This is a proposal designed to protect governments entering into contracts, businesses in the course of their regular businesses, and other members of the general public, from the risk that a company that enjoys the benefits of limited liability becomes insolvent or goes bankrupt, except when these persons are consciously evaluating this risk because they are intentionally making an investment.
This would make our economy more robust and would make bankruptcies for covered businesses much less expensive, simpler, more swift, and much less likely to have contagion effects that propagate beyond the bankrupt firm.
It basically generalizes the model of agencies like the the FDIC and the Pension Benefit Guaranty Corporation (a government agency that partially pays obligations of insolvent defined benefit pension plans), which have proven to be very effective at mitigating the harm caused by insolvent major private institutions, especially during recessions and financial crises, thereby making the economy more robust and reducing systemic risk in the economy, and making the navigation of institution insolvency more smooth collectively and for innocent people affected by these insolvencies.
It is also inspired by regulations in other countries of limited liability entities that is more robust than in the U.S. and regulation of limited liability entities used in the practice of law in Colorado.
There is a good argument that some insurance requirement should be present for all limited liability entities. Realistically, almost all covered entities below already have insurance and the bonding requirement is the innovative part.
Who Would Be Subject To The Bonded And Insured System?
The basic idea is that certain companies would have to be bonded and insured. This would include:
Every company with publicly held equity or debt doing business in the United States or traded on a securities exchange in the United States.
Every privately held limited liability entity with 50 or more persons providing services to it during the course of the most recent calendar year, for whom a W-2 or 1099 had to be issued.
Every privately held limited liability entity bidding on or performing a significant contract or grant with a government in the United States.
Every privately held limited liability entity bidding on or performing a significant contract or grant with a public charity doing business in the United States. A public charity would be a non-profit defined as such in the Internal Revenue Code. A public charity is doing business in the United States if it is organized under the laws of a government in the United States or if the contract or grant is to be performed for an office of the public charity in the United States or the contract is to be performed in the United States.
A significant contract or grant would be a contract that is either more than $1,000,000, or more than $100,000 if the amount of the contract is more than 10% of the government entity or public charity's annual expenditures in its most recent fiscal year.
Any company or non-profit that opts into the system even though it is not required to do so. A company that opted in would be authorized to advertise that fact. False claims of being bonding and insured voluntarily would be handled by the Fair Trade Commission (FTC).
What Would Participants Be Required To Do?
Participants would be required to obtain federal government regulatory agency approved bonding and insurance.
The company would be required to have certain kind of liability insurance in placxe. This would include: (1) comprehensive general liability insurance, (2) worker's compensation insurance, (3) automobile insurance and the equivalent for other vehicles, (4) construction defect coverage for firms engaging in construction, (5) professional liability insurance for firms providing professional services, (6) flood insurance for business with operations in flood plains, and (7) earthquake insurance for businesses located in high earthquake risks. There would be no deductible as to third-parties on these insurance policies, but the insurance company could reserve a right to reimbursement for a deductible from the company up to an amount allowed by a formula or rule. The insurer would also provide a legal defense to the claims and eroding policies (where defense costs were paid from the policy limits) would be prohibited.
The company would be required to be bonded with a bonding agency meeting certain standards up to a dollar amount determined by a simple formula. Bonding agencies in the program would also have to pay a tax to fund a firm that would guarantee claims on bonds that are owed by insolvent bonding agencies. The bonding agency would be required to pay on demand any covered claim up to the dollar amount of the bond on a covered claim.
Covered claim types would include properly "perfected" claims for essentially all trade creditors of a company including deductibles owed to insurance companies, money market loans (up to some formula cap amount), mechanic's lien claims where the company doesn't have primary contractual liability, and tax obligations other than income taxes (e.g. withholding taxes, sales taxes, excise taxes, and property taxes). The main liabilities that would not be covered claims would be (1) finance debt (i.e. loans of cash for more than 91 days or large short term loans up to some formula cap amount, obligations on guarantees of such loans such as corporate bonds, unsecured bank loans, deficiency judgments on secured loans, and derivative instrument debts), (2) claims for income taxes, (3) claims on insurance claims in excess of policy limits, (4) civil claims for uninsurable tort claims, punitive damages and penalties, and (5) criminal penalties, fines and costs.
The most common way to "perfect" a claim would be to get a money judgment against the bonded company that has been unstayed and unpaid for five weeks (35 days) from entry of judgment. But insurance company deductible claims would be perfected if certified by the insurance company as having been paid by it and not reimbursed within 91 days but not more than three years, by the bonded company. Tax claims would be perfected when assessed. In the case of companies that have ceased to be going concerns, a Bond Claims Receiver, a public official similar to the U.S. bankruptcy trustee, would be appointed by a federal district court or bankruptcy court upon the petition of the company or its bonding agency or other claimant representatives where a mass claim filing was underway or imminent.
Bonding agencies would have a right to indemnification from the company bonded for the aggregate outstanding amount all claims paid by the bonding agency, plus a service fee in a contractually established amount subject to regulation by the federal government regulatory agency for each claim paid, plus interest at a rate similar to subordinated corporate bond interest rates on the outstanding balance owed each day. This indemnification right would be secured by a UCC-1 filed blanket security interest under the UCC in all of the tangible and intangible personal property of the company and recorded security interests in all of its real property, with these security interests subordinate only to purchase money security interests in the collateral (and refinancing of that debt), tax liens to the extent provided by law, HOA liens to the extent provided by law, and express subordinations agreed to by the bonding agency.
Bond premiums would be subject to an excise tax used to fund an agency that would pay some or all of covered bond claims in excess of bonding agency bond amount limits because the federal government agency's required bond amount limits were too low in the case of a particular company.
Establishing Regulations
A federal advisory board attached to the Commerce Department Bureau administering the program would establish regulations for the program.
The insurance coverages and minimum policy limits and maximum deductible amounts required for each type of insurance would be established with a rule or formula, and this agency would also establish a simple formula to determine the dollar amount of the bond required.
This advisory board would also establish regulations to determine which state licensed insurance companies and bonding agencies would qualify for use by companies in the program.
Primary regulation of bonding agencies and insurance companies would remain with state governments and would be ratified by this agency essentially providing a second look to make sure that state regulation of bonding company and insurance company reserves was not too lax.
Enforcement
Publicly held companies would have to certify to the SEC that they were still bonded and insured on each regular report or with a special notice if this ceased to be the case. Compliance by publicly held companies would be enforced by the SEC.
A small new Commerce Department Bureau with a tiny budget and few employees would enforce compliance with an administer the program in the case of non-publicly held companies, government agencies, and public charities. It would would have a system for sanctioning or bringing into compliance entities in its jurisdiction that should have been bonded and insured, but were not, and for dealing with bonding agencies and insurance companies that fail to comply with the rules.
The Commerce Department Bureau would also vet insurance and bonding companies that wished to participate in the program to determine if they complied with the regulations for the program and were eligible to provide insurance or bonding that satisfied the program's requirements.
Privately held companies with 50 or more employees would have to certify that they were bonded and insured on their tax returns each year with a notice given by the IRS to the Commerce Department Bureau, if they were not. Other privately held companies filing tax returns with the IRS would have to check a box that they were or were not covered on their annual tax return, and another box regarding whether they were or were not required to be covered which would be similarly reported if appropriate. Firms that were covered or required to be covered, but did not have to file their own tax returns with the IRS in a given year, would still have to file an annual report with the IRS certifying their compliance and informing it of their non-compliance with referral to the Commerce Department Bureau, if necessary. Public charities would certify compliance on their annual Form 990 filed with the IRS or risk losing public charity status and would also be referred to the Commerce Department Bureau if they were not.
Local governments and state agencies would be to certify compliance each year to a responsible state government official designated by the state, and that designated state official would certify compliance (subject to exceptions reported along with a report on the actions being taken by that state official to resolve the non-compliance) to the Commerce Department Bureau.
Bonding agencies and insurance companies of covered companies would have to notify the SEC or the Commerce Department Bureau, as the case might be, if their bonds or insurance policies were terminated by the company covered by them for any reason.
Complaints that a company required to be bonded and insured, or representing that it was bonded and insured, was not bonded and insured, could be made to the SEC for publicly held companies, to the designated state official for state and local governments, and to the Commerce Department Bureau otherwise.
Complaints that a bonding agency or insurance company of a bonded and insured company was not acting properly would be referred to the state regulatory licensing that company.
A corps of Bond Claim Receivers would be established as an additional division of U.S. Bankruptcy Trustee's office. The U.S. Bankruptcy Trustee's office would not have any direct dealing with the Commerce Department Bureau or the SEC.
What Would This Mean?
Bankruptcies involving reorganizations of going concerns be limited to allocating the assets of the company left over after payment of purchase money secured debt, priority tax and HOA liens, and the bond indemnification lien debt. The only claimants in the bankruptcy would be (1) finance creditors, (2) income tax claims, (3) claims on insurance claims in excess of policy limits, (4) civil claims for uninsurable tort claims, punitive damages and penalties, and (5) criminal penalties, fines and costs.
Finance creditors would have loan covenants requiring excess insurance policies if in their financial judgment, the federal regulatory agency's minimum policy limits were too low and management didn't already decide to put that in place to protect equity owners.
People other than finance creditors dealing voluntarily with bonded and insured companies would almost never have uncollectible debts, thus protecting innocent people who have no choice but to do business with some big business in many circumstances.
The fact that all of their legal obligations would be collectible would also encourage bonded and insured companies to act lawfully, relative to people who would be uncollectible vis-a-vis major tort or other debt obligations. This would prevent the contagion of unpaid claims of bonding and insured companies from taking down innocent firms that do business with them, governments that do business with them, and public charities.
This system would not impact the vast majority of existing small businesses or impede small business formation, but would highly the heightened default risk of dealing with these businesses as trade creditors. But individual small business defaults of non-government contractors don't pose the same systemic risk to the economy.
Hi Andrew, Is a similar approach used by other OECD countries? Any examples you can point to?
ReplyDeleteSeems like it adds another layer of bureaucratic control and overhead to midsize company formation. Is this issue really such a cost to other small/medium companies that fixing it would lead to higher employment and higher wages? Or would it trade off employment for wages? Or even decrease both in the skilled trade space while adding more middle class bureaucrats?
Your proposal seems to callout for the presentation of a model. As a pipe dream, I would like every legislative proposal of size bigger than X to have the requirement to also file a economic model. In a few decades we would have a library of models to critique and compare.
Cheers,
Guy
@Guy
ReplyDeleteYou could get pretty close by simply creating a priority for trade creditors in bankruptcy over investment creditors which is far less obtrusive. This is an idea that flows from the practical reality that the vast majority of Chapter 11 bankruptcies actually do just that even though trade credit and investment credit have the same priority. No business that wants to continue to exist as a going concern can afford to do otherwise. Also, in big businesses, distinguishing between post-petition trade credit, which is a first priority administrative claim, and pre-petition trade credit, which is a non-priority general creditor claim, is essentially impossible to do cost effectively as a practical matter. But it seems unfair to have different priorities, in practice, for creditors of companies that liquidate rather than reorganize and linking an awareness of and ability to bargain around the risk to claim priority also makes sense.
The status quo also does a few other things that backdoor into something close to this scheme. Government construction contracts of any consequence already require contractors to be bonded and insured. And, the rules of the major stock exchanges prohibit listed firms from having non-purchase money secured debt for the most part and corporate bond covenants and stock exchange listing rules also place limitations on debt to equity ratios that are quite conservative. All publicly traded corporate bonds also have covenants requiring insurance, although they aren't standardized.
Many OECD countries (including, e.g., almost all of the developed countries in Asia) require every limited liability entity to have adequate insurance in place, although not bonding. Colorado requires all professionals in limited liability entities to have malpractice insurance as do many other states. Almost all U.S. states require all cars to have insurance in force although the quality of compliance varies a lot from state to state.
The FDIC really is exactly this in the finance sector (bank demand deposits and check float are no more or less than trade credit) and has over time been expanded from commercial banking to all deposit account banking including credit unions, savings and loans, etc.
The idea came to me during the Financial Crisis when all of FDIC-type insured institutions did fine, but two entire industries in the financial sector which lack that - investor owned investment bank and subprime lending were entirely wiped out with almost every firm in the entire industry in each case wiped out. The sister Denver branch of the large law firm I was working for at the time did nothing but handle the massive volume of litigation arising from one of the biggest bankrupt subprime lenders.
I also wrote and presented an academic conference work in progress paper on how the fact that key lenders had started structuring high risk loans as a conventional first loan plus a second loan for the remainder of the mortgage debt below 20% down performed so much more poorly (with incredibly massive losses in CA, FL and other non-recourse mortgage lending losses) than lenders who had used the business model of a single mortgage with mortgage insurance (who had almost no losses) because the way that the mortgage insurance industry underwrote loans evaluated risk better than the mortgage based security market for second mortgages, and explained has the tax preference for a second loan over mortgage insurance and other tax incentives contributed materially to the systemic risk in the economy and contagion impacts.
Policy-wise, I am basically taking the position that serious recessions are unavoidable, so instead of trying to engineer the out of the economy, we should trade some marginal reduction in economic growth rate maximization for a more robust economy with less leverage and more equity and insurance.
Non-profits that get grants also typically have to have insurance in place as a grant condition on themselves.
ReplyDeleteBottom line:
The insurance requirement would have almost no economic income on 95%+ of the firms covered and those that currently don't meet it are disproportionately the bad actors who cause greatly outsized risk of harm to the people they do business with and the larger economy that is greatly under-appreciated. In most cases, they already have to certify it to somebody anyway and it would make the paperwork associated with multiple lenders and accountants.
The impact on government construction contractors is near nil since they already have to have bonding.
The bonding cost for publicly held firms would be very modest to firms with good credit ratings, on the order of a blip in the prime rate by a quarter of a percent or less. There might be a little impact on the margins at low end of the NASDAQ and the OTC market, but lots of those firms already are doing going private transactions because the real downside of going public to them is that you need to be a C-corporation with double taxation, instead of a pass through entity, if you are publicly held. Big government contractors and large employers are also typically very creditworthy so, again, not too expensive.
But one large firm bankruptcy ultimately ending in liquidation that seriously stiffs the vendors and subcontractors and employees, which is rare in usual times, but common enough to impact a substantial minority of firms in financial crisis type condition, can be catastrophic for the small firms that have key contracts with these big firms, even though this would only modestly increase the overall losses of a corporate bond portfolio and would have virtually no impact on the loss profile of holders of equity and subordinated bonds that almost always lose everything (or get low single digit pennies on the dollar) in a bankruptcy, even if it is a reorganization that keeps the business going as a going concern.
So, basically, between bonding charges and increased risk for unsubordinated corporate bonds and private unsecured bond-like lending to closely held firms, the economic impact would be comparable to maybe a quarter of a percentage long term increase in interest rates give or take.
But this gets balanced against the benefits: quicker and easier due diligence when contracting with or lending money to bonded and insured firms, better conscious evaluation of insolvency risk than the status quo, a private sector force (bonding agencies) that provide a counterweight to the natural tendency of investor owned firms to favor excessively leveraged heads I win, tails you lose driven risk decisions (documented historically, for example, in the pre-FDIC history of bank insolvency and more recently in the collapse of the entire investor owned investment bank industry in the first serious recession after they were legalized), and a dramatic increase in the survivability of small and medium sized businesses in recessions bad enough to result in the demise of several significant large firms. You could model it as the economic equivalent of every covered firm having a AAA credit rating vis-a-vis non-long term investment business partners. This could actually be a huge boost to small and medium sized businesses in the program who now lose many significant contracts to bigger businesses for this reason.
This is also really just one component of a larger program that I imagine to make the U.S. economy more robust in economic downturns.
ReplyDeleteThe crown jewel of that would be to remove the incentives in the current U.S. tax code that strongly favor debt over equity (by making dividends paid deductible and eliminating preferential tax rates for corporate profits, for capital gains on stock or derivatives, and on qualified dividends which are a kludge to minimize double taxation of corporate profits). This would almost certainly lead to long term reductions in debt to equity ratios and to higher dividend payment rates (which in turn, would also lead to a tighter link between share prices and firm profitability). Lower debt to equity ratios lead to fewer firm failures in recessions and keep the cost of what bond financing is down lower because the risk is lower, but also reduces ROI on equity since it is less leveraged. Put another way, some of the ROI on equity we have in the current economy is due to the externality of being able to impose contract default risks on people outside the firm who often can't meaningfully evaluate that risk due to the small size and nature of the individual trade credit transactions.
Also we should change tax code provisions that favor debt based solutions like second mortgages over insurance based solutions like mortgage insurance because insurance companies has a very strong historical track record of doing more accurate risk evaluation than secondary debt market investors do. Eliminating the mortgage interest deduction for second homes and cash out refinancing, and allowing a mortgage insurance and property insurance deduction could help too.
Another big tax code provision that should be changed to change incentives is to end the overwhelming preference for stock option compensation of big business executives (which provides incentives to make gains but doesn't imposes costs if there are losses leading to heads I win, tails you lose incentives) in favor of incentives to compensate these executives with actual equity share compensation that has both upsides and downsides for he executives. The financial crisis revealed that this drove many bad decisions.
Removing tax incentives to leverage relative to a tax neutral environment would reduce a lot of systemic risk from the U.S. economy in downturns and make the inevitable recessions hurt our economy less and put the losses on the laps of people and institutions in a better position to weather them and to make decisions that make them less serious.
Medicare for all type structures would also make our economy much more robust and would be more efficient than the status quo too, it would reduce the "monthly nut" of firms and households which would help a lot when income takes a hit in recessions and would prevent long term bad health decisions from being made due to temporary financial weakness.
We'd also want to tweak securities law provisions that favor debt over equity a bit too strongly, and find better ways to facilitate small offerings of equity to investors who aren't widows and orphans but also don't meet current accredited investor standards, again, in order to make debt to equity in the economy lower and make it more robust.
ReplyDeleteAt the state and local level, encouraging rainy day funds which some states already have, would be a good move.
Changing the way we finance higher education (a joint state and federal issue) would also greatly reduce high leverage in households due to student loans, although there are loans that already have some safety valves that also help a little.
We should also shift K-12 financing from property taxes (which create a fixed monthly payment for both business and household taxpayers regardless of current income), to income taxes which are paid by taxpayers who have a current ability to do so, in addition to leading to better K-12 funding equity. It would also make housing more affordable.
Ending non-recourse mortgage financing laws like CA's and FL's would also be very important because it leads to heads I win/tails you lose driven bad decision making in mortgage underwriting and in decisions to take out mortgage debt that give rise to immense risk of loss during housing bubbles which these foreclosure law rules encourage. These laws in a few key states with important real estate markets were the proximate cause of the financial crisis - housing bubble collapse --> national financial sector collapse driven by mortgage backed securities losses --> widespread finance collapse driven harm to other parts of the economy. Borrowers with skin in the game don't take on risks that they can afford even if they can trick corrupted mortgage finance lenders into thinking that they can.