09 July 2015

The Economics and Political Economy of Trade Credit Insurance

It is widely understood in the investment world that bondholders and long term secured creditors of publicly held companies are financial creditors making a long term investment who need to consciously consider the creditworthiness of the company during the life of a bond when they make their investment and bear the risk of loss upon a default.  Also, there may be hundreds of thousands of bondholders in a typical publicly held company, but typically, the bondholder's interests are managed by a trustee for the bondholders and the total number of trustees for bondholders for a publicly held company is rarely more than a couple of dozen, and often there are just a handful of them.

The same cannot generally be said of the legion of trade creditors of a typical publicly held company.  These may number in the tens of thousands, have claims that range from tiny to substantial, they are not organized collectively outside of bankruptcy, and they almost always predominantly get paid in full in the long run during a Chapter 11 reorganization bankruptcy.  For those not familiar with the term, "trade credit" generally refers to willingness of a vendor or customer doing business with a company in the course of its day to day operations to defer payment for a short period of time (typically thirty to ninety days) without interest.  It wouldn't be unusual for trade credit (also known in accounting terms as "current liabilities") to be 10%-20% of the book value of a firms assets at any given time.

I've proposed in the past that trade creditors of companies formally be given priority in bankruptcy so as to recognize the economic reality that manifests in Chapter 11 reorganizations, and for reasons described below for an alternative approach involving insurance and/or bonding of companies by private (but perhaps, if necessary, government chartered) insurance companies.

But, there is another approach, which borrows from the area of deposit insurance in financial institution insolvencies that has been very effective in preventing financial institution insolvencies from causing wider damages to the economy.

What if publicly held companies, either to secure favorable terms with trade creditors in the marketplace, or as a matter of regulatory mandate, secured "trade creditor insurance" from a suitably regulated insurance company with adequate reserves and financed this system by paying premiums for this insurance, which would guarantee payment of the company's trade debts (but not its financial debts) in the event of its insolvency, just as comprehensive general liability insurance (which is not legally required, but is universally maintained by publicly held companies presumably to reassure investors) is routinely secured to finance a company's tort debts.

The company providing the trade creditor insurance would in turn have a priority claim in any insolvency proceeding similar to that of the FDIC, to be indemnified for the claims it paid.

Alternately, the trade creditor insurance company could simply take a security interest in all of the company's assets (subject only to purchase money security interests in select individual purchases), as a condition of granting the insurance, which would afford the company priority without having to change the bankruptcy law.  It would be necessary, however, for existing standard stock exchange regulations and bond covenants to be amended to permit firms to do this, because these regulations and covenants currently prohibit publicly held companies from granting these kinds of blanket security interests because that would impair the priority of bondholders and stockholders, thereby making insolvencies more complex in a Red Queen style battle of investors and creditors to position themselves to have priority in any bankruptcy.

Thus, in a typical publicly held company bankruptcy under this regime, there would be only a couple dozen of so creditors who would participate in the bankruptcy phase of the proceeding after the insurance company paid off and settled all of the remaining claims, greatly simplifying this part of the litigation in a way that does not prejudice any creditor's rights.  This is how bankruptcy proceedings for insolvent financial institutions work now.

Thus, trade creditors of a bankrupt company would not need to panic because they would be assured immediate prompt payment of their claims in full almost as quickly as they would have been paid by the company had it been solvent, and only trade credit insurance companies and financial creditors of firms would have to seriously investigate a publicly held company's creditworthiness.

If this sounds familiar, it should.  This kind of arrangement is routine in the construction industry, and is almost universal among government entities employing contractors to do doing construction work, and is called 'bonding", as in the familiar phrase "licensed, bonded and insured."

If publicly held companies and privately held companies seeking to compete in the same markets with them, were routinely bonded, this would reduce the transaction costs involved in dealing with such firms, would produce more prompt and dramatically simplified resolutions of insolvencies of bonded companies, and would greatly reduce systemic risk in the economy at large, making it more robust during economic downturns.

But, because the risk that a publicly held bonded company would be unable to pay trade creditors in the long run would already be so low (perhaps 1% of outstanding trade credit or less), in part, because of debt to equity ratios mandated by stock exchanges in order for a company to be listed, and by corporate bondholders as loan covenants, typically limiting debt to something like 50% of assets in non-financial companies, the premiums that a publicly held company would have to pay for this kind of bonding would probably be quite modest. They would be lower still if trade creditor insurance indemnification claims were given priority in bankruptcy.  And, they could be lowered even further if bonding companies imposed their own covenants upon companies that would mitigate the risk of defaults on trade credit in advance.

We can be reasonably certain that requiring these companies to be bonded as to trade creditors would not led to a parade of horribles, because in the many circumstances like deposit insurance, security registration insurance, government project bonding, and construction contractor bonding, to name a few, where these kinds of regimes are in place, they do not appear to pose a significant impediment to the profitability of these sectors of the economy.  If anything, the increased trust that these arrangement engender make these sectors of the economy work more efficiently.

Indeed, the creation of an industry with an institutional and lobbying interest is controlling systemic risk in American's big business sector, and powerful tools through insurance underwriting to accomplish those ends, might arguably, in the long run, be as important for the American political economy as the direct benefits of the policy itself.

One of the problems that led to the financial crisis was that credit rating firms, which have immense impact on insolvency risk management in the big business sector, had no skin in the game to temper the small dollar incentives created by fees charged to firms to have their credit rated so that they could obtain bonds.  The harm caused by inaccurate credit rating assignments by these firms far outweighed any capacity those firms had to compensate people harmed when those inaccurate credit rating assignments were the result of negligence or outright fraud.  They were judgment proof.

In contrast, firms providing bonding and/or trade credit insurance (to the extent that the two are distinguishable) would have substantial financial reserves which would give these firms a powerful economic incentive to set premiums accurately relative to risk for particular publicly held businesses or for privately held businesses seeking to participate in the marketplace with those publicly held businesses on an equal footing.  By collectivizing trade creditor credit risk, bonding firms would overcome the collective action problems faced by trade creditors pre-default, because they would have the means and the incentives to aggressively ferret out major securities fraud, which they would bear much of the brunt of the risk if that fraud was not stopped in a timely manner.  This is something that is much less true of the far less deep pocketed firms that audit publicly held company financial statements now.

It is even conceivable that this kind of regime could become almost universal without any legislative change at all, if the markets found that bonding made firms more attractive to deal with (and hence more profitable and a better investment at little additional cost), and stock exchanges and bond investors acquiesced to it.  After all, firms already almost universally secure comprehensive general liability insurance without any express legislative mandate to do so, and the incentives associated with this reform would be similar.

Even before securities laws were enacted, economic realities pushed the investment banking industry to establish creditable assurances, like independent auditing of financial statements in accordance with generally accepted accounting standards, due diligence investigations by law firms offering public securities for sale, stock market exchange listing rules governing the structure and capitalization of firms traded on these exchanges, and so on.  Many of these measures don't appear in any statute, or were only codified as law long after they became universal.  There is no reason to think that the investment banking industry's continuing process of structuring corporate America in a way to provide credibility to its participants is complete now.

Indeed, one of the "cultural" factors that distinguishes economies that operate well from those that do not, is the internalization of these kinds of business practices which often get lost in translation when a developing company simply tries to copy another country's statutes without assimilating the business practices in which those statutes were intended to operate.  Even the best tools don't work well when the people trying to build a house with them don't have an architect's plans and have never built a house before themselves.

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