What should happen to people who can’t repay their debts? In the ancient world it was common to enter “debt bondage”, a form of slavery. More recently we had the debtor’s prison, of the sort with which Charles Dickens’ unfortunate father found himself acquainted.
Personal bankruptcy acts over the 19th century phased out such severities. And for people who formed companies, funded by borrowing, the major legal innovation was modern “limited liability” in 1855. This restricted the claims of creditors to the funds you had invested in the company – in other words, aggrieved lenders couldn’t move onto your other savings after they’d exhausted the assets of the firm.
The perennial objection to such protections is what economists call “moral hazard”: the idea that they give people an incentive to take excessive risks, knowing that they can walk away from the financial consequences if they go wrong, while others have to pick up the tab.
“The directors of such companies – being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own,” griped Adam Smith in The Wealth of Nations back in 1776. “Negligence and profusion,” predicted the Scottish father of economics, “must always prevail, more or less, in the management of the affairs of such a company.”
We’re hearing an echo of that moral hazard argument today, with the swell of complaints about Company Voluntary Agreements (CVA) on the British high street. The House of Fraser department store chain, struggling like much of the rest of the retail sector, entered a form of insolvency last week. But instead of opting to wind up the company and liquidate its assets to pay creditors, it is instead attempting a CVA.
This means the historic retail name (now Chinese-owned) is asking all its creditors, including its landlords, to agree to a reduction in their claims so the company can continue trading.
Landlords say CVAs have become a form of shakedown for them. A CVA requires only 75 per cent of support of all creditors to be approved. But the creditors who take the biggest financial hit are them, in the form of lower rents than previously agreed. House of Fraser is looking for a 25 per cent rent cut on the stores it will keep open. It’s suggested that CVAs are being instigated cynically by firms, not as a last ditch bid for survival, but as a way of simply cutting their costs.
Some other retail firms who don’t enter CVAs also detect unfair competition. Why should they, successful businesses, continue paying their agreed level of rent, while a competitor who has overextended themselves gets a rent cut to help finance a turnaround? Isn’t this moral hazard in blazing neon? Only up to a point. A government review of the CVA regime, something the British Property Federation wants, seems warranted. Yet some of the claims of abuse are overblown. Entering a CVA is not a cost-free option for any firm, just as declaring personal bankruptcy is not cost-free for the over-indebted individual.
Both will find it more difficult to borrow again for their next venture. And if they can borrow it will be at a penal interest rate.
There’s reputational damage for a retailer, too. For a store with a higher-end reputation, such as House of Fraser, last week’s headlines are not exactly desirable PR. Similarly, when it comes to personal bankruptcy, we are a still, here in the UK, a long way from the American culture of wearing them as a badge of pride for the serial entrepreneur. The days of the debtor’s prison may be gone, but bankruptcy is not the subject of loud dinner party boasts.
It’s also important to think about incentives on all sides when it comes to a CVA proposal. Landlords would certainly take a financial hit if a tenant went into liquidation, as they would have to re-let the property, possibly after a long and costly vacancy period. And the new rental agreement with a fresh tenant might be at a lower rate anyway. If the troubled tenant genuinely signed up to a rent that was economically unsustainable for any firm, a CVA can be regarded as a useful institutional solution which allows market forces to operate while also minimising wasteful adjustment costs.
This leads to a related point: moral hazard is also not a one-way street. For every irresponsible borrower, there is usually an irresponsible lender. We saw this vividly in the eurozone crisis with Greece. German and French banks lobbied for full protection for their unwise investments in Greek sovereign bonds and the European Commission and the International Monetary Fund strove, for far too long and at great social cost in Greece and the wider eurozone, to give it to them.
As Ashoka Mody, a former IMF economist argues compellingly in his new book EuroTragedy, it would have been better for the inevitable default to have been allowed to happen much earlier.
It’s impossible to entirely divorce morality from the repayment of debt, whether personal or corporate.
And we shouldn’t try to: moral hazard exists. But, by the same token, it behoves us to also recognise that, sometimes, we’re all better off if creditors don’t ultimately get back what they might have once expected.