Author: jcp1jcp

by J.C. Pate

April 27, 2020

Business interruption insurance does not cover pandemics and proposals to retroactively change these agreements would unfairly rewrite the rules.

As the coronavirus pandemic spreads throughout the country many state and local governments have required non-essential businesses to close, including restaurants, theaters, gyms, and the like.  The impact on the economy has been devastating with small and medium businesses hit particularly hard.  These businesses, their owners, and their employees are innocent bystanders in this tragedy.  In response, many ideas have been put forward to provide support.  

One particularly bad idea being promoted by some politicians and litigation lawyers is to retroactively require business interruption insurance to cover losses related to the pandemic.  These policies were not originally written to cover pandemics so the premiums paid were not priced to include this risk.  Retroactively changing these policies would be unfair to the insurers who entered into these agreements and would fundamentally damage the reliability of contracts, resulting in serious harm to our economy’s ability to operate efficiently.  

To understand this issue, it is helpful to start with an overview of business interruption insurance.

These policies are written to cover physical loss or damage.

Business interruption insurance is generally written to cover certain costs arising from physical loss or damage due to events such as fires or floods.  This kind of policy does not cover losses related to government-mandated business closures due to a pandemic because there is no physical loss or damage in these cases.  

Insurance policies only cover items that are specifically listed.  

Insurance policies start with a specific list of items that are covered and build from there by adding certain clarifications and conditions.  An examination of business interruption insurance policies will reveal that losses from pandemics are not included in the original list of covered items.  

Many policies go further and specifically exclude any losses related to virus outbreaks.   This is an extra clarification added for the avoidance of doubt.  Some politicians have suggested if policies do not have such a “virus exclusion” that must mean the policy covers losses from pandemics.  However, just because something is not excluded does not mean it is covered.  This makes sense because it is impossible to list every possible exclusion.  

The policy protections cannot get bigger than the original set of covered items, whether or not exclusions are added for clarity.  For this reason, it is a mistake to assume that a policy without a “virus exclusion” will cover pandemic losses.

Insurers need to clearly understand what is covered so they can calculate the risk of loss and charge premiums that are commensurate.

It is important for insurers to know upfront what risks a policy covers so they can analyze and quantify the potential risk.  This process determines what premiums they charge their customers.  In the typical business interruption insurance policy, insurers never agreed to cover losses from pandemics or the business closures we are seeing now.  As a result, the premiums paid by customers never included amounts to cover the risk of pandemics.  Mandating new retroactive coverage is akin to requiring insurers to sell fire insurance to a homeowner after their house has caught on fire.  

It is important to read the text of each insurance policy to understand the coverage.

Insurance policies are based on standard forms approved by state insurance regulators.  However, each insurance policy is individually negotiated between two parties, so it is important to read the full text of each contract to understand the coverage. 

In particular, it is insufficient to find some words in a policy that sound helpful to one’s position and fail to read the complete text.  For example, a politician might see a section in a policy regarding “Civil Authority Coverage” and assume this means losses from government-mandated shutdowns are covered.  However, these clauses are typically limited by a requirement for physical loss or damage to the insured property or adjacent properties.  Losses from a pandemic would not meet these requirements.  This is an example of why the best way to resolve insurance disputes is on a case-by-case basis driven by an analysis of the relevant policy, not by imposing blanket government mandates.   

Retroactively rewriting insurance policies is illegal and damaging to our economy.

Retroactively rewriting insurance policies to cover pandemics would be a violation of long-standing contract law.  Despite this hurdle, seven states are currently considering legislation to retroactively require policies to cover pandemics.  This would likely be an unconstitutional breach of the Constitution’s “Contracts” clause (“No State shall… pass any… Law impairing the Obligation of Contracts”).  

We can be certain insurance companies would vigorously contest such an egregious overreach in court, so there is no prospect for payouts happening any time soon.  In the current situation, businesses are in dire straits and need help as quickly as possible.  Given the predictable legal hurdles, this idea should be disqualified based on timing concerns alone.

This issue has much bigger implications than the concerns of the insurance companies that might be adversely affected.  Damaging the reliability of contractual arrangements would be extremely destructive to the ability of our economy to function efficiently.  Businesses and individuals need to have confidence that they can rely on contractual agreements freely negotiated between parties.  Even the attempt to break these arms’-length agreements sets a bad precedent and could make it more difficult for businesses to get standard business interruption insurance in the future.   

What is the ultimate objective behind these proposals?

The lawyers agitating for retroactive pandemic coverage likely know this idea is lacking merit, but they are filing lawsuits against insurers anyway.  Given their weak legal position, why are they pursuing this course of action?  It seems there is a multi-pronged strategy.  

One objective is to extract out-of-court settlements from insurers who might prefer to avoid lengthy and unpredictable litigation.  A second route is to persuade politicians to legislate a rewriting of business interruption insurance policies to require them to retroactively cover pandemics.  Because this idea of breaking contracts is probably illegal and would be extremely damaging to our economy, it seems like a longshot.  

Perhaps the ultimate plan is to use existing business interruption insurance as a framework for distributing government aid to businesses.  One of the plaintiffs’ lawyers, John Houghtaling, alluded to this angle when he said, “We are willing to support federal subsidies for insurers who cooperate with us.” 

Proponents say this approach would have the advantage of utilizing existing insurance industry infrastructure.  Insurers have established processes to administer business interruption payments, including methodologies to analyze and validate losses and quantify appropriate payouts.  The hope is that these existing systems would provide an efficient way to distribute government aid to a large number of needy businesses. 

While it is true that insurance companies have some relevant expertise in calculating business interruption losses and an existing system for disbursements, this idea has a serious drawback.  If the insurers administering the plan are merely intermediaries passing on government money, they would have no “skin in the game.”  As a result, insurance companies would have no incentive to accurately calculate losses.  This would increase the potential for waste and fraud.  

There are other problems.  Not all businesses have business interruption insurance.  Approximately two-thirds of small businesses with less than 50 employees do not have this type of insurance to begin with.  Also, it would be difficult to quantify in advance the amount of payments that would result from this type of program, creating an open-ended payment obligation for the government.

Two Wrongs Don’t Make a Right

Many of our country’s businesses and their employees are suffering through no fault of their own as their operations have been severely damaged by government directives to reduce their activities.   A strong case can be made that these businesses should receive assistance.  

This is no excuse to unfairly penalize other innocent parties, such as insurance companies.  They never agreed to cover losses from pandemics and were never paid to assume that risk.   

More fundamentally, the reliability of contracts freely agreed between parties is a crucial underpinning of our economy.  Retroactively rewriting insurance policies would erode this pillar of our economy and would be extremely damaging to our country’s ability to grow and prosper.  

America’s businesses are suffering and deserve help.  Policymakers should work to find the fairest and most efficient way to direct taxpayer resources to provide the needed assistance without causing further collateral damage to our economy.  

by J.C. Pate

Our country is suffering from a massive economic shock due to the coronavirus pandemic.  Over 20 million people have been added to the unemployment rolls in a matter of weeks and thousands of businesses have been forced to close.  The crisis has motivated a broad range of government responses focused on supporting those in need.  Now a massive federal infrastructure bill is being floated.  Proponents claim this will provide jobs for the recently unemployed and add needed stimulus to the economy.  This is the wrong idea at the wrong time.  

All around us, we see carnage in the employment market.  The desire to alleviate this suffering is understandable.  However, infrastructure initiatives are poorly suited to help.  Most of the recent job losses are in service industries such as travel, tourism, restaurants, entertainment, and the like.  Infrastructure projects tend to generate jobs in more specialized areas such as construction, engineering, and project management.  The current wave of unemployed are not well-suited for these types of jobs.  They would benefit from more targeted forms of aid.

What about the goal to stimulate the economy?  Large infrastructure projects are typically slow to get underway, undermining the potential for boosting the economy anytime soon.  Also, due to the nature of the crisis, the impact of stimulus spending is likely to be muted as large numbers of people continue to stay home, either due to government direction or general caution.

We need to prioritize our spending and focus our efforts on initiatives with the most impact.  The government response to this crisis thus far has been unprecedented, around $2 trillion dollars (close to 10% of GDP) in federal spending.  The resulting increase in national debt has been precipitous, leaving us with limited resources. In this context, infrastructure projects are highly problematic because they are notoriously prone to cost overruns and squandering taxpayer dollars.

As currently practiced, large-scale federal infrastructure projects are inherently wasteful and should not be undertaken at all without fundamental reform.   The use of public-private partnerships should be considered as a way to source additional investment capital and leverage valuable project management expertise.  The bidding process should be reformed to give a fair opportunity to non-union workers, thereby lowering labor costs and increasing efficiency.  The permitting process and environmental reviews should be streamlined to avoid the extensive delays typically seen with large infrastructure projects.  Without these reforms, infrastructure projects are likely to waste far too much time and money. 

If the federal government does pursue an infrastructure bill, spending should be carefully prioritized to maximize the impact of our limited funds.  It is far too easy for politicians to hijack large spending bills and divert funds to special interests or politically favored groups.  To guard against this wasteful practice, rigorous and transparent cost-benefit analysis should be an important element of this exercise.  

This will help to ensure that any federally-driven capital projects have clear and compelling long-term value propositions with the potential to increase economic productivity.  Some examples include modernizing the electrical grid or updating our air traffic control system.   We should vigilantly avoid wasteful white elephant projects such as cross-country high-speed rail or alternative energy schemes that cannot be justified on their own economic merits.  

A robust cost-benefit analysis process would also have the advantage of giving due consideration to critical maintenance and repair projects.  Maintenance can provide an attractive return on investment but is often wrongly overlooked in favor of more grandiose undertakings.   

Another strategy to optimize government infrastructure spending is to use block grants to the states.  Local governments are well placed to know how to most efficiently allocate scarce resources to achieve the best outcome for their constituents.  The effectiveness of these block grants could be increased by requiring recipients to contribute modest co-investments and perform and publish cost-benefit analysis to justify their spending decisions. 

As we scramble to overcome this crisis, the suggestion for a massive infrastructure bill is poorly suited to our current challenge.  This proposal will not be effective in putting the recently unemployed back to work and the objective of using infrastructure spending to stimulate the economy is unlikely to be very effective in the current circumstances.  Our government is currently facing immense demands on its fiscal resources so it is imperative that we wisely allocate our limited firepower for maximum benefit.  Without fundamental reform to the process for undertaking infrastructure projects, such an initiative will result in an unacceptable waste of our scarce resources.  At the very least, any infrastructure spending should be subject to thorough and transparent cost-benefit analysis to optimize its impact.  

by J.C. Pate

April 27, 2020

No one likes paying taxes, but we should never underestimate the appeal of cooking up new taxes for other people to pay, especially if a narrative can be constructed about how those other people are behaving badly.  This is part of the reason we keep hearing proposals for financial transaction taxes.  Many of the candidates who ran to be the Democrat nominee came out in favor of transactions taxes, including Sanders, Warren, Biden, Bloomberg, Buttigieg and Gabbard.  One of the most detailed proposals came from Bernie Sanders who proposed a financial transaction tax as the source of funds to finance his proposal for student loan forgiveness.  Setting aside the pros and cons of Mr. Sanders’ student loan proposal, is a financial transaction tax good policy? And is the proposal supported by a sound rationale?

Mr. Sanders estimated that his proposal would cancel approximately $1.6 trillion in student loans.  To pay for this, Sanders proposed a financial transaction tax of 0.5% tax on stock transactions, a 0.1% tax on bond trades, and a 0.005% tax on derivatives transactions.   Over ten years, Mr. Sanders estimated this tax would bring in approximately $2.4 trillion.

Why stick securities traders with the bill?  According to Sanders, there are two reasons.  First, a good portion of trading is “short-term” or “speculative” and therefore somehow bad.  Second, the banking industry received a bailout after the financial crisis so now it is Wall Street’s turn to help out struggling Americans.  

But are these reasons logical or even correct?

Underlying many proposals for financial transaction taxes is the view that trading, especially “short-term” trading, is somehow evil or at least of no fundamental value.   Often short-term trading is labelled as “speculation” to create a negative connotation.  For example, on his website Mr. Sanders proposes to “restrict rapid-fire financial speculation with a financial transactions tax.”  This belief is misguided for several reasons.  

There is nothing inherently good or bad about a securities trade as a result of the length of time an investor holds an asset.  The price for any financial instrument is anchored by the intrinsic value of the asset, basically an estimate of all its future cash flows discounted back to today’s dollars.  For a stock, this is an estimate of the future earnings of the underlying company.  Traders often consider additional technical factors such as moving price averages, short interest, trading volume, and market momentum.  However, the life-time earnings potential of a stock or bond will ultimately be the most important input to determine its price, even for investors who hold that stock or bond for a very short period of time.  Therefore, it is misleading to conflate “short-term” trading with “short-termism”.  Given these factors, it makes no sense to use taxes to punish market makers and short-term traders.  In fact, chasing them out of markets will ultimately reduce the efficiency of the markets and harm other long-term investors.  

What about the bank bailouts after the financial crisis?  Doesn’t this make “Wall Street” a deserving target for this tax?  Mr. Sanders promotes this view when he says, “During the financial crisis, Wall Street received the largest taxpayer bailout in American history. Now it is Wall Street’s turn to help rebuild the middle class.”  This story doesn’t really hold up.  All of the bailout money extended to the banks was fully repaid, with interest.  And some of the institutions that trade securities today didn’t receive bailout money at all.

The effort to paint the banks as bad actors who deserve to be stuck with the bill is really just a diversionary tactic.  The cost of transaction taxes would not really be borne by the banks or trading institutions.  Instead, these costs would be passed on to end users, such as individual investors, pension funds, and holders of 401(k)s.  Under the Sanders’ proposal to add a tax of 0.5% to stock trades, a retail investor making a modest stock trade of $10,000 would end up bearing an additional cost of $50 — a meaningful amount for a small investor working to build a retirement nest egg.  Implementing a financial transaction tax would also require the addition of a new bureaucracy and impose increased compliance costs on the financial sector, creating wasteful friction in the economy.  

Attempts to implement financial transaction taxes can be expected to encounter several challenges.  Investors may seek to move their trading to other jurisdictions not subject to the tax, thereby lowering the proceeds from the tax below current estimates.  Such a loss of trading activity would reduce liquidity in our markets, resulting in less efficient price discovery — something that would harm all investors.  Also, traders can use alternative strategies to accomplish their trading objectives.  For example, traders can use equity derivatives to gain exposure to certain equities instead of trading in the equity securities directly.  Such strategies can be especially attractive when derivatives and the underlying instruments are taxed at different rates (as in the Sanders’ proposal).  

These are some of the reasons that previous attempts to implement financial transaction taxes have had disappointing results.  For example, a financial transaction tax was implemented in Sweden in the 1980s.  Tax revenue fell far short of expectations and trading volume declined significantly as investors fled to other securities exchanges.  After several years, the transaction tax in Sweden was deemed a failure and repealed.

The proposal from Mr. Sanders is based on a false narrative of extracting money from evil banks that unfairly benefitted from a bailout.  But the reality is quite different.  All the bailout money extended to banks has been repaid with interest.  And the cost of a financial transaction tax will simply be passed on to investors, including pension funds, small investors, and holders of 401(k)s.  More fundamentally, there is nothing inherently bad about trading financial instruments, even on a short-term basis.  On the contrary, trading of all kinds is based on long-term value expectations and adds to healthy price discovery and liquidity.  Upon examination, the facts don’t fit Mr. Sanders’ narrative, but the truth is not really the point.  The point is to paint a picture where the victims paying the tax are somehow bad actors who deserve to be punished.  Instead of trying to camouflage the true cost of taxes in this way, we should focus on making taxes as transparent, efficient, and fair as possible.

JC Pate

by J.C. Pate

April 27, 2020

First, it is important to understand stock buybacks and how they are used by companies.  As a company operates its business, management will plan on maintaining a capital structure with a target percentage of equity capital appropriate for the industry and the risk in the operating environment.  This capital plan should include enough equity for a variety of economic situations, such as recessions, new investment opportunities, or the emergence of competitive threats.  Equity is more expensive than debt, so holding too much equity is inefficient and reduces the productivity of our economy.  On the other hand, too much debt can be risky.  So managements strike a balance they believe will be appropriate for a range of economic situations.   

It is not realistic to expect companies to carry enough surplus equity capital to deal with every hypothetical situation that could possibly occur, such as this once-in-a-century pandemic.  Indeed, it would be extremely inefficient for companies to design their capital structures with such highly unlikely and difficult to predict events in mind.  This would substantially reduce the growth rate and employment potential in our economy.  To the extent American companies were required to maintain such excess amounts of equity, their global rivals would gain a significant competitive advantage.   

Companies sometimes find themselves with more equity than required by their target equity to debt ratio.  Often this occurs when companies cannot find enough investment opportunities that meet their minimum rate of return hurdles.  When this happens, equity capital can be returned to shareholders via stock buybacks or dividends, allowing shareholders to earn a return on their investment.  Shareholders can then reallocate this capital to other more compelling investment opportunities, thereby improving productivity and economic growth.  

Buybacks are fundamentally similar to dividends.  Both are ways to return excess equity capital to shareholders.  Instead of using buybacks to manage its capital structure, a business could instead declare a one-time special dividend.  Some taxable shareholders prefer stock buybacks as a way for companies to return capital because dividends are taxed when they are received while capital gains are not taxable until they are realized.   From the company’s perspective, both approaches serve the same function.

All this seems fairly logical.  So, why do some people find the concept of stock buybacks offensive?  Some people imagine that if companies were prohibited from using buybacks to return excess capital to shareholders, this money would be paid to employees.  But in our free market system, companies are already incentivized to pay their employees the going rate.  Artificially forcing companies to pay employees above the market rate would put those companies at a competitive disadvantage, hurting the business.  Over time, jobs would be lost.

Others say that if companies were forced to hold on to excess equity, then they would be motivated to invest those amounts.  But if companies had good investment opportunities, they would already be using their equity for those purposes.  Also, this concern misses the point that excess equity capital returned to shareholders via buybacks is recycled to other more attractive investments.  This optimization of capital boosts our economy overall.  Any prohibition of this healthy process would create an inefficient allocation of capital, slowing our economy.  

A more legitimate complaint is that stock buybacks can be used to manipulate earnings per share measurements and improperly increase executive compensation.  If this is happening, the problem is poorly designed management incentive packages.  Corporate boards should establish executive compensation plans based on fundamental performance and not financial targets that can be artificially manipulated.  

Opponents of stock buybacks have long argued that government should prohibit stock repurchases.  This would be a terrible idea.  The government has little understanding of the unique risks and opportunities faced by the wide variety of industries operating in our economy and has no expertise in how to direct companies to manage their capital structures.  Government interference in capital allocation decisions would inevitably create a drag on our economic productivity.

Also, this type of prohibition would be complicated.  Logically, a restriction on buybacks would also apply to one-time special dividends.  How would this limit be defined?  Perhaps by prohibiting distributions above the historical level of dividends increased by some “appropriate” growth rate.  Such limitations would be cumbersome and difficult to estimate in our dynamic economy.  This type of government micromanagement would likely have unintended adverse consequences.  Companies with conservative dividend levels might worry that such a distribution cap could constrain their ability to disburse surplus equity capital.   This could create an incentive for them to increase ongoing dividends to more aggressive levels to avoid the potential drag of trapped excess equity capital.  Perversely, this could be a source of increased financial risk in the economy.  

Turning to the current situation, how should we think about buybacks for companies receiving rescue packages?  In the case of the coronavirus crisis, companies are faced with an unexpected external shock not of their own making and therefore seem deserving of rescue funding.  Indeed, before the virus hit, the economy was performing strongly and most companies now being considered for rescue packages were doing well and had generally healthy balance sheets.  Pre-crisis, these companies were properly capitalized for the existing operating environment.  Some may have undertaken stock buybacks in the preceding years.  But the unforeseeable disastrous impact of the crisis is not a valid reason to second guess their decisions to return excess capital to shareholders based on the economic situation at the time.  

Having said that, it is entirely reasonable for the government to insist that any company receiving a rescue package must stop share buybacks until rescue funds have been repaid.  Such a requirement is a normal protection for a lender to a distressed company.  After the rescue financing has been repaid, these prohibitions should fall away and companies should be allowed to manage their capital structures as efficiently as possible. There is nothing inherently bad about stock buybacks.  Buybacks are a healthy way for companies to recycle equity capital to more efficient uses, thereby promoting the overall health of the economy.  It is fair to prohibit buybacks for any company receiving a rescue package, but such restrictions should terminate when the rescue funding has been repaid.  Apart from certain highly-regulated monopolies such as utilities, the government should not be in the business of telling companies what the right capital structure is for their particular situation.  This would only put pressure on the growth potential of our companies.  We should be careful that our crisis response does not create ongoing inefficiencies in the economy such as limitations on stock buybacks undertaken in the normal course.