Trade Credit Insurance

It is will understood that bondholders and long term secured creditors of publicly held companies are financial creditors making a long term investment who need to consciously consider the creditworthiness of the company during the life of a bond when they make their investment and bear the risk of loss upon a default.  Also, there may be hundreds of thousands of bondholders in a typical publicly held company, but typically, the bondholder’s interests are managed by a trustee for the bondholders and the total number of trustees for bondholders for a publicly held company is rarely more than a couple of dozen, and often there are just a handful of them.

The same cannot generally be said of the legion of trade creditors of a typical publicly held company.  These may number in the tens of thousands, have claims that range from tiny to substantial, they are not organized collectively outside of bankruptcy, and they almost always predominantly get paid in full in the long run during a Chapter 11 reorganization bankruptcy.  For those not familiar with the term, “trade credit” generally refers to willingness of a vendor or customer doing business with a company in the course of its day to day operations to defer payment for a short period of time (typically thirty to ninety days) without interest.  It wouldn’t be unusual for trade credit (also known in accounting terms as “current liabilities”) to be 10%-20% of the book value of a firms assets at any given time.

I’ve proposed in the past that trade creditors of companies formally be given priority in bankruptcy so as to recognize the economic reality that manifests in Chapter 11 reorganizations, and for reasons described below for an alternative approach involving insurance and/or bonding of companies by private (but perhaps, if necessary, government chartered) insurance companies.

But, there is another approach, which borrows from the area of deposit insurance in financial institution insolvencies that has been very effective in preventing financial institution insolvencies from causing wider damages to the economy.

What if publicly held companies, either to secure favorable terms with trade creditors in the marketplace, or as a matter of regulatory mandate, secured “trade creditor insurance” from a suitably regulated insurance company with adequate reserves and financed this system by paying premiums for this insurance, which would guarantee payment of the company’s trade debts (but not its financial debts) in the event of its insolvency, just as comprehensive general liability insurance (which is not legally required, but is universally maintained by publicly held companies presumably to reassure investors) is routinely secured to finance a company’s tort debts.

The company providing the trade creditor insurance would in turn have a priority claim in any insolvency proceeding similar to that of the FDIC, to be indemnified for the claims it paid.

Thus, trade creditors of a bankrupt company would not need to panic because they would be assured immediate prompt payment of their claims in full almost as quickly as they would have been paid by the company had it been solvent, and only trade credit insurance companies and financial creditors of firms would have to seriously investigate a publicly held company’s creditworthiness.

If this sounds familiar, it should.  This kind of arrangement is routine in the construction industry, and is almost universal among government entities employing contractors to do doing construction work, and is called ‘bonding”, as in the familiar phrase “licensed, bonded and insured.”

If publicly held companies and privately held companies seeking to compete in the same markets with them, were routinely bonded, this would reduce the transaction costs involved in dealing with such firms, would produce more prompt and dramatically simplified resolutions of insolvencies of bonded companies, and would greatly reduce systemic risk in the economy at large, making it more robust during economic downturns.

But, because the risk that a publicly held bonded company would be unable to pay trade creditors in the long run would already be so low (perhaps 1% of outstanding trade credit or less), in part, because of debt to equity ratios mandated by stock exchanges in order for a company to be listed, and by corporate bondholders as loan covenants, typically limiting debt to something like 50% of assets in non-financial companies, the premiums that a publicly held company would have to pay for this kind of bonding would probably be quite modest. They would be lower still if trade creditor insurance indemnification claims were given priority in bankruptcy.  And, they could be lowered even further if bonding companies imposed their own covenants upon companies that would mitigate the risk of defaults on trade credit in advance.

Indeed, the creation of an industry with an institutional and lobbying interest is controlling systemic risk in American’s big business sector, and powerful tools through insurance underwriting to accomplish those ends, might arguably, in the long run, be as important for the American political economy as the direct benefits of the policy itself.

One of the problems that led to the financial crisis was that credit rating firms, which have immense impact on insolvency risk management in the big business sector, had no skin in the game to temper the small dollar incentives created by fees charged to firms to have their credit rated so that they could obtain bonds.  The harm caused by inaccurate credit rating assignments by these firms far outweighed any capacity those firms had to compensate people harmed when those inaccurate credit rating assignments were the result of negligence or outright fraud.  They were judgment proof.

In contrast, firms providing bonding and/or trade credit insurance (to the extent that the two are distinguishable) would have substantial financial reserves which would give these firms a powerful economic incentive to set premiums accurately relative to risk for particular publicly held businesses or for privately held businesses seeking to participate in the marketplace with those publicly held businesses on an equal footing.

from Wash Park Prophet
via Denver News

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