The unintended effect of examinership may force the closure of good firms, writes Bill Hobbs
The unintended consequence of limited liability status, highlighted over 150 years ago remains today – how to prevent the rogue from abusing the privilege of limited liability company status?
When first introduced in Britain the middle of the 19th century limited liability was seen as a “Rogues Charter” contrary to the tradition of the honourable businessman. Originally designed to encourage greater investment by shareholders in publically quoted companies it was extended to cover private companies where sole traders could establish a company and also benefit from limited liability.
While the incorporated limited liability company has significantly contributing to economic growth by providing a model though which investments are made in creating jobs, wealth and economic growth, its contribution to society has been tempered with concerns that unscrupulous dishonest business owners and managers benefit from abusing limited liability status.
In essence the problem is a moral hazard one where “limited liability” perversely gives shareholding owners and managers an incentive to trade recklessly, as they will take all the benefit and do not bear the risk of high failure, save the value of their shareholding. When their shares become valueless, far too many gamble for resurrection and trade into hopeless insolvency. The risk of the business is passed onto those who can least afford it – other small business owners.
The courts have generally acted to protect owner’s limited liability status and failed to protect business creditors. Stripping limited liability protection of owners, called piercing the corporate veil, has been said to be as rare as a lightening strike. However it’s not the job of the courts to fill a legislative vacuum in this area of business morals or behaviours. This is the job of law makers – politicians.
The enterprise model of the limited company is fundamental to the economic and social well-being of a nation. That is until rogues own and trade within its privileges. While laws do exist to deny rogues the protection of limited liability, they are a blunt instrument applied after the damage had been done. And the rogue knows this.
Some maintain small business owners are not really that protected as they are frequently required to sign personal guarantees. Whilst a “personal guarantee” may lessen limited liability, it’s a double edged sword. When powerful creditors, financiers, and bankers demand personal guarantees, then the legitimacy of limited liability is undermined. And this is the rub – what is the proper balance between providing for and rewarding honest risk taking and protecting against rogue trading? Should creditors in a powerful position be allowed to pierce the corporate veil and demand personal guarantees as a matter of course? Is the “personal guarantee” being used to strip bare the protection afforded the honest ethical entrepreneur?
Very often honest business ethic gives way to unscrupulous behaviour as business owners maximise financial leverage, pocketing the profits leaving their businesses financially vulnerable. Frequently these rogues act to distort competition and force honest businesses to collapse. Their suppliers, creditors, financiers, customers and competitors are left with the risk while they take all the benefits. This would not be possible were it not for limited liability status. Many argue the small private limited company is simply the owner’s alter-ego, affording him risk loss insurance privileges.
This is acutely seen with the Phoenix syndrome, when company owners shut down one company and immediately clone a new one to trade free of debts, leaving a trail of economic and social destruction in their wake. Others dodge the liquidation insolvency process which requires liquidators to report to the States corporate enforcement office the ODCE. They cease trading betting their company will be struck off and creditors denied legal redress. Others knowingly trade, betting that company liquidation or examinership will work in their favour.
Some times good intentions have unintended consequences. Introduced in 1990 the company examinership process is designed to rescue viable but troubled companies where they can demonstrate a reasonable chance of survival. Recent court cases have tested “reasonableness” in refusing to grant protection to bail out schemes that could not demonstrate viability. Nonetheless the unintended consequence of allowing a business owner start with a clean slate and others invest in the enterprise, is that legitimate business who are trading their way through difficult times are put at a competitive disadvantage as the recovered company competes at lower costs than its competitor. Some say examinership may allow free riders to buy into viable businesses at low cost and risk to themselves. Indeed examinership may distort competition in certain markets depending on the relative size of competing firms. While the intention may be to rescue viable businesses and preserve jobs, the unintended effect may distort competition, forcing the closure of good firms and consequential loss of jobs.
There are some owners who through no fault of their own get into trouble and others who where reckless and negligent in running their business. Honesty is a cornerstone of business behaviour. If the test of what an honest business person would have done is applied to the examinership process then whether or not rescue is reasonably possible can be tested within the bounds of honourable, ethical and moral business behaviour.
Soon to be enacted, revised and simplified company laws will elevate the status of the small private company, affording it the same status as a human person. But what of consideration of the wider social and economic effect of the unscrupulous owner who would hide behind limited status? Will greater protection be afforded to unsecured creditors against rogue traders? Are the state agencies charged with supervision and oversight preventative measures sufficient? Should consideration of a special statutory insolvency office to liquidate rogue companies with powers to strip away the corporate veil allowing small creditors some possibility of recovering money’s owed from rogue business owners be considered?
Insolvency provisions should not provide safe haven and sanctuary for less than honest behaviour. Nor can they be so onerous as to punish the honest business owner.
This article appeared in the Irish Examiner, Business Section, Monday 22nd February 2010
Monday, February 22, 2010
Monday, February 15, 2010
Tsunami of debt looms ominously on the horizon
Neither banks nor credit unions will be able to lend freely for some time, writes Bill Hobbs
The Governments assertion that NAMA would “get credit flowing again” was contradicted by the IMF which said it wouldn’t. The IMF view is not surprising as informed Irish commentators have long pointed out that asset managers or bad banks are not designed to get credit flowing again. This is not their purpose. They are designed to bail out troubled banks by taking over their bad loans. NAMA is no different, even if the Finance Minister has powers to direct banks to lend. No more than King Canute could order the tide back, the Minister cannot order a bank to lend when it can’t nor order it to make bad loans.
NAMA was marketed as an investment, offering to make money over ten years. It’s an offer based on past historic performance and wholly unrealistic, optimistic assumptions about future market conditions. Yet its business plan did not demonstrate what would happen if these conditions do not occur. Were Nama a consumer investment product, its prospectus (business plan) would probably breach regulatory consumer protection codes and its promoters would probably be ordered to withdraw the product.
It’s known that banking crisis cause prolonged credit starvation and higher costs of credit. It’s also known that credit starvation leads to credit rationing which in turn marginalises financially vulnerable businesses and people – in many cases excluding them access to affordable credit on favorable terms. This is precisely what is happening here, even where funds have been specially earmarked by banks for making new loans.
Irish banks are victims of a self generated earthquake that almost brought them crashing down. The damage wrought by the initial shock wave is represented by NAMA’s €90bn nationalisation of construction and property development loans. The state will unwind these loans at a huge cost that some have convincingly estimated could be €12bn or more. Once “Namatised”, the recapitalisation requirement of four state guaranteed banks is being estimated at about €10bn, before factoring in the higher levels of regulatory capital required by regulators and capital needed to fund further loan losses. Furthermore state owned Anglo Irish Bank will also need billions in fresh state capital. The state will have to fund recapitalisation effectively taking the banks into near full temporary public ownership, as private investors are unconvinced other loan losses have been fully addressed.
These losses are the after shocks; the second, third and fourth wave of bad debts. They are the souring loans below the NAMA buy out threshold, loans to consumers and loans to small businesses. Irish consumers and small business owners, who are the most indebted in Europe, are facing declining turnover or incomes, higher taxation and as banks increase their lending margins to keep alive, higher costs of credit. This combination of factors along with negative equity will inevitably trigger loan defaults. And business loans, frequently secured by their owner’s personal guarantees, will morph into personal debt as they go bad. Billions will have to be written off, as people simply cannot repay what they owe.
Will the banks be profitable enough to self-fund reconstruction and write off their post-Nama balance of bad debts? Many doubt they will. For now they will not make new loans but will focus on driving down costs and driving up profits through increasing their lending margins. Already most foreign owned banks are closed to new business and have announced large scale branch closures and staff redundancy programmes.
Whilst other countries have similarly troubled banks, the exceptional thing about here is the entire banking system and its participant firms are in trouble including the credit union sector. While home mortgage arrears are rising, these are lag indicators given that people prioritise mortgage payments. Unsecured, credit union loans are a lead indicator of consumer debt problems. Its been estimated that close to 10% of their loans are in arrears, many of which were made to first time house buyers to fund down payments on their homes. Trade body ILCU (Irish League of Credit Unions) said last year credit unions were increasing lending but their published accounts are showing a dramatic decline in new loans. Significantly under lent – only 50% of assets are in loans- they are nonetheless suffering from many of the same problems the banks have. Experiencing declining profitability they are struggling to safely lend, provide for loan losses and fund higher levels of regulatory capital.
Fearing the new Central Bank Commission may become a more effective regulator; the ILCU appears to want nothing to do with it. It is proposing the credit union sector should not be regulated by the financial services regulator but should once again be regulated by an independent credit union regulator under the Department of Enterprise Trade and Employment. However it has not demonstrated why this would lead to better regulatory outcomes, improve safety and soundness or ensure credit unions make more loans.
One thing is certain, neither banks nor credit unions will be able to lend freely for some time to come. Billions of household deposits are funding loans already made. Locked into zombified balance sheets, savings cannot be mobilised for productive lending by the banking system. Meanwhile an onrushing tsunami of debt – the stuff NAMA is not designed to take over, is appearing on the horizon.
This article appeared in the Irish Examiner, Business Section, Monday 15th February 2010
The Governments assertion that NAMA would “get credit flowing again” was contradicted by the IMF which said it wouldn’t. The IMF view is not surprising as informed Irish commentators have long pointed out that asset managers or bad banks are not designed to get credit flowing again. This is not their purpose. They are designed to bail out troubled banks by taking over their bad loans. NAMA is no different, even if the Finance Minister has powers to direct banks to lend. No more than King Canute could order the tide back, the Minister cannot order a bank to lend when it can’t nor order it to make bad loans.
NAMA was marketed as an investment, offering to make money over ten years. It’s an offer based on past historic performance and wholly unrealistic, optimistic assumptions about future market conditions. Yet its business plan did not demonstrate what would happen if these conditions do not occur. Were Nama a consumer investment product, its prospectus (business plan) would probably breach regulatory consumer protection codes and its promoters would probably be ordered to withdraw the product.
It’s known that banking crisis cause prolonged credit starvation and higher costs of credit. It’s also known that credit starvation leads to credit rationing which in turn marginalises financially vulnerable businesses and people – in many cases excluding them access to affordable credit on favorable terms. This is precisely what is happening here, even where funds have been specially earmarked by banks for making new loans.
Irish banks are victims of a self generated earthquake that almost brought them crashing down. The damage wrought by the initial shock wave is represented by NAMA’s €90bn nationalisation of construction and property development loans. The state will unwind these loans at a huge cost that some have convincingly estimated could be €12bn or more. Once “Namatised”, the recapitalisation requirement of four state guaranteed banks is being estimated at about €10bn, before factoring in the higher levels of regulatory capital required by regulators and capital needed to fund further loan losses. Furthermore state owned Anglo Irish Bank will also need billions in fresh state capital. The state will have to fund recapitalisation effectively taking the banks into near full temporary public ownership, as private investors are unconvinced other loan losses have been fully addressed.
These losses are the after shocks; the second, third and fourth wave of bad debts. They are the souring loans below the NAMA buy out threshold, loans to consumers and loans to small businesses. Irish consumers and small business owners, who are the most indebted in Europe, are facing declining turnover or incomes, higher taxation and as banks increase their lending margins to keep alive, higher costs of credit. This combination of factors along with negative equity will inevitably trigger loan defaults. And business loans, frequently secured by their owner’s personal guarantees, will morph into personal debt as they go bad. Billions will have to be written off, as people simply cannot repay what they owe.
Will the banks be profitable enough to self-fund reconstruction and write off their post-Nama balance of bad debts? Many doubt they will. For now they will not make new loans but will focus on driving down costs and driving up profits through increasing their lending margins. Already most foreign owned banks are closed to new business and have announced large scale branch closures and staff redundancy programmes.
Whilst other countries have similarly troubled banks, the exceptional thing about here is the entire banking system and its participant firms are in trouble including the credit union sector. While home mortgage arrears are rising, these are lag indicators given that people prioritise mortgage payments. Unsecured, credit union loans are a lead indicator of consumer debt problems. Its been estimated that close to 10% of their loans are in arrears, many of which were made to first time house buyers to fund down payments on their homes. Trade body ILCU (Irish League of Credit Unions) said last year credit unions were increasing lending but their published accounts are showing a dramatic decline in new loans. Significantly under lent – only 50% of assets are in loans- they are nonetheless suffering from many of the same problems the banks have. Experiencing declining profitability they are struggling to safely lend, provide for loan losses and fund higher levels of regulatory capital.
Fearing the new Central Bank Commission may become a more effective regulator; the ILCU appears to want nothing to do with it. It is proposing the credit union sector should not be regulated by the financial services regulator but should once again be regulated by an independent credit union regulator under the Department of Enterprise Trade and Employment. However it has not demonstrated why this would lead to better regulatory outcomes, improve safety and soundness or ensure credit unions make more loans.
One thing is certain, neither banks nor credit unions will be able to lend freely for some time to come. Billions of household deposits are funding loans already made. Locked into zombified balance sheets, savings cannot be mobilised for productive lending by the banking system. Meanwhile an onrushing tsunami of debt – the stuff NAMA is not designed to take over, is appearing on the horizon.
This article appeared in the Irish Examiner, Business Section, Monday 15th February 2010
Monday, February 1, 2010
Good SMEs will fail without strategic state support
Weak business will and should be allowed to go under - it's the good ones we need to save, writes Bill Hobbs
Banks have tightened lending criteria, rationing credit as they shore up shattered balance sheets, improve liquidity and raise margins to rebuild profitability. Accessing affordable credit on favourable terms is now almost impossible for all but the best of borrowers. Last week Minister Mary Coughlan, demonstrating Government’s meek response to a financing crisis that threatens to destroy a generation of small businesses, announced her officials were considering a credit guarantee scheme for small businesses.
“FOGAPE”, the Chilean state credit guarantee scheme for small businesses – which is one of many – was mentioned as a model. Established in 1980 and active since 1998, this scheme guarantees - provides loan loss coverage - upwards of 80% of SME bank borrowings. The guarantee is provided to good small business borrowers who, were it not for the absence of good collateral, would otherwise be granted credit on favourable rates and terms. Fogapes’ small loss insurance fund of $200m can underwrite losses on upwards of $2bn on SME loans. Banks tender for its coverage and pay a commission which in turn funds any losses incurred by it. Evidence, dating from 2006, indicates the design of the scheme has led to an increase in favourable lending by banks to small business. In response to its economic crisis, the Chilean government increased funding to provide guarantees of upwards of $2bn dollars in November 2008.
It is one of the many innovative schemes enhanced or introduced by Governments worldwide to support small businesses. The jury is out whether many of these are effective in helping good businesses survive and prosper as emergency measures are known to delay the inevitable insolvency of bad businesses that ought to be allowed to fail.
Here, business trade bodies ISME, SFA, IFA and others have been pleading for a range of responsive measures from the Government since 2008. And its response starkly contrasts with the response of other Governments since the onset of the global crisis.
The OECD report on “The impact of the global crisis on SME and Entrepreneurship Financing and Policy Reponses” published in June 2009, illustrates how 29 countries implemented extensive measures for SME’s, including credit guarantee schemes designed to allow banks to make good loans to good borrowers. Other measures include export credit guarantees, credit mediators who mediate between businesses and their bankers, favourable tax regimes such as accelerated depreciation schedules, employment subsidies, faster payment by state and public bodies (British policy is to pay within ten days) and payment forbearance in “profit insensitive taxes” paid regardless of whether or not a business is making a profit.
These measures target three areas: stimulating demand for goods and services, preventing depletion of working capital and liquidity and helping to maintain capital investment levels.
Access to financing is one of the most significant challenges for the creation, growth and survival of SME’s, particularly innovative ones. This historic problem of accessing affordable credit on favourable terms has worsened considerably as they have suffered a double blow. There’s been a drastic drop in demand for goods and services and tightening in credit terms, as banks ration scarce funding to their better customers. This double whammy, amplified by Government’s deflationary fiscal policy, has severely affected their all important life sustaining cash flow and liquidity.
SME’s are facing significant challenges. They cannot downsize as they are already small. They are less diversified, have weaker financial structures (lower capital and higher debt), have no credit rating and are heavily dependent on bank credit and have limited financing options. If they are part of a global value chain they bear the brunt of difficulties as large companies implement cost reduction, inventory control and cash flow responses to declining demand.
Increasing delays in receiving payments when added to unsold stock results in an endemic shortage of working capital and decrease in cash or liquidity. Added to this rising defaults and insolvencies leave many without a key supplier or uncollectable bad debts.
Mazars’ “Review of Lending to SMEs” published in August last year highlighted the paucity of data available to assess banking credit to business and stark difference between what banks were saying they were doing and what small businesses were experiencing. The review illustrated what happens in a credit crisis as banks struggling for their own survival, tighten lending criteria and make only good loans to good borrowers who have good collateral.
Used to boom time growth, far too many small businesses are neither good borrowers or have good collateral. Far too many did not allow for business risk and failed to create cash flow, liquidity and capital buffers. Far too many business owners used boom time positive cash flow as a personal asset, plundering it to make investments in building personal wealth – more often than not investing in property. Many cannot prove they have a sustainable business case for the future as there is no demand for overpriced poor quality goods and services.
Banks cannot be expected to make bad loans to bad borrowers. Weak businesses will and should be allowed to go under - this is the nature of business. What’s important is to ensure that established good well managed businesses and innovative start ups with viable futures are supported and have access to credit on fair terms. It’s important to ensure where they cannot access credit due to lack of collateral then the state provides a temporary public guarantee. It’s also important that any guarantee scheme is designed to limit moral hazard risk of bankers selecting against the state by using the guarantee to support bad businesses. The danger is such behaviour while alleviating liquidity and cash flow problems only delays inevitable insolvency.
Considering credit guarantees in isolation of an integrated series of measures to help good businesses survive and prosper is not what is needed. Government has yet to design and implement a cohesive strategic policy response to the immediate and long term problems faced by SME’s. In the meantime far too many good businesses will fail.
This article appeared in the Irish Examiner, Business Section, Monday 1st February 2010
Banks have tightened lending criteria, rationing credit as they shore up shattered balance sheets, improve liquidity and raise margins to rebuild profitability. Accessing affordable credit on favourable terms is now almost impossible for all but the best of borrowers. Last week Minister Mary Coughlan, demonstrating Government’s meek response to a financing crisis that threatens to destroy a generation of small businesses, announced her officials were considering a credit guarantee scheme for small businesses.
“FOGAPE”, the Chilean state credit guarantee scheme for small businesses – which is one of many – was mentioned as a model. Established in 1980 and active since 1998, this scheme guarantees - provides loan loss coverage - upwards of 80% of SME bank borrowings. The guarantee is provided to good small business borrowers who, were it not for the absence of good collateral, would otherwise be granted credit on favourable rates and terms. Fogapes’ small loss insurance fund of $200m can underwrite losses on upwards of $2bn on SME loans. Banks tender for its coverage and pay a commission which in turn funds any losses incurred by it. Evidence, dating from 2006, indicates the design of the scheme has led to an increase in favourable lending by banks to small business. In response to its economic crisis, the Chilean government increased funding to provide guarantees of upwards of $2bn dollars in November 2008.
It is one of the many innovative schemes enhanced or introduced by Governments worldwide to support small businesses. The jury is out whether many of these are effective in helping good businesses survive and prosper as emergency measures are known to delay the inevitable insolvency of bad businesses that ought to be allowed to fail.
Here, business trade bodies ISME, SFA, IFA and others have been pleading for a range of responsive measures from the Government since 2008. And its response starkly contrasts with the response of other Governments since the onset of the global crisis.
The OECD report on “The impact of the global crisis on SME and Entrepreneurship Financing and Policy Reponses” published in June 2009, illustrates how 29 countries implemented extensive measures for SME’s, including credit guarantee schemes designed to allow banks to make good loans to good borrowers. Other measures include export credit guarantees, credit mediators who mediate between businesses and their bankers, favourable tax regimes such as accelerated depreciation schedules, employment subsidies, faster payment by state and public bodies (British policy is to pay within ten days) and payment forbearance in “profit insensitive taxes” paid regardless of whether or not a business is making a profit.
These measures target three areas: stimulating demand for goods and services, preventing depletion of working capital and liquidity and helping to maintain capital investment levels.
Access to financing is one of the most significant challenges for the creation, growth and survival of SME’s, particularly innovative ones. This historic problem of accessing affordable credit on favourable terms has worsened considerably as they have suffered a double blow. There’s been a drastic drop in demand for goods and services and tightening in credit terms, as banks ration scarce funding to their better customers. This double whammy, amplified by Government’s deflationary fiscal policy, has severely affected their all important life sustaining cash flow and liquidity.
SME’s are facing significant challenges. They cannot downsize as they are already small. They are less diversified, have weaker financial structures (lower capital and higher debt), have no credit rating and are heavily dependent on bank credit and have limited financing options. If they are part of a global value chain they bear the brunt of difficulties as large companies implement cost reduction, inventory control and cash flow responses to declining demand.
Increasing delays in receiving payments when added to unsold stock results in an endemic shortage of working capital and decrease in cash or liquidity. Added to this rising defaults and insolvencies leave many without a key supplier or uncollectable bad debts.
Mazars’ “Review of Lending to SMEs” published in August last year highlighted the paucity of data available to assess banking credit to business and stark difference between what banks were saying they were doing and what small businesses were experiencing. The review illustrated what happens in a credit crisis as banks struggling for their own survival, tighten lending criteria and make only good loans to good borrowers who have good collateral.
Used to boom time growth, far too many small businesses are neither good borrowers or have good collateral. Far too many did not allow for business risk and failed to create cash flow, liquidity and capital buffers. Far too many business owners used boom time positive cash flow as a personal asset, plundering it to make investments in building personal wealth – more often than not investing in property. Many cannot prove they have a sustainable business case for the future as there is no demand for overpriced poor quality goods and services.
Banks cannot be expected to make bad loans to bad borrowers. Weak businesses will and should be allowed to go under - this is the nature of business. What’s important is to ensure that established good well managed businesses and innovative start ups with viable futures are supported and have access to credit on fair terms. It’s important to ensure where they cannot access credit due to lack of collateral then the state provides a temporary public guarantee. It’s also important that any guarantee scheme is designed to limit moral hazard risk of bankers selecting against the state by using the guarantee to support bad businesses. The danger is such behaviour while alleviating liquidity and cash flow problems only delays inevitable insolvency.
Considering credit guarantees in isolation of an integrated series of measures to help good businesses survive and prosper is not what is needed. Government has yet to design and implement a cohesive strategic policy response to the immediate and long term problems faced by SME’s. In the meantime far too many good businesses will fail.
This article appeared in the Irish Examiner, Business Section, Monday 1st February 2010
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