Bankruptcy and sovereign backstops during crises
During the difficult economic situation of the last couple of years in India, I have been emphasizing two things:
Bankruptcy is a form of protection for firms that are unable to pay their debts on time, and not a punishment for past sins. As such, during bad times, we need a working bankruptcy law and not a suspension of the bankruptcy process. My blog post two months ago argued this in detail.
Only the sovereign can absorb tail risks in crisis situations, and second loss instruments are the mechanism through which the government can provide this protection. I have proposed this several times during the last year: Recapitalizing the financial sector this April, Structuring the Yes Bank rescue this March and Real Estate and Infrastructure Resolution last September.
Last week, a leading US bankruptcy scholar, Adam Levitin, along with two co-authors published a white paper describing how the US government should respond to economic crises like Covid-19. (Adam Levitin’s book “Business Bankruptcy: Financial Restructuring and Modern Commercial Markets” is the best book on financial restructuring that I have seen).
When it comes to assisting large US firms, the core of Levitin’s proposal is a combination of bankruptcy restructuring and sovereign second loss backstop.
a capital injection in the form of preferred stock, conditioned upon the cancellation of existing common equity interests and dollar-matched conversion of unsecured debt to new common equity interests
This is a very simple bankruptcy regime: existing shareholders are wiped out, creditors become owners and therefore bear first dollar of loss, and the sovereign provides second loss protection through the preferred stock. If the company and its stakeholders do not like this standardized regime, they can resort to the normal bankruptcy process (Chapter 11) which works in the US even in crisis times like these (unlike in India).
Posted at 6:52 pm IST on Mon, 6 Jul 2020 permanent link
Comments