New rules to protect the many from the few

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It has been another uneasy week for relatives of the residents of the 700 care homes in Britain run by the struggling Southern Cross group. David Cameron, prime minister, has given assurances that people too old to look after themselves will not be woken one morning by an insolvency practitioner asking them to leave. But the legal basis on which he does so is not clear.

Still, Mr Cameron knows that if necessary parliament will give him whatever retrospective authority he needs to make good on his pledge. We have been here before. Alistair Darling, former chancellor, found himself in a similar position as queues formed outside the branches of Northern Rock. We will invent a way to ensure that the intolerable does not happen. There is evidently a policy gap.

The problem is hardly new. The second-largest operator of homes for the elderly, Four Seasons, is owned by a consortium of banks following a forced debt equity swap two years ago. Ironically, Four Seasons’ biggest shareholder is Royal Bank of Scotland, the bank recapitalised by the taxpayer as a result of making too many loans like that one.

Residential care is correctly seen as a growth market, and from time to time the companies engaged in it have attracted heady stock market valuations. These mispricings, exploited through sale and leaseback deals and high leverage, enabled private equity houses to extract large amounts of money from the sector, leaving thinly capitalised businesses vulnerable to any slowdown or pressure on fees. Southern Cross and Four Seasons are fresh instances of a recurring theme: profits accrue to a few financiers, consequential losses are widely diffused.

It is central to capitalism that bad businesses fail. But in the past two decades many corporate collapses involved businesses that were not fundamentally bad but whose financial structures could not accommodate even modest setbacks. Bankruptcy of a corporate entity in these circumstances may have large, adverse and avoidable consequences for people who were not party to the original agreements. These issues arise for any business with a dominant market position or engaged in the production of a key public service. Elderly people who find that the bed on which they lie has been the subject of a financial transaction on which the lessee has defaulted are just a particularly hard case.

In 1986 Britain created a new insolvency regime, loosely modelled on the US Chapter 11, designed to make it easier to continue the business of a failed company. In many respects, this has worked well – perhaps too well. Pre-packed administration deals are marketed as a means of escaping liability for over-rented property, while US airlines fly in and out of Chapter 11 almost as often as they fly in and out of Chicago, waving creditors goodbye without changing the pilot. A recent Office of Fair Trading report highlighted the too common phenomenon of the administrator who remains in charge of the business for several years until his own fees have exhausted the assets.

General insolvency rules are inadequate when a care home, or a bank, or a water supply company fails. The first priority in these cases must be the residents, depositors and customers: creditors come after. We need special regimes for such businesses, which would limit gearing, without discouraging entrepreneurs looking to enter these sectors.

A resolution authority, more powerful than the existing Insolvency Service, could not only protect unsecured creditors more effectively, but also balance the interests of creditors with those of the public at large. Without such an institution it is hard to see how we can ever take schools and hospitals out of direct state control. We are engaged in yet another round of reform which ducks the issue of what happens when these organisations fail. Failure is intrinsic to the market economy: but the legitimacy of capitalism depends in part on how it deals with the consequences of such failure. Recently, it hasn’t been doing too well.

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