A Cure for Covid-19 and a Vaccine for Creditors?

By Prof Hans Tjio
and Melvin Chan

Balance has been tipping over from creditors to shareholders and the pandemic is only bringing this deepening fault line to the fore.

Covid-19 slammed into the global consciousness this March and, as expected, immediately torpedoed the markets.

But despite the worsening economic data hogging news headlines, exacerbated by intensifying US-China tensions, the markets have paradoxically strengthened since. The S&P 500 has rebounded by more than 30 per cent since its March nadir, breaching its five-year pre-Covid-19 high.

Is the stock prices’ defiant upward trajectory in these trying times so inexplicable? Commentators point to spooked investors not knowing where else to park their liquidity and to tech stocks being the major beneficiaries. But a further explanation may be rooted in the realignment in the creditor-debtor tug of war, which Covid-19 has only brought into starker relief.

Something has happened to the Company as we know it

The concept of a company is simple enough at its core. A separate legal entity from its shareholders, a company allows businessmen to conduct business through a corporate that bears the risks of its enterprise solely. The company’s creditors could look only to its assets and capital, and would have no direct recourse against its shareholders.

The key tenet underpinning the company’s status as a separate legal entity which gave confidence to its creditors was the inviolability of the company’s capital – the company’s shareholders have no direct access to its assets. This allows the assets to be applied to creditors’ rights in an insolvency. In effect, the paid-up capital is locked-in, and originally, the law only allowed a company to reduce its capital by a capital reduction court order.

This balance between creditors’ and shareholders’ interests, premised on the sanctity of the company’s capital, has allowed corporates to take business risks, and trade and commerce to develop and flourish.

But there has long been a growing disturbance in the force.

Laws to protect insolvent companies from creditors were an early intervention, justified on the grounds that they created more equitable and improved returns for creditors and other stakeholders. More recently, rules against financial assistance and share buybacks were relaxed, tilting the balance further in favour of shareholders.

To highlight exactly how far the creditor has been left behind, we observe the developments leading up to, and during the pandemic.

The perpetual tug of war

In more buoyant times, increased shareholder activism pressured corporations to prioritise shareholders’ immediate interests over the company’s long-term, strategic considerations. This shift could be tolerated so long as profits flowed, with creditor and shareholder interests aligned.

However, in recent years, companies have lobbied to fundamentally – and almost insidiously – backtrack from protecting creditors in favour of securing value for shareholders. In the past, once a company became technically insolvent, creditors’ interests came first – a gospel truth. Shareholders were last in line.

But this “truth” has been gradually eroded. In its early incarnations, insolvency laws such as the US’s Chapter 11 provisions and Singapore’s statutory protection for companies in judicial management gave companies breathing space to recover when they fell on hard times. Over time, and accelerated by the global financial crisis (“GFC”) in the late 2000s, legislators and the courts have further weakened insolvency laws. Courts have made it more challenging to prove that a company is in fact insolvent. Post-GFC, many banks can also, in theory, no longer become insolvent given bail-in rules that automatically convert debt to equity when they default.

Covid-19 exposes fault lines

Then the pandemic happened. In the ensuing bedlam to stem economic and financial haemorrhage, governments the world over enacted laws to protect companies hit by the fallout. Wrongful trading rules, intended to stop a company incurring further debts when it has no reasonable prospect of repaying them in full, were suspended. In tandem with this, many countries (including Singapore) also implemented temporary moratoriums on creditors taking legal action against debtors.

While strong arguments exist in favour of providing ailing companies some life support, the crisis accentuated a growing power-balance shift between creditors and shareholders. As the pendulum has been allowed to swing – and at times has even been held aloft by the myriad of moratoriums and protective measures – the constituency that has most benefited are the controlling shareholders, at creditors’ grave expense.

But even prior to Covid-19’s onset, the rules that once supported maintaining a company’s capital have been weakening. Take for instance share buybacks, where companies repurchase shares they had issued from the markets in order to bolster stock prices. The US no longer prohibits this, and now relies on fraudulent conveyance rules to “catch” transactions that intend to defraud creditors. While seemingly sound in concept, the practical reality is anything but.

The raised bar for proving insolvency makes creditor protection even harder. As a result, companies have been able qualify as “profitable” (a requirement dispensed with in the US that Singapore still retains), allowing them to undertake enormous volumes of share repurchases and dividend payments: great for maintaining or raising share prices, not so much for developing the underlying business over the long term.

Historically, US airlines have been one of the biggest culprits of share buybacks. Over the last decade, they have collectively spent 96 per cent of their free cash flow on share buybacks, leaving virtually no reserves for the proverbial rainy day. Unfortunately, that day finally came early this year. And it has not quite stopped raining since.

Since then, US carriers have accepted grants and loans from the US$25 billion Cares Act bailout package, and continue to plead for extended relief after funding expired a month ago. While the pandemic must bear some of the blame for this predicament, it has also shone a searchlight on the shift towards enhancing shareholder value, at the creditor’s expense – in this case, the federal government and ultimately, the general public, who are forced to bail the carriers out during crises.

Lest we think that the shifts have only occurred in more cavalier markets, Hyflux’s spectacular implosion brings this warning very much home. For the better part of a decade prior to 2017, the erstwhile water-treatment darling now undergoing a S$3 billion debt restructuring was able to pay dividends to its shareholders, despite its net negative cash flow position. The dividend payments appeared to be supported by established and sound accounting principles, being premised on retained profits recognised in accordance with FRS 11 for Construction Contracts.

While the plight of retail investors (read: retirees who invested their life savings in Hyflux’s preference shares and perpetual securities) have fuelled the headlines, skirting under the radar is the chilling fact that Hyflux was seemingly entitled to benefit its shareholders at the ultimate expense of its creditors under conventional and prevailing accounting practices.

Hyflux did not appear to have done anything illegal or improper in this regard. The question is whether Hyflux ought to have done so, and the focus thus shifts from one of legal entitlement to governance. And this would be a recurring theme in the economic fallout from the pandemic.

Given the fault lines in the regulatory structure, there is nothing quite like a global pandemic to pry open these fissures and bring them to the fore. First, tanking markets will reveal corporate wrongdoing a rising market would mask, with the prime example of oil trader Hin Leong, which attempted to hide US$800 million of losses that might not have surfaced if oil prices had not tumbled. Second, with the increased challenges in enforcing their rights, banks and other voluntary creditors will demand higher interest rates. Trade suppliers may not deal with the company at all. The trust that had been built – from protecting the company’s capital – has been eroded. This will result in higher business costs.

A vaccine for our times

Even as the initial round of protective measures approaches its expiry, markets and regulators are discussing the possibility of permanent debt relief once Covid-19 passes in order to prevent a global crash. Similar protections were rolled out in the GFC’s wake, but fortunately many financial institutions and corporates that received bail-out funds because they were “too big to fail” could not, due to enhanced capital adequacy rules, use their money to buy back shares.

Where then do we go from here? As with Covid-19, no panacea exists for the realignment towards shorter term shareholder interests. While it may no longer be possible to revert to the creditor’s absolute primacy, we need to strike a new balance. Otherwise, we may have a stupid situation where governments have to intervene in markets to dampen soaring stock prices so that the real economy can do well.

In this regard, it pays to recall that our founding Prime Minister Lee Kuan Yew warned of the stock market’s overvaluation in 1973 that some think ended the early-’70s bull run. It was fortunate that he did, as Singapore’s economy would have suffered even more from the fourth Arab-Israeli war oil shock. This contrasts with the way that US and Chinese politicians today talk about keeping share prices up.

We can only hope that a Covid-19 cure is found soon, so that the interests of creditors and shareholders can once again be aligned, and the fissures mended. Because the alternative, a vaccine to readjust a company’s value from shareholders to creditors, appears to be a long ways away.

A version of this article was published in The Business Times on 31 October 2020 under the headline “Covid-19 tips balance further in favour of shareholders over creditors”.


TSMP law corporation