptcy process is governed by legal rules providing certainty and predictability.[22] Many jurisdictions around the world have one or more dedicated “restructuring proceedings” on their statute book.[23] In jurisdictions such as the United States and the United Kingdom, there is a long history of fine-tuning of this type of law.[24] A sophisticated ecosystem of judges, lawyers, bankers and other bankruptcy practitioners has been optimized for a certain “normal,” which includes anticipated downturns in the business cycle.[25]
However, the design features of bankruptcy procedures are inapt to handle the massive influx of COVID-distressed businesses. Bankruptcy is complicated and costly.[26] A procedure such as Chapter 11 of the Bankruptcy Code in the United States is geared towards an encompassing financial and possibly also economic restructuring of a distressed firm.[27] The firm’s finances are rescheduled, and management gets some “breathing space” for an operational restructuring through a lengthy process that could last more than a year.[28] However, this benefit comes at a cost: the direct and indirect costs of bankruptcy can eat up as much as 10-20% or more of a firm’s value.[29]
The overwhelming majority of COVID-distressed firms do not need such a process, nor are these firms in a position to afford the bankruptcy costs previously mentioned. These firms do not require a substantial financial and/or economic restructuring. Rather, they are experiencing a temporary cash-flow problem because of lockdown-induced trading disruptions. What these firms need is temporary and limited financial assistance. That is not what bankruptcy is designed to provide.[30]
Hence, bankruptcy is not a good solution to COVID-induced financial distress.[31] This deficiency is not primarily a problem of lack of resources.[32] Bankruptcy’s failure to adequately address the special features of COVID-distress is structural and not so much one of scale.[33] The bankruptcy process does not provide the fix that the overwhelming majority of COVID-distressed firms need.
Nor is it a good idea to try to adapt bankruptcy laws to better deal with the requirements of the pandemic, as many jurisdictions have tried.[34] A tested instrument, which works well for most firms in normal times, should not be modified to deal with extraordinary situations such as COVID-19 or other unforeseen pandemics. Whatever tweaks may serve to make bankruptcy law marginally better at dealing with COVID-19-related distress will also move the legislation and its application from its current equilibrium to a less optimal situation in the long run.
Accordingly, we posit[35] that the best option is an approach based on providing financial assistance to the businesses affected by significant but temporary decreases in revenue, avoiding the need to file for formal bankruptcy protection at least until the current COVID-19 situation has been brought under control and these businesses are in a position to resume normal trading.[36] Such relief can be effected by the relevant governments in two main ways (or different combinations thereof), namely bailouts and bail-ins. In a bailout, it is the state or other public institution who funds the relief; in a bail-in, it is private stakeholders.[37] The difference is in the source of the relief funds.[38] The size of these funds is not decisive when characterizing a measure as a bailout or bail-in.[39]
Both bailouts and bail-ins have the same goal, namely, to provide financial breathing space to a distressed company when bankruptcy seems to be the only other option. Bailouts comprise “government . . . payments (including loans, loan guarantees, cash, and other types of consideration) to a liquidity-constrained private agent in order to enable that agent to pay its creditors and counterparties.”[40] Bail-ins serve a similar function, i.e., to provide some breathing room to businesses until trading can resume.[41] However, they do so by pausing or reducing claims at the expense of counterparties rather than taxpayers.[42] One can define bail-ins as a government mandate to “in a ‘one time’ way, outside of formal reorganization law . . . [provide] some degree of forgiveness by creditors or counterparties.”[43]
In the current COVID-19 crisis, one of the first types of government response came in the form of deploying statutory bailout and bail-in schemes that were already in place pre-pandemic.[44] In addition, dedicated (new) COVID-19 schemes were created and implemented to combat the economic effects of the pandemic.[45] Finally, instead of being based on a general statutory scheme, which applies to a larger group of firms, a bailout can also be effected ad hoc to rescue an individual firm or a small group of firms.[46] If private stakeholders bail out the firm, we have a private workout (see Table 1).
| Table 1 | |||
| Source of Funds/Type of Scheme | Statutory Scheme, Pre-Pandemic | Statutory Scheme, Post-Pandemic | Ad hoc Intervention |
| Public | Statute-Based Bailout | Statute-Based Bailout | Ad hoc Bailout |
| Private | Statute-Based Bail-In |
Statute-Based Bail-In | Private Workout |
Politically, bailouts are more popular than bail-ins.[47] Bailouts shift the financial burden to future generations, and they spread this burden over the whole population—there are clear winners and no clear losers.[48] By comparison, bail-ins target a select group of private stakeholders who are impacted immediately.[49] From a fairness perspective, both approaches have at least some merit: the pandemic affects us all, hence financial aid should come from taxpayers’ resources; on the other hand, stakeholders of private firms have voluntarily assumed specific risks, including, in particular, bankruptcy risks.
COVID-related statutory bailout schemes in many jurisdictions help prevent a mass influx of distressed businesses into their respective bankruptcy systems.[50] However, sometimes these statutory schemes do not provide sufficient resources to successfully allow certain (large) critical/systemic companies to remain viable without requiring further arrangements.[51] At the same time, bankruptcy proceedings remain an unattractive option, for reasons we explore in the next Part.
Hence, in the following Part, our focus is specifically on the bailouts in the upper-right corner of Table 1: those that constitute non-statutory ad hoc interventions.
Which companies are critical/systemic, and what are the characteristics that allow us—and the relevant governments—to identify them? This is one of the key questions that we set out to address with this Article, since the characteristics of those firms permit us to tackle two very important issues: what are the reasons that justify firms being subject to an ad hoc bailout, if needed, and why are regular bankruptcy proceedings not the most appropriate tool to deal with such firms.
A first approach at defining critical/systemic firms may aim to understand what types of companies (and in what sectors) different governments across the world have considered important enough to directly intervene in a situation of crisis on an ad hoc basis to ensure their survival. Analysing what firms have been rescued by governments across the globe in ad hoc bailouts, and why they have been rescued, may provide us with a starting point to formulate our proposed definition.
According to empirical research conducted in the aftermath of the Great Recession, ad hoc bailouts that are conducted by governments in practice exhibit a series of commonalities.[52] First, governments tend to bail out firms that present a “systemic risk.”[53] Second, the political orientation of governments seems to have an effect on the type of firms that receive support.[54] Left-of-center governments tend to rescue more firms and firms with larger numbers of employees,[55] while right-of-center governments tend to rescue fewer firms, but those tend to be more significantly concentrated around capital-intensive businesses.[56] Third, the presence of strong special interests that would be harmed by the failure of the firm also appears to have an effect on the likelihood of a bailout.[57]
Most relevant among these findings, for our purposes, are the scope of the definition of “systemic” and a better understanding of the underlying circumstances favored by governments of different political orientation in their decisions on bailouts. On the definition of “systemic,” the industries where a higher share of distressed firms tend to be bailed out are finance, transportation, and utilities.[58] The main reason being that “out of concern for aggregate welfare costs, governments might be more likely to provide bailouts to firms that pose the threat of systemic risk to the broader economy.”[59] As to the circumstances that appear to play a role depending on the political orientation of the government, the key difference seems to be the relevance and threshold of “subsidiarity”—i.e., the point at which the type and gravity of the effects appears to warrant state intervention.[60] The presence of strong special interests does not have an effect on our characterization of critical/systemic firms, but it will certainly play a role in the design of the principles governing bailout interventions, as described below.
A taxonomy of actual government bailout practices regarding presumptively critical/systemic firms is a helpful starting point. However, it is not sufficient for constructing a “normative” view of what these firms should be, or which of their characteristics justifies government intervention to rescue them. For these purposes, and before developing our own view, we discuss other instances of actual or proposed governmental and/or regulatory protection of certain types of firms and justifications for such interventions. We analyze (i) the restrictions on foreign direct investment (FDI) within the OECD, (ii) the EU regulations on state aid, (iii) the concepts of “infrastructure” and “public utilities” as applied in the theory and practice of regulation,[61] and (iv) the scope of activity of state-owned enterprises (including the EU caselaw on “golden shares”). We use these regulations as a proxy to understand which types of firms policymakers and public officials consider being of pivotal relevance to the economy, and why.
The first proxy that we consider relates to instances in which states exercise their jurisdictional power to limit the “access” of foreigners to their markets. For a long time, the OECD has monitored the ways in which both its members and third countries have established such restrictions.[62] One of the most comprehensive studies available in this regard was conducted at the turn of the century.[63] However, in recent years, governments have been extending the scope of these restrictions.[64] This trend has only intensified since the start of the COVID-19 pandemic.[65] As specific examples of the current scope of these limitations, we focus on restrictions in the United States[66] and the United Kingdom.[67] In the United States, foreign investors willing to invest in “any person engaged in interstate commerce” may need to deal with CFIUS (the Committee on Foreign Investment in the United States) if the proposed control transaction could affect U.S. “national security” (though the scheme also refers to national defense and critical infrastructure).[68] The core industries and types of firms affected by CFIUS regulations are defense, infrastructure, semiconductors and sensitive technologies, telecommunications, financial institutions, and information technologies.[69] In the United Kingdom, the historical practice was not to restrict foreign investment in any material way.[70] Under the recently enacted National Security and Investment Act 2021, the United Kingdom has established its first[71] stand-alone foreign investment regime.[72] The Act directly subjects a number of key sectors to this new regime, supplemented by a general reference to “national security.”[73] These sectors include defense, energy, communications, data infrastructure, critical suppliers to government and emergency services, computer hardware, robotics, quantum technologies, and biological engineering.[74]
Another interesting proxy comes from state aid regulations, a quintessential expression of European Union (EU) substantive laws and political economy. The EU strives to implement a “single market” within its borders, and a number of tools are in place so that this objective is achieved.[75] Among those measures, the regulation of state aid is enshrined in Articles 107-109 of the Treaty on the Functioning of the European Union (TFEU).[76] The general rule is that state aid is incompatible with the internal market and thus forbidden.[77] However, in certain cases (which include assistance to firms in certain industries[78] or regions or rescuing and restructuring certain types of firms), the EU rules provide an exception because of the particular relevance of the special interests that are present.[79] And it is these exceptions that may help us in developing our concept of critical/systemic firms. The exceptions most relevant for our purposes are those included in the European Commission’s Guidelines on state aid for rescuing and restructuring non-financial undertakings in difficulty.[80] These Guidelines focus on seven different “compatibility criteria” that need to be met for the specific state aid being permitted.[81] Of these, the one that is particularly important is the need for the relevant aid to pursue “an objective of common interest, in that it aims to prevent social hardship or address market failure by restoring the long-term viability of the undertaking.”[82] According to the Guidelines, this objective is present when there are significant “externalities,” such as when the effects on employment are particularly severe or where an important service would be interrupted without any clear alternatives.[83] Effects on employment and the provision of important services might generally be subsumed under the rubric of “externalities,” but they present some specific facets (and are so salient in the public’s mind) that it may be worth describing them as separate from (but closely related to) the more general “externalities.”
The concept of “public utility” or “public service corporation” in the Brandeisian tradition is based on the idea that there are certain economic activities that are “affected with a public interest” that should therefore be subject to a specific regime.[84] The reason that these corporations conducting such specific economic activities are considered special is because they affect “juris publici,” i.e., rights belonging to the public at large.[85] This approach, developed in the United States at the turn of the 20th century, was construed from traditional English common law principles, particularly those relating to “public” or “common callings” (the most famous of which was the “common carrier”). To this, additional layers were added as the states built their general “police power” and established the first corporate regulations in the state charters of incorporation.[86] During the first decades of the last century, this “public utility” regulation had a prominent position in U.S. legislation and public policy.[87] But after the New Deal, it disappeared from policy discourse and lawmaking.[88]
However, in the past few years, the approach has been experiencing a strong revival thanks to influential voices within the law and political economy scholarship.[89] The proponents of this tradition of the “public utility” have updated the original framework to our current world, and the focus now is on the concept of “infrastructural goods and services.”[90] The main characteristics of what constitutes such “infrastructural goods and services,” which are candidates to be subject to a special regulatory regime (as the public utilities were at the turn of the 20th century), will also prove helpful to us when delineating the contours of critical/systemic firms in this article. These characteristics are (i) the existence of economies of scale for the production/provision of the goods or services, (ii) the position of the company as point-of-access to a wide range of downstream uses, and (iii) the vulnerability of the social infrastructure to private power or domination. [91] We are thus talking of firms which are involved in the production and provision of public goods that are a gateway for other goods and services generally needed by citizens to conduct their normal lives[92] and that, absent regulation, are susceptible to some form of private control because certain operators are capable of reaching a privileged position due to the scale of such firms.
State-owned enterprises normally respond to the need for the government to directly intervene in the market economy for very specific reasons, mainly to support national interests (e.g., to generate income through natural monopolies, protect a nascent industry, or provide certain goods or services in competition with the private sector) or to address market failures (provision of public and common goods, externalities).[93] In the EU context, there is a clear focus on “network” industries, such as energy, railways or telecommunications, as the natural fit for SOEs.[94] These are industries characterized by the existence of significant externalities and the provision of public goods.[95]
“Golden shares” represent an evolution from government’s direct ownership of critical enterprises.[96] When EU governments started privatization processes in the late 1990s with a view to achieving the fiscal requirements established for access to the monetary union, they decided that, given the relevance of these companies and the services they provided, they should retain some degree of control despite parting with all (or most) of their economic ownership interests.[97] In some cases, this control was established through corporate protections or ownership of special classes of shares and in many other cases through regimes established under the relevant public laws of the respective jurisdiction before or concurrently with the privatization of the relevant companies.[98] The powers through which such “golden shares” were exercised were essentially limits to voting rights, the establishment of certain veto rights, or special powers to appoint a certain number of members of the board of directors of the privatized company.[99] The companies that remained “protected” through this regime despite their privatization tended to be involved in utilities/energy (e.g., EDP—Energias de Portugal, Endesa, SNEA—Société Nationale Elf Aquitaine (now Total)), infrastructure and transportation (e.g., BAA (now Heathrow Airport Holdings)), telecommunications (e.g., Portugal Telecom, Telefónica), defense-related activities (e.g., Rolls-Royce, BAE Systems), or (allegedly) critical manufacturing (e.g., Volkswagen).[100] Though the challenge of these regimes before the Court of Justice of the European Union is an extremely important topic affecting the (legally permissible) structuring of ownership interests resulting from a bailout,[101] for our purposes in this Section, that is secondary to the specific types of companies that the EU Member States’ governments made subject to the respective regime in the first place.[102]
* * *
When considering all these types of regulation together, the following principle emerges: continuation (liquidation) of critical/systemic firms creates significant positive (negative) externalities, affecting society at large or a sufficiently wide group that is not represented within the stakeholders that are in a position to protect their interests in bankruptcy, and thus the loss allocation as per the bankruptcy laws is not socially acceptable. These externalities manifest themselves mainly because critical/systemic firms provide society with a public good (including essential services that would otherwise not be provided) or an “infrastructure” which is necessary for the functioning of the economy. At the same time, this characterization of critical/systemic firms includes enterprises important for the stabilization of the economy and the limitation of the macroeconomic costs that would be imposed on the social security system (and on individuals) as a result of a significant shock to the labor market resulting from the liquidation of this type of firm.[103] There are other manifestations of externalities in the context of critical/systemic firms, namely ripple effects resulting for the economy as a consequence of their failure.[104]
Very few other characterizations have been attempted in the literature,[105] but the phenomenon of (non-financial) critical firms is sometimes discussed, even without attempting to characterize them, from a purely practical perspective.[106] Concepts such as “situational monopoly,”[107] despite the differences with our framework, seem to be hinting at similar issues that can be captured more precisely with the concept of externalities, as developed in this Article.
At the same time, it is important to note that what counts as a relevant positive or negative externality in a particular jurisdiction is jurisdiction-specific, reflecting the collective preferences in that jurisdiction. Hence, a company which may be critical/systemic in one jurisdiction may not be critical/systemic in another.
Against the background of the described externalities as the key element (or property) of a critical/systemic firm, the next step is to assess whether bankruptcy is a good option or not for such a firm. We discussed the suitability of bankruptcy generally in Part II, but we are now considering a very specific and much narrower subset of firms, and thus, we must address some other important issues.
First, there are far fewer businesses in this cohort. Hence, the argument against bankruptcy based on the negative effects caused by system overload does not apply with equal force to critical/systemic firms. However, the impaired ability of bankruptcy systems to work effectively under the conditions of the pandemic might also negatively affect its usefulness as a crisis tool for critical/systemic firms. A large truck will not find a place in a large garage if it is already full with many small cars.
More importantly, the expected bankruptcy costs are higher for critical/systemic firms compared to other firms—both in absolute and possibly also in relative terms.[108] Critical/systemic firms are not only large but often also publicly traded.[109] Hence, they are hit by changing market perceptions as to the firm’s future and loss of trust much more severely than other firms.[110] In addition, the need for a swift resolution is stronger because of the correlation between time spent in bankruptcy proceedings and bankruptcy costs.[111]
Second, the most important issue is the presence of the aforementioned externalities. By definition, such externalities fall on parties external to the companies which would be subject to a bankruptcy process. In key Western jurisdictions (such as the United States and the United Kingdom), these parties have no or only a very limited say in any decisions to be made during the proceedings.[112] In other jurisdictions, bankruptcy laws and proceedings grant to those external stakeholders certain (direct) rights or (indirect) protections, through third parties that are actually a party to the bankruptcy proceedings.[113] This results in a narrower scope for government intervention through bailouts, as some of the externalities are appropriately internalized through the exercise of the aforementioned rights and protections. But a large share of these externalities remain unaddressed under “regular” bankruptcy provisions even in those jurisdictions.
Bankruptcy is a public process attending mostly to private interests of those participating in it and in which the debtor and its creditors attempt to sort out the debtor’s financial problems.[114] The process is not designed to vindicate public interests going beyond those of the stakeholders in the private entity which finds itself in bankruptcy.[115] It is highly unlikely that the benefits (costs) of positive (negative) externalities are taken into account fully when deciding on the optimal course of action in the proceedings. This may result in a significant destruction of social value even if the actors involved (creditors, shareholders and management) act in a perfectly rational way.
A different process led by the government, such as an ad hoc bailout, creates or safeguards (social) value by ensuring that, for example, the effects of contagion[116] and on the labor market[117] are considered when deciding whether the critical/systemic firms should continue operating or not, and how it might best be restructured. This could not happen within a “regular” bankruptcy process, and therefore the relevant actors might decide on a liquidation which destroys social value.[118] In order to avoid this, these firms need to be kept outside of the bankruptcy process.[119]
Bailouts and bankruptcy are not mutually exclusive. Both are solutions to financial distress that result from separate decisions.[120] And it cannot be ruled out that a bailout may be needed after an unsuccessful attempt at solving the firm’s issues in bankruptcy. Alternatively, a firm may be bailed out but somehow cannot continue to operate profitably after the assistance and needs to seek bankruptcy protection. Bailouts and bankruptcy are both tools with different characteristics, and the specific situation at hand may present necessities that are better catered to by one or the other at different points in time.
So far, we have discussed why traditional bankruptcy laws may not be the best tool to address the problems of COVID-distressed companies in general. In addition, we have taken a further step considering the same issue in relation to what we have called critical/systemic companies. This is a subset of companies that, because of their very specific characteristics, may warrant a direct intervention of the government to allow them to survive.
We have mentioned “systemic risk” as one of the key rationales for the use of bailouts by governments. Particularly since the Great Recession (and especially in the realm of financial institutions), a significant regulatory effort has been made in relation to what has been called “macroprudential” regulation; that is, establishing a number of rules and provisions that, ex ante, allow us to reduce the level of risk in the economy.[121] However, this ex ante regulation will not be sufficient in every case to prevent the occurrence of “systemic risk,” which is a specific manifestation of the existence of important externalities affecting the wider economy.[122] Hence, we will always be confronted, to some degree, with the need to react to crises ex post. However, being able to react flexibly to address issues that had not been anticipated should not be an excuse for arbitrary interventions.
The stakes may be high, and the parties involved quite important, but the negative consequences of an unconstrained use by states of their ability to bail out critical/systemic firms could be significant. Hence, principles or standards need to be established beforehand to help guide the actions of governments and their officials in these cases. Further, such actions need to be subject to judicial control (ideally after the fact) in accordance with provisions that provide the government with sufficient flexibility to address difficult issues with limited information and under a pressing timeline.[123]
Historically, it was economist and journalist Walter Bagehot in nineteenth-century England who first formulated guiding principles for bailouts.[124] This first attempt at devising the principles that should guide a bailout of financial institutions in a banking crisis, with the government functioning as a “lender of last resort,” was still in the mind of policymakers in the United States when considering the rescue of automakers in 2008.[125] According to Bagehot, every intervention of the “lender of last resort”[126] should be characterized by three key features: (i) lend as widely as possible, (ii) against good collateral and (iii) at a high rate of interest.[127] These principles were established to address a specific type of bailout for a narrow subset of companies,[128] but they have been used in practice by policymakers to frame responses for other more intrusive interventions and to be applied to firms in other sectors.[129] As such, we think that they are a good starting point for the discussion of the principles that we are proposing in this Part.
In our view, the following four principles ought to guide the actions of government when considering (or implementing) an ad hoc bailout of a critical/systemic firm: proportionality, efficiency, equity, and transparency. These principles are essential to establish the legitimacy of the government intervention, which is crucial if we aspire to justify it as an appropriate use of government power.[130] If government is conducting a public intervention with public money to pursue public objectives, it follows that, at the very least, we need to ensure that such intervention is perceived as legitimate by society.
The first principle concerns the proportionality of the intervention. Given the significant uncertainties of the situation—for example, absence of a counterfactual, difficulty in establishing the costs and benefits of the intervention—it is fundamental that the government only intervenes when necessary to achieve its objectives, such as the preservation (minimization) of positive (negative) externalities by ensuring the continuation of the firm as a going concern, and that such intervention is conducted in the least intrusive way possible. This generally means that the government should only take equity stakes in private companies when there is no other feasible alternative to preserve (avoid) the positive (negative) externalities associated with the rescue operation. Further, if it is deemed indispensable to take an equity stake in the company, it must be a temporary one with a clear exit path.[131]
Governments must consider which specific tools they will use to ensure the continued viability of the struggling firm. If provision of a guarantee is sufficient to achieve that end, no funds should be advanced. If funds can be advanced under a loan with sufficient collateral, there is no justification for taking an equity interest, i.e., to commit more risky capital. The government should be operating in the market in a way similar to a private party to avoid market distortions to the extent possible. If the government intervention strengthens the equity position of the firm, the government must be entitled to a commensurate return.[132]
Proportionality requires that, even in such dire circumstances, market distortions[133] are minimized and that companies are allowed to continue operating without unnecessary meddling from a shareholder that is not particularly adept at running a private business.[134] If the government is required to provide an equity (or equity-like) investment to reinstate and maintain the solvency of the company, there are different ways to structure such an investment so that it is adequately remunerated, maintaining sufficient influence to protect taxpayers’ interests without exercising day-to-day control of the operations of the company.[135] In practice, this should result in governments being reluctant to take positions in ordinary fully voting shares and ensuring that any such participations are restricted in terms of both scope and time.[136] An interesting example is provided by the bailout by the German government of Lufthansa in June 2020.[137] The government ended up with 20% of the equity in the company after a €9 billion investment across the capital structure.[138] That 20% made the German government the largest shareholder in Lufthansa.[139] Despite that, the government did not exercise their voting rights on a day-to-day to basis, took only two seats in the twenty-member supervisory board[140] of the company, and is only keeping the right to convert some of its hybrid-debt investment into an additional 5% equity stake in the event of a hostile takeover.[141]
Similarly, proportionality also requires (together with efficiency and fairness) that the government only assists to the extent necessary, after the pre-existing investors in the firm have done all that is possible to remedy or at least mitigate the situation of distress. In order to assess what this means in practice, it will be helpful to consider two principles with long-standing tradition in EU state aid rules for restructuring aid: “significant own contribution”[142] and “adequate burden sharing.”[143] Similar requirements have been included in other formulations of key principles applicable to bailout practice in the United States.[144] The investors in the firm that is being rescued need to contribute to the rescue of the firm if they are to retain any interest, i.e., they need to absorb at least part of the relevant losses to the extent necessary for the firm to be able to continue operating.[145] Such contribution or sharing is fundamental to ensure that moral hazard is kept to reasonable levels and to maintain the degree of equity necessary to ensure the legitimacy of a bailout. This means that, in practice, ad hoc bailouts will contain an element of ad hoc bail-ins. It is through this ad hoc decision as to which stakeholders and/or counterparties need to participate through the bail-in that government exercises a flexibility not available elsewhere to overcome the risks and issues connected to critical/systemic firms suffering from COVID-induced financial distress.[146]
Designing a rescue package for critical/systemic firms, which involves a combination of ad hoc bailout and bail-in measures, involves intricate negotiations. Governments cannot simply dictate a bail-in with respect to such firms, allocating a cost to a specific party in a way that is not provided for in ordinary legislation and for which the government does not have an immediate legal authority. Forcing a bail-in outside bankruptcy creates significant problems such as the expropriation of private rights (including the Takings Clause in the United States).[147] But bail-ins are needed, among other reasons, to deal with moral hazard (as explained above, and also related to efficiency considerations), to reduce costs and to ensure fairness in the distribution of the costs and benefits resulting from the bailout.[148]
Hence, in the absence of legislative support to simply mandate a bail-in, and if “hijacking” the bankruptcy process to conduct a bailout is not a sensible option,[149] the main practical mode of implementing a bailout of a critical/systemic firm is to structure it so that a (partial) bail-in can be achieved. This should be relatively straightforward in the case of shareholders. Allocating costs to them is simply done by taking an equity participation that dilutes pre-existing shareholders. The matter becomes much more difficult when dealing with creditors or other stakeholders. What has happened in practice is that the need for the (partial) bail-in as a precondition for the bailout has forced creditors to “voluntarily” accept the bail-in—or risk a liquidation where their rights would be worth far less.[150] However, requiring bail-ins creates far too much tension and delays processes to the point where avoidable losses are incurred because of the delay.[151] In other situations, despite the need for a (partial) bail-in for the aforementioned reasons, exacting it at the time would be counter-productive to the objectives of the bailout.[152] In such a case, it is important to have a tool that allows for the bail-in to be effected at some time in the future when affected creditors are no longer at risk of facing financial distress as a consequence of the bail-in.[153]
A public intervention by the government to carry out an ad hoc bailout of a critical/systemic firm should also be assessed against the measuring rod of economic efficiency in the sense of the Kaldor-Hicks principle or of cost-benefit analysis. A number of arguments[154] may be made against using efficiency in this sense as normative goal, but despite its shortcomings, it still is the most widely used benchmark in public policy.[155]
Since we discuss externalities as a key motivation for the intervention to rescue critical/systemic firms via ad hoc bailouts, it is of the utmost importance that the aforementioned measures of efficiency, when applied to the bailout, properly account for all the relevant costs and benefits that need to be internalized. Some of these externalities may have time-varying characteristics, with their value changing throughout the economic cycle.[156]
Even accepting that the assessment of those externalities will be tentative, it is clear that government needs to conduct the analysis to ascertain the adequacy of the intervention. The fact that there is uncertainty surrounding the exact benefits of the intervention should be an additional supporting argument for proportionality (in the sense of subsidiarity, as discussed above);[157] only when the benefit is clear should we feel comfortable with the significant use of public resources that an ad hoc bailout of a critical/systemic firm entails.
But, even when we are reasonably certain about the increased social value resulting from the preservation (avoidance) of positive (negative) externalities in a specific case, government needs to be acutely aware of the important costs that could result from the intervention, namely in the form of market distortions,[158] the creation of moral hazard, or suboptimal governance structures, especially if the state takes a controlling stake in the distressed firm.[159] It is important that no intervention causes material long-term distortions to efficient private bargains.
In general, COVID-distressed firms should only be bailed out if their business model is sound or can at least be re-engineered to make it sound (again).[160] This consideration applies of course to critical/systemic firms as well: any public intervention should be calibrated such that the scope and mode of operation of the critical/systemic firm is adjusted to make it as efficient as possible under the circumstances.[161]
In the end, a bailout is a way to allocate costs resulting from a shock.[162] Governments need to make sure that the cost is effectively borne by society in the best possible way.[163] That means that the result needs to make economic sense (normally through a cost-benefit analysis). But it also needs to be acceptable to the polity.[164] Accordingly, the way in which the decision-making process surrounding the bailout is organized and its distributive effects (and the fairness thereof) are critical.
By definition, an ad hoc bailout of a critical/systemic firm will consist of a significant transfer of resources from the government (funded by the generality of taxpayers) to a very specific company and/or its counterparties.[165] Such a transfer poses per se a number of questions as to the fairness of the intervention and its effects on different people. The government, using public funds for a public purpose, needs to ensure that its public intervention does not unjustifiably favor one constituency over another.
A first issue here is what can be done to further the public purpose. A key element was discussed in Section IV.A above, when we mentioned the need for the government to ensure that it would retain a sufficient influence over a bailed-out firm to protect the taxpayers’ interests and that incumbent stakeholders should contribute to the rescue via a (partial) bail-in.[166] Another task is to ensure that the intervention is efficient (as discussed in Section IV.B above) and that the relevant externalities[167] are appropriately addressed.
A further question is whether the government should leverage its position as provider of much-needed resources to advance specific policy goals. For instance, if the government is providing resources to a company that is considered to be critical/systemic because of labor market considerations, it is only natural that it will exercise its power to ensure that the company maintains certain employment levels. Similarly, establishing restrictions to the use of funds[168] made available to ensure the viability of the firm—e.g., not using the funds to pay out a dividend or conduct a share repurchase program—would be unobjectionable.[169] Advancing other policy goals that do not directly affect the preservation of the firm—such as “green” goals beyond what is required under “normal” legislation—is certainly subject to debate.[170] It is our view that advancing these other relevant policy goals would be an appropriate and legitimate use of the government’s power in deciding whether to use public funds to rescue a critical/systemic business.[171] Public opinion seems to agree with this approach,[172] and recent research shows that there is higher support for government bailouts among the polity when the rescued companies are perceived to be acting in a proper way in relation to the power they hold and prominent role they play in society, such as by exhibiting good environmental behavior.[173]
Thus far, we have discussed the ways in which bailouts can benefit not just the bailed-out firm but also the public broadly. Now we need to turn to the issue of ensuring that the intervention does not bring about negative effects or that, if it does, these are limited and appropriately dealt with. The more general issue in this regard is that of the potential creation of distortions in the market.[174] Certainly, there should be sufficient safeguards to ensure that the interests of competitors of the bailed-out firm that do not receive government assistance are taken into account. In this regard, EU state aid regulations provide a good example of institutional safeguards,[175] established to provide fairness and transparency to the process and scope of bailouts and to ensure that competitors that may have claims in relation to their fair (or unfair) treatment are duly heard.[176]
A related area of concern is that of “specially connected” firms that may receive more beneficial treatment. Research on state intervention in the economy and, more specifically, on the political economy of bailoutssuggests that there are indeed certain types of firms that are more likely to receive a favorable governmental intervention because of their preexisting relationship with government officials.[177] However, it seems that institutional safeguards in democratic states manage to keep this kind of problem under control.
Finally, equity also manifests itself in procedural safeguards to ensure that the interests of shareholders and creditors are preserved in accordance with established guidelines. This use of safeguards closely relates to our earlier discussion of bail-ins and whether they should be required of creditors as a condition of a bailout.[178] A first question to consider is whether it is fair for government to decide that a specific stakeholder is to suffer a loss on their interest. A second issue is whether there is sufficient justification for the discriminatory treatment of stakeholders when imposing a bail-in on some while not on others. The first issue presents a number of important problems, particularly in relation to the protection of private rights against expropriation. Without attempting to provide a comprehensive answer to this problem, we think it is critical to identify several potentially applicable protections against expropriation in a specific case and to establish the relevant benchmark in reference to which the government should evaluate stakeholders’ rights. As to the latter, we think there is a good case to be made for the use of liquidation as the relevant benchmark, because the company would not be viable without the government’s intervention in such a case. The second issue is a matter of considering which stakeholders are in a position to best absorb the relevant losses without creating the type of negative externalities that the bailout is trying to avoid.
A key element to ensure equity and fairness involves establishing procedures that guarantee consistency in the decision-making of the government and its officials in a way that is transparent and can be reviewed after the fact by reference to pre-specified criteria or standards.
Bailouts are an exercise of the “power of the purse” by governments in a way that may have significant distributional effects.[179] Hence, it is vital that the bailout of a critical/systemic firm is conducted for the right reasons, and the public accepts (at least implicitly) as legitimate the use of the funds. The only way in which this can be ensured, in a context in which government (or its agencies implementing the plan) has a high degree of flexibility and discretion to act, is by ensuring that the bailout is conducted by the government[180] publicly and transparently.[181]
This general principle, though, needs to be adequately operationalized.[182] In the first instance, this means that relevant and detailed information justifying the intervention and its scope must be disclosed to the public. This transparency with the public should include a comprehensive discussion of the relevant normative criteria applied in the decision to bail out a critical/systemic firm. Such thorough transparency is essential in securing the legitimacy of a government’s decision to implement a particular bailout.
This need for material transparency might be difficult to satisfy in real time, particularly if a bailout requires discretion regarding a businesses’ inner workings or requires the government to act especially quickly. Even though such circumstances may justify some temporary adjustments to the principle of maximum transparency, full material disclosure ought to be made as soon as possible.
In any event, all decisions relating to the bailout will eventually become transparent because they are subject to ex post judicial control.[183] As has already been mentioned, officials should be given sufficient flexibility and discretion in carrying out any necessary interventions, as their time-sensitive nature means that swift decisions must be made to effectively react to new-found circumstances. Importantly, decisions relating to a bailout are typically made in light of very limited information and working against a counterfactual about which we do not have any certainty.
As previously discussed, bailouts are ex post responses to a critical situation and thus are not the best place to utilize specific rules formulated ex ante. However, governments can engage in effective ex ante action by establishing sufficiently abstract guiding principles which provide policymakers with a framework for decision-making, to ensure that the ultimately-implemented bailout is one that is satisfactory to the public and possesses the required legitimacy. Judicial control, ex post, of how the actions of the government and its officials meet such ex ante guiding principles is therefore a necessity.[184]
The COVID-19 pandemic continues to threaten lives and livelihoods across the world in a dimension not seen since the influenza pandemic of 1918–1920 and the Great Depression of the 1930s.[185] Scholars and policymakers are struggling to identify how best to respond to the financial distress of millions of businesses suffering from the sudden and unprecedented loss of revenues caused by lockdowns.[186] No consensus has yet emerged on whether bailouts, bail-ins, bankruptcy, or a combination thereof is best suited to contain the pandemic-induced economic damage to firms and the economy as a whole.
In this Article, we have investigated an issue in this context which, so far, has received little attention in scholarly and public debate: namely, whether the general considerations relevant to the policy question on bailouts, bail-ins, and bankruptcy apply equally to what we define as critical/systemic firms. We characterize a firm as critical/systemic if continuation of the firm is associated with significant positive externalities and, conversely, discontinuation with significant negative externalities. Critical/systemic firms often are involved in the provision of public goods in a jurisdiction.
We demonstrate how bankruptcy is particularly ill-suited to handle the financial distress of such firms. This is because bankruptcy is a process in which the debtor and its creditors seek to resolve the debtor’s financial distress by readjusting the involved stakeholders’ claims on the debtor’s assets. Central to the bankruptcy process are private rights. The process is not designed to vindicate public concerns and interests other than the debtor’s narrow financial interests.[187] A bankruptcy court is not a forum to adjudicate on positive or negative externalities associated with the financial failure and possible preservation of a critical/systemic firm.[188] This consideration differs from the arguments against the suitability of bankruptcy to handle COVID-induced financial distress of millions of small and medium-sized or even large, but not critical/systemic enterprises.
Hence, bailing out such enterprises often will be a sensible and sometimes even an inevitable decision. However, given the scale of the financial and non-financial interests at stake in such a bailout, it is all the more important that decisions are taken in a principled manner. Therefore, we suggest four principles, which should guide policymakers who have to decide on and implement bailouts of critical/systemic firms: proportionality, efficiency, equity, and transparency. Observing these principles should help policymakers navigate the tricky normative terrain of large-scale bailouts, which will maximize the perceived legitimacy of the government’s actions while simultaneously preserving the necessary flexibility and discretion.