Finding the Right Answer to Macro Crises: Bail‑Out vs Market Approach
Bail-out, bail-in, or restructuring? The past Covid pandemic period in Germany was characterised by a governmental policy that avoids corporate insolvencies and prefers bail-outs of distressed businesses. We believe that such policy is misled as it creates unwanted risk incentives, distorts market selection and resource allocation, and reduces beneficial transformative pressure. A preferable crisis resolution strategy should be designed in concert with a functional restructuring and insolvency regime. In this blog, we outline the German response to the Covid pandemic, analyse the temptation to bail out debtors during a macro crisis, and show how an efficiently reformed restructuring and insolvency framework would lead to superior results.
- The German response to the Covid pandemic
The number of insolvency filings dropped to a historically low level during the pandemic despite government-ordered business closures and curfews. The policy approach to avoid widespread insolvencies (and the risk of mass layoffs) was based on two pillars: emergency adjustments and exceptions to the German insolvency regime; as well as bail-out and state-sponsored business relief programs.
During the pandemic, the director’s obligation to file for insolvency was suspended, with various adjustments as the crisis evolved. To the suspension of the director’s filing obligation, further privileges were linked such as tightening the claw-back provision, exemptions from lender liability, equitable subordination, and director’s liability. All these measures were intended to support the debtor in the continuation of the business.
Aside from temporary legal reforms, the German government rolled out massive bailout subsidies amounting to several hundred billion euros while the ECB supported the member states with a purchase programme for securities trading in the European Union of both private and public issuers amounting to almost two trillion euros.
- Temptation to Bail-Out
Governmental decision-makers face a strong temptation to bail-out debtors during a macro crisis, even more if it is doubtful whether the legal regime is fit to cope with the particular challenges. To illustrate the temptations, we distinguish between two kind of crisis: a crisis with insolvencies that are ‘too big to fail’, and another type of insolvencies that are ‘too widespread to handle’. The ‘too big to fail’ paradigm justified bailouts during the financial crisis. The failure of systematically relevant financial institutions—so was the concern—would trigger a chain-reaction and cause other financial institutions in highly interlinked sectors to become distressed with business failures in the real economy to follow. During the Covid pandemic, the concern was rather a crisis that is ‘too widespread to handle’. Government-ordered business restrictions and consumer reluctance prompted the risk that too many businesses would have been forced to shut down and file for insolvency at a time. Such scenario may have led a wide impact across the country, not least putting pressure on the labour market, risking a sharp decline of business prices and hitting a resource shortage at insolvency courts and administrators.
- Reform Proposal for Restructuring and Insolvency Laws
To strengthen alternative approaches to bail-out, the restructuring and insolvency framework should be reformed based on the experiences of the recent macro crisis and the shortcomings identified during that period. The measures we propose are intended to shift the focus toward a privately led crisis response, merely supported, if at all, by public funding.
The following reforms should be considered:
- Filing obligation: The German concept of criminal sanctions for delayed insolvency filing is outdated. Similarly, the inflexible director liability sanctioning a delayed filing by requiring reimbursement of outgoing payments does not appropriately address the challenges posed to businesses during a macro crisis with inherent uncertainty. We instead propose a flexible wrongful trading rule according to which directors are liable for actual damages to their creditors in case they continued trading despite the fact that the debtor was likely to become unable to pay its debts within a three-month projection period. In any case, directors should be able to exempt themselves from liability if they could reasonably expect to continue trading in the best interest of company and creditors.
- New financing: New financing is often vital to overcome a crisis, but lender liability and lengthy claw-back periods can be a heavy burden for debtors in distress seeking such financing opportunities. We propose to strengthen the position of lenders in distress in order to incentivise private credit solutions; eventually in the best interest of distressed businesses. Crisis investment should be privileged with predictable and practicable safe-harbour rules. Such privilege may even extend to shareholder loans.
- German StaRUG scheme to be strengthened for financial restructuring: The StaRUG procedure should be the primary statutory tool to address financial distress in a debtor-in-possession procedure under court supervision; preferably at an early stage of distress. However, the current scope of the StaRUG plan including mere financial claims is too narrow. The process must allow to alter or terminate certain long-term contracts. We therefore propose, to make future claims arising from executory contracts subject to a restructuring plan.
- International group restructurings: The reality of many mid- to large-cap debtors is not the single entity concept on which insolvency law is built. Financing may be sourced, secured, and guaranteed from various companies which are highly interlinked. We argue that a single group plan upon which creditors of different entities can vote in classes which account for their respective structural position within the corporate group is a long overdue reform project.
- Hybrid solutions: Bailouts may have their rightful place as emergency mechanisms to contain grave externalities and to lessen the social hardship of a macro crisis. We, however, believe that bailouts should always be justified and considered in concert with restructuring solutions. Private initiatives, eg lending by private investors, should be promoted—for instance by tax benefits/exemptions—as a solution superior to a primarily government-subsidised approach as during the Covid pandemic.
When debtors and creditors as well as other stakeholders within the business network have both an incentive and a stable framework to take up negotiations, in- and out-of-court restructurings can have a transformative effect. They assist the development of new and resilient business structures that adequately adapt to a changing environment as affected by the crisis, thus facilitating an efficient (re)allocation of assets. Debtors, shareholders and creditors are in the best position to evaluate and decide the way forward in a crisis and should be encouraged to do so. A pure bailout strategy intended to preserve the status quo leads into the wrong direction and creates hard-to-monitor incentives, especially if untargeted subsidies are distributed as a response to a macro crisis in immense volume.
Dr. Wolfram Prusko is a partner at Willkie Farr & Gallagher LLP.
Dr. Dr. David Ehmke is an associate at Willkie Farr & Gallagher LLP.
This post is part of an OBLB series on Corporate Restructuring Laws Under Stress. The introductory post of the series is available here. Other posts in the series can be accessed from the OBLB series page.
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