31 July 2010

Special Rules for Special Interests

Here is an example of where stakeholder theory and agency theory can be applied: the recent bankruptcies (insolvency administration and restructuring) of General Motors and Chrysler. Both companies' businesses had onerous contracts with their workforces, and in both cases managers -- in this case the courts and others involved in the process -- needed to address the status, priority and treatment of different stakeholders (or counter-parties):
  1. Employees and former employees, with employment contracts and outstanding benefits due from the company
  2. Secured creditors such as bondholders,
  3. Customers (e.g. with outstanding product liability claims),
  4. Suppliers with outstanding claims,
  5. Actual and potential buyers of the business or its assets, and
  6. Other creditors, counter-parties and stakeholders.
Of course this was a highly political affair and so the US (and Canadian) federal governments were heavy-weight players in this high stakes game. Before going into the details of what happened, I believe it is important to address the principles by which such decisions should be decided, and to discuss some of the alternative approaches. In particular I wish to highlight the agency theory oriented approach and contrast this with the stakeholder theory oriented approach (see here for my essay discussing these two approaches and perspectives generally).

The stakeholder theory approach seeks to balance and trade off the interests between the various stakeholders or stakeholder classes. This approach seeks compromise by stakeholders, negotiation, and some kind of balance resulting. In a business bankruptcy or insolvency case, this in effect means some kind of fair or equitable sharing of the pain or shortfall that is to go around, perhaps coloured by concerns such as the capacity of the party to bear the loss, the degree of involvement in or responsibility for the business's difficulties and so on. Another angle would be the kind of deal or resolution that would enable the restructured business to be as viable as possible.

The agency theory approach has a much greater focus on the legal form of the stakeholder's interest (or class of stakeholders), representing the deals struck in the past. Such deals have implied or express terms of priority as far as payment or settlement of obligations, for example, shareholders rank last, after subordinated creditors, who in turn rank after unsecured creditors, who rank after secured creditors. These terms of the deals struck in the past provide a sequence of who must bear the losses generated. The agency theory approach would also emphasize the obligation on the managers, be they shareholder appointed, court appointed or otherwise, to seek to maximise the economic value of the business through efficient management so that the amount of the loss that needs to be allocated is minimised. This approach therefore sees stakeholders as autonomous to promote their own interests and to do their own deals before the insolvency, and the role of managers is to maximise economic value and to honour the terms of the deals done with stakeholders, including those related to creditor priority.

I also want to emphasize the role of the law, in the agency theory approach, to regulating stakeholder conflicts. The law provides a sufficiently specific set of institutions for both a) creditor priority in a liquidation, restructuring or reorganisation and b) for the procedures and powers for administering the affairs of an insolvent party. The role of managers (including liquidators, receivers, trustees and administrators) is maximise economic value added by the business but also to work within the law that provides the procedures and priority rules. The insolvency law provides for a liquidator of a company to, for example, disclaim onerous property including unprofitable contracts. Given that most stakeholders' relationship with the company is created and governed by contract, such a power amounts to a power to a) cancel any contract with a stakeholder that is not adding economic value to the company's business and b) convert any loss to the stakeholder resulting from such a disclaimer into a claim on the company to pay money. Such a step is not necessarily an end to the stakeholder relationship, of course, as such a relationship can be continued on re-negotiated market terms should that be in the interests of both the business and the stakeholder.

In the cases of GM and Chrysler, the bankruptcies are alleged, by Richard A. Epstein, to have involved not disclaiming an onerous employment contract that should have been disclaimed, and thereby giving employees' and former employees' unsecured claims satisfaction ahead of secured creditors.

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