The rules governing capitalist organisations, dating back to the mid-19th century, are fairly simple. In short, the shareholders of a limited liability corporation are entitled to the residue after any claims against that corporation have been met. When a corporation is unable to meet valid claims, control passes to the holders of these claims in a legally defined order of priority. But, as finance has grown more complex, these rules have come to look more shaky; they can falter dangerously in modern banking or in the case of a struggling retail business such as BHS.
For plainly solvent companies, the concept works well: shareholders enjoy rights of control and have financial incentives to ensure the business is effectively managed. It also works for plainly insolvent companies. But what of the grey area in between — companies that might or might not be able to meet valid claims in future?
This problem was always present, and law developed to deal with it. In particular, directors have a responsibility to assess the solvency of the business, and the privilege of limited liability may be withdrawn if they take advantage of that grey area to trade recklessly. But such provisions can, and should, deal only with egregious cases. Struggling businesses should be able to take a shot at trading out of financial difficulties. Otherwise few start-ups could succeed.
Yet financial innovation has expanded the grey area in which companies might or might not be viable. In 2008 no one could honestly have said whether or not big financial institutions were solvent or not. And banks are not the only businesses whose standing depends on political decisions the companies concerned cannot control. Mezzanine finance is part of the normal structure of a private equity buyout. Bail-in bonds for troubled banks institutionalise that elision of debt and equity. And when a pension deficit recovery plan is scheduled to last decades into the future, who is to know whether the implied claims will actually be met?
When the equity of a limited company is negligible relative to the scale of the business, that business is in effect owned by no one. Or, worse, the claims of shareholders and other stakeholders become call options, with the undesirable incentives to risk-taking such asymmetry implies. These perverse incentives were at the heart of the 2008 financial crisis. That is why it is right to insist that if financial conglomerates continue to engage in speculative trading they should carry a much higher proportion of their capital as equity than the new rules from the Basel Committee on Banking Supervision imply.
Into the ownership vacuum of a business with equity of little and uncertain value enters Dominic Chappell, a former bankrupt with little capital or relevant expertise. Through his vehicle, Retail Acquisitions, he paid Sir Philip Green £1 for BHS, a high-street chain with more than 10,000 employees and a large pension fund deficit. The business collapsed in just over a year, leaving workers with no jobs and reduced pensions, creditors unpaid and a gaping hole to be filled by the UK’s statutory Pension Protection Fund.
America’s Chapter 11 bankruptcy legislation, which charges an experienced judge with restructuring the variety of claims against companies in financial difficulties, provides the elements of a solution to these problems.
Struggling companies have multiple stakeholders. Once Sir Philip’s equity had vanished, the principal economic interest in BHS was held principally by the PPF and secondarily by the employees.
The economic logic that gives the right and obligation for shareholders in thriving companies to appoint and supervise management suggests equivalent rights in struggling companies should go to the parties that will lose from their collapse.
This article was first published in the Financial Times on June 15th, 2016.