The Future of Corporate Governance in Capital Markets Following the COVID-19 Crisis

Report

30 June 2021

5. The implications of COVID-19 for the corporate sector and emerging policy issues

Abstract

This chapter focuses on potential long-term implications of the COVID-19 pandemic on corporate governance and capital markets more generally. It discusses a number of structural weaknesses in both the stock market ecosystem and corporate bond markets. This provides the basis for a discussion about the role that capital markets can and should play in the post-crisis recovery. Based on this, and drawing from the findings in previous chapters, it identifies a range of corporate governance policy issues that may need to be addressed as the crisis subsides. This is followed by an analysis of insolvency systems across countries and out-of-court restructuring practices in corporate bond markets.

5.1. The erosion of corporate equity capital

The coronavirus pandemic and related measures implemented to tackle the health crisis led to an unprecedented slowdown in economic activity worldwide. As a result, most companies and industries have experienced a sharp contraction in sales. At the global level, the aggregate sales of the 10 000 largest non-financial listed companies fell 9% in the first quarter of 2020 compared to the same period in 2019 (Figure 5.1). China and Japan experienced the largest declines in the first quarter, with a drop of 14% and 15% respectively. Listed companies in the United States were the only group that saw a slightly positive sales growth of 1% during the first quarter. With aggregate sales declining 14% worldwide in the second quarter compared to the same period in 2019, all regions experienced a double-digit drop with the exception of China and Japan where sales of listed companies dropped by 3% and 8%. Particularly, the corporate sector in Europe was hit hard in the second quarter by severe falls in sales reaching 19%.

The third and fourth financial statements show a relative improvement in the year-over-year sales growth rates compared to what reported in the second quarter. The aggregate sales at the global level have shown a 2% and 1% drop compared to the previous quarters. At the country and regional level, China was the main outlier with an 11% and 22% increase in sales for the third and fourth quarter respectively. Despite a rebound of economic activity in the second half of 2020 compared to the previous quarters, companies from Europe saw an 8% and 1% drop respectively for the third quarter and fourth quarter.

Figure 5.1. The COVID-19 impact on sales of the listed corporate sector, YoY change by country/region

The impact of the COVID-19 crisis on aggregate sales was particularly harsh in some industries. Figure 5.2 shows that, after a fall of almost 50% in sales during the second quarter of 2020, the energy industry again saw a 27% and 26% decline in the third and fourth quarters compared to the same periods in 2019. Other industries severely impacted by the pandemic have been consumer cyclicals and industrials, which experienced two-digit drops in both the first and second quarters. At the same time, corporations providing goods and services in non‑cyclical industries experienced a modest fall in the second quarter only. Corporations in the healthcare and technology industries actually recorded positive growth rates in all quarters.

Figure 5.2. The COVID-19 impact on sales of the listed corporate sector, YoY change by industry

5.1.1. The COVID-19 impact on credit rating

The changes in credit ratings are another important indicator of the impact of the COVID‑19 crisis on the corporate sector. Despite the decline in overall bond credit quality in recent years, both the default rates and downgrade ratios have remained stable at low levels compared to historical averages. An important reason is that the unprecedented low interest rates since 2008 have improved the ability of non-financial companies to cover their interest obligations. However, as the COVID‑19 outbreak caused sharp reversals in earnings expectations for companies, their interest coverage and profitability ratios significantly weakened. This has resulted in higher downgrade ratios. Panel A of Figure 5.3 presents the monthly rating downgrades and upgrades starting from January 2015. Except for a few months around early 2016, the number of rating downgrades in a single month never exceeded 100, averaging 50 per month throughout the 2015‑2019 period. However, in March 2020 alone there were 272 downgrades of non‑financial companies. The number of rating upgrades was down to just 4, which is far below the historical monthly March averages of 39 for the last five years. Although the total number of downgrades declined somewhat in May and June, it remained above 100. According to Panel B of Figure 5.3, the highest number of downgrade events in 2020 were related to the energy, hotels and entertainment, and transportation industries.

Among the different rating categories, non-investment grade issuers experienced the majority of the downgrades since the outbreak of the COVID‑19 pandemic (Figure 5.4, Panel B). There were 229 downgrades (84% of all downgrades) within the non-investment grade category in March, followed by 227 downgrades (86% of all downgrades) in April. These numbers were 5 to 6 times higher than the corresponding previous 5‑year averages (48 and 36, respectively). Between May and August, the number of downgrades within the non-investment grade category was lower compared to March and April but still significantly higher than historical averages. However, from September to December 2020, the number of monthly downgrades were on average 14 less than the historical average. Downgrades within the non‑investment grade category are noteworthy because a move down the rating ladder in the non‑investment grade category can disproportionately change investors’ willingness to lend to the company, especially in times of crisis. Panel C of Figure 5.4 shows downgrades within the investment grade category. In March and April 2020, 31 companies in each month were downgraded within the investment grade category, which far exceeded the historical averages for these months, which were 13 and 7, respectively. Although the number of downgrades within the investment category declined in May and June 2020, they remained elevated compared to the previous 5‑year average. For the rest of the year, except October and November, the number of downgrades were lower than their 5‑year averages.

As BBB is the lowest rating in the investment grade category, the significant increase in issuance at this rating in recent years has caused concern about the impact of potential downgrades on the non‑investment grade segment. In the first half of 2020, 38 investment grade companies with 12 only in March 2020 were downgraded to non-investment grade status. This was more than the total number of such downgrades in 2018 and 2019 combined. In June 2020, there were 4 fallen angels, which was lower than the numbers recorded in March, April and May 2020 (Figure 5.4, Panel D).

Figure 5.4. Corporate bond downgrades of non-financial companies by rating category

5.1.2. The risks of debt overhang and zombification in the corporate sector

High levels of leverage can significantly constrain a company’s investment capacity and growth. In particular, highly leveraged firms are more vulnerable to macroeconomic shocks and more susceptible to tightened credit conditions. High debt levels can affect corporate investment and growth in different ways, for example through increased debt service during deleveraging periods and declining capacity to obtain new loans due to balance sheet deterioration (OECD, 2021[1]). Rollover risks also significantly increase in crisis periods, especially for firms with a large portion of short-term loans (Kalemli-Özcan, Laeven and Moreno, 2019[2]).

A recent example is the developments in Europe after the 2008 financial crisis and the subsequent euro area debt crisis. In the aftermath of the crisis, the ratio of non‑performing loans (NPL) to total lending increased steadily in many European economies at least for a 5-year period. Although the stock of non‑performing loans in the banking system declined from its peak, it was still relatively high in some EU economies by the end of 2019 (Figure 5.5, Panel A). High levels of NPLs not only decrease the resilience of the banking system, but also hampers the efficient re‑allocation of capital in the economy and the ability of the banking sector to support investment growth.

The persistent decline in corporate investment in Europe after the 2008 financial crisis was also associated with the rise of so‑called non‑viable zombie firms, defined as mature companies that are consistently incapable of covering their interest payments (Adalet McGowan, Andrews and Millot, 2017[3]). Underperforming firms, that in a competitive market would have exited the market, remain alive, causing an increasing misallocation of resources in the economy and preventing new, more productive entrants. As shown in Panel B of Figure 5.5, the share of total equity capital sunk in non‑viable firms in most European economies remained elevated several years after the crisis. For example, in Spain and Italy the share of total equity in these firms doubled from around 5% in 2007 to 10% in 2013. The large amount of resources sunk into these firms protected the survival of low-productivity firms at the expense of investments in more productive ones.

Figure 5.5. Non-performing loans and zombie firms in selected European economies

Due to substantial losses in revenues across industries and economies, the COVID‑19 crisis will inevitably lead to an increased share of under-capitalised companies worldwide. In order to prevent a long-lasting debt overhang problem in the corporate sector, it would be of particular importance to ensure that fundamentally sound businesses will have effective access to long-term market‑based finance to strengthen their balance sheets. This is particularly important for growth companies - larger mid‑sized companies - that have high growth potential and under the right circumstances would be able to benefit from raising capital in the market. Despite the critical role they play in innovation, productivity and net job creation by challenging established corporations and stimulating new entrepreneurs, their expansion is sometimes constrained by lack of access to affordable risk capital or concerns about losing their independence through an acquisition by private equity investors or a larger potential competitor. Addressing these constraints and making sure that risk capital is not tied up in non-viable businesses will be vital for unleashing corporate investments in the aftermath of the crisis and creating a more dynamic business sector that will underpin a sustainable recovery.

5.2. Structural weaknesses in the stock market ecosystem

Public equity markets could play a key role on the road to recovery from the COVID‑19 crisis by supporting the recapitalisation of the corporate sector and preventing an aggravated debt overhang problem. Indeed, experiences from the 2008 financial crisis demonstrate that for already listed non‑financial companies, raising equity capital through new stock offerings was a major source of capital. In 2009 alone, publicly listed non-financial companies raised a historical record of USD 511 billion of new equity through the stock market. The ability of markets to allocate capital to viable companies from underperforming firms with limited prospects to survive can further support long-term resilience of the corporate sector.

As shown in Chapter 2, there has been a long-term decline in the use of public equity markets in many advanced markets. One main driver of this development has been the increased number of companies that have delisted from the stock markets outside of Asia. Globally, since 2005, over 30 000 companies have delisted from the public stock market. In particular, there were almost 8 000 delistings from the European companies over the 2005‑2019 period, over 5 000 delistings of US companies and around 1 300 of Japanese companies. For the United States and Europe, these delistings have not been matched by the number of new listings, which resulted in a net loss of listed companies in every single year between 2008 and 2019.

Moreover, there has also been a substantial fall in some advanced markets in listings of smaller growth companies, defined as companies that raise about USD 100 million in an IPO. In the United States, for example, the portion of growth company listings was around 50% between 2009 and 2019, compared to 77% during the period 1995-1999. This trend has continued in 2020 with only 26% of listings made up by growth companies. Likewise, in Germany the share of growth company listings declined from 77% of all listings over the 1995-1999 period to 50% in 2020. An important consequence of the overall decline in listed companies is that several thousand fewer companies during the COVID‑19 crisis have been able to use the stock market for secondary equity issuance, which in the wake of the 2008 financial crisis helped many firms to overcome financial difficulties.

Many suggestions have been offered to explain the decline of IPOs in advanced economies. From the demand of public equity capital perspective among companies and entrepreneurs, these include lower cost of debt financing and better access to private capital. Some of the structural impediments are discussed below. However, it has also been suggested that acquisitions by large existing firms have contributed to drying up the pipeline of smaller company IPOs. Especially, it has been argued that active acquisition strategies by large technology companies have encompassed growth companies and transformed the global capital market. While the choice of going public rests with the company, a vibrant public equity market is also one of the few possibilities for ordinary households to use their savings for directly or indirectly participating in corporate wealth creation.

5.2.1. The role of institutional investors in capital allocation

Institutional investors have come to make up the largest category of owners in stock markets, holding 43% of the global market capitalisation. These are mainly profit‑maximising intermediaries that invest on behalf of their ultimate beneficiaries. The most important ones are mutual funds, pension funds and insurance companies. It has been argued that the shift from direct retail investments to institutional investors has created a bias that favours large companies in public equity markets. For example, a US Treasury report on capital markets states that smaller public companies have expressed concerns that they are being overlooked by institutional investors (U.S. Department of the Treasury, 2017[4]). Further, in the section where the report discusses why there are fewer listed companies and IPOs in the United States today, it is also noted that institutional investors have historically favoured large public companies over smaller ones.

In order to examine the institutional ownership of large and small listed corporations respectively, Figure 5.6 compares the average portion of capital held by institutional investors in large companies - those with market capitalisation above the median level for the region - and small companies - those with market capitalisation below the median level for the region. The data show that in all markets, the average share of institutional ownership in large listed companies was significantly higher than their ownership in smaller companies. In the United States, for example, on average 73% of all shares in large listed companies were held by institutional investors by the end of 2020 while the same ratio for smaller listed companies was around 41% (Figure 5.6, Panel A). Even in Japan, where institutional investors hold a relatively low portion of large companies’ capital, their average share of ownership in large companies is more than three times that in smaller companies. In addition, there is a positive correlation between the share of equity in the hands of institutional investors and the average difference in the holdings between large and small companies. In other words, a higher presence of institutional investors in a market widens the difference between the average institutional holdings of large versus small companies (Panel B of Figure 5.6).

Figure 5.6. Institutional ownership in small and large companies

5.2.2. The changing business models of stock exchanges

Stock exchanges play a critical role in matching companies that need access to external equity capital with investors that are in search of investment opportunities. They also serve other key functions that are in the public interest. These include ensuring an efficient price discovery process, certain regulatory functions, supervision and sometimes enforcement responsibilities.

Since the mid‑1990s, the stock exchange industry has experienced profound structural changes. In advanced economies, stock exchanges were traditionally established as member‑owned organisations, government institutions or special statutes. Since the mid‑1990s, however, most stock exchanges have been transformed into privately owned for‑profit corporations. Today, all major stock exchange operators in advanced economies have their shares listed and traded on their exchanges, while the mutual form based on brokers’ membership has almost disappeared.

During this transformation, there have been a large number of mergers and acquisitions (M&A) in the stock exchange industry, involving companies from sectors such as electronic trading platforms, financial information providers, financial index providers, data management and asset management. The changes in the ownership structure of stock exchanges, as well as the structural changes that followed from M&A activities have been accompanied by a shift in stock exchanges’ revenue structures. As shown in the OECD report “Changing business models of stock exchanges and stock market fragmentation”, the share of revenues from listing new companies and issuer services, which consists of new listing fees - including from exchange‑traded funds (ETFs) - and fees paid by existing listed companies dropped from 14% in 2004 to 8% in 2014. During the same period, the share of revenues from derivatives trading and over‑the‑counter (OTC) markets increased by almost half and represented 22% of total revenues in 2014. This makes income from trading (cash, capital markets, derivatives and OTC) the largest source of revenue with a total share of 48% in 2014.

Together with the emergence of new investment techniques and instruments, such as ETF and high‑frequency trading (HFT), it can be said that the new stock market structure encourages a focus on large liquid company stocks. As a result, investor attention has been diverted away from potential growth companies, which in turn have been discouraged from going public. The lack of interest in smaller companies in the stock market is illustrated by the fact that in most markets trading volume is highly concentrated to large companies. The share of total trading volume attributed to the largest 10% of companies in terms of market capitalisation was over 70% in most markets, such as the United States, the United Kingdom, Germany and France. In Japan, for example, about 75% of the total trading volume is attributed to the trading of shares in the 10% largest companies. Similarly, about 25% of all trading in Japan is in the shares of the largest 1% of companies, as measured by market capitalisation (OECD, 2016[5]).

5.2.3. High underwriting fees and the cost of listing

The underwriters in capital markets, principally investment banks, underwrite debt/equity issuances and syndicated loans, as well as provide advisory services in M&A transactions. The underwriting process mainly consists of origination, distribution, risk bearing and certification. During the process, the underwriter advises the issuing firm on the type, timing and pricing of the securities, prepares the required documentation and forms a banking syndicate which markets and distributes the securities to investors.

An important feature of investment banking services is that they are fairly concentrated at the global level. OECD research illustrates that with respect to public equity, investment grade corporate bonds, syndicated loans and M&A activities, the market share of the 20 largest banks varied between 63% and 75% of total global transaction value in 2016. The non‑investment grade corporate bond market, which was the smallest market segment in terms of total transaction value in the same year, had the highest degree of concentration with 85% of total value attributed to the top 20 banks (OECD, 2017[6]).

Traditionally, there was one underwriter who used to assume a leading role in public equity offerings, assuming greater responsibility and coordinating the transaction with other investment banks. This “lead underwriter” also received the lion’s share of the underwriting fee paid by the company. However, since 2000, the traditional “one‑lead underwriter” model has, in the US market, successively shifted towards a model that relies on a consortium of multiple underwriters. During the last few years, about half of all equity offerings have three or more lead underwriters. Another key feature of the US capital markets has been the “one-fee” model, particularly for smaller issues. In all years since 2000, the median underwriter fee paid by US companies for an initial public equity offering was always 7% of the total proceeds. Japan also has a “one-fee” model, but at a somewhat higher level of 8% for initial public equity offers (OECD, 2017[6]).

Figure 5.7. Underwriting cost of median initial public offerings as a share of total proceeds, small versus large companies, 2020

Underwriting fees constitute, by far, the largest direct cost of an IPO. Figure 5.7 provides the underwriting cost for small and large company equity issues in the United States, Europe, Japan and China in 2020. For IPOs below USD 100 million, the underwriting cost is between 3.5% and 8% of total proceeds. Importantly, underwriting fees for secondary public offerings by smaller companies that are already listed in the United States and Japan have been over 5% in recent years. Hence, already being listed and widely traded does not result in any significant reduction in underwriting costs.

Another important aspect of listing costs is the costs associated with the discounts that investment banks apply to companies’ valuations before the public offerings. Underwriters argue that a discount is required to ensure investor participation, the stock’s upside potential and the oversubscription of the issuance. Since large companies tend to use international investment banks as underwriters, who in most cases work in a consortium of multiple underwriters, sizeable discounts may particularly discourage them from joining public markets. Despite the availability, although limited, of market-based financing options with comparatively lower underwriting fees, there has been a very limited number of large companies that have listed in Europe over the recent years. An important illustration, with respect to concerns about the costs of listing, is the listing of the Swedish company Spotify, which completed a direct listing in the United States without raising any capital. As expressed by the company’s chief financial officer (CFO), by not doing a traditional IPO the company not only avoided paying excessive underwriting fees but, above all, they avoided a substantial IPO discount (OECD, 2020[7]).

5.2.4. Lack of research and analyst coverage

An important prerequisite for visibility in stock markets is that the company is subject to market research and analyst coverage. By supporting market liquidity, market research improves both the attractiveness of listing for smaller companies and the attractiveness of smaller growth companies as an investment. In light of its importance, there have been concerns that market research covering smaller companies has significantly declined over the recent years in most markets. In particular, it has been claimed that following the regulatory changes related to separating research costs in MiFID II (“unbundling”), asset managers’ demand for research has substantially declined in Europe. This has been particularly true for smaller listed companies (CFA Institute, 2019[8]). In order to mitigate the impact of such changes on smaller companies, some countries have created programmes to provide research coverage on smaller companies. For instance, in Spain the stock exchange has introduced a programme to provide research on smaller listed companies in a standardised format.

5.3. Emerging corporate governance policy issues

The G20/OECD Principles of Corporate Governance were developed with an understanding that corporate governance policies have an important role to play in achieving broader economic objectives with respect to investor confidence, capital formation and allocation (OECD, 2015[9]). The quality of corporate governance affects the cost for corporations to access capital for growth. However, it is not only the total amount of investment that is important for creating a dynamic business sector. The efficiency with which the capital is allocated among competing ends and how the use of this capital is monitored must also be considered. These are also three main corporate governance functions: raising capital, allocating capital and monitoring its use.

To tackle the challenges posed by the COVID‑19 crisis, fulfilling these tasks is more important than ever. Corporate governance policies and regulations that can effectively support markets to perform these functions will be key in creating a more resilient and dynamic business sector that will underpin a sustainable recovery from the crisis. In addition to this report, the Corporate Governance Committee and its Regional Corporate Governance Roundtables have since 2015 documented and analysed a number of relevant developments in corporate practices, ownership structures and capital markets structures that may call for an adaptation of corporate governance policies and regulations.

5.3.1. Increased leverage and excessive risk taking

The COVID-19 crisis has caused a sharp contraction in economic activity and corporate revenues around the world. It has also changed the conditions for corporations to access finance and the range of investment opportunities. However, not all firms, even those in the same industry and operating in the same economy, have been affected to the same degree or in the same way. The varying impact of the crisis at the firm level is to an extent related to underlying pre‑conditions that have made some companies more vulnerable to financial shocks, such as high leverage levels.

It is the management and the board who have the mandate to decide on the optimal capital structure of a company. In doing so, they should consider the best interest of the company and ensure its financial soundness. However, the extended borrowing over the past decade by companies with lower quality ratings and increased leverage levels has raised major concerns that there has been excessive risk taking in some parts of the corporate sector. One example has been the use of corporate bond markets by non‑investment grade companies to finance share buyback operations, which ultimately reduces the company’s capital base and contributes to increasing leverage in the economy. Since the 2008 crisis, the share of corporate bond offering documents that disclose share buybacks or dividends among the intended uses has increased considerably. In the early 2000s, less than 2% of non-investment grade bonds were intended to be used for corporate payouts. Over the period from 2015 to 2020, payout‑related non‑investment grade issuance constituted, on average, 11% of total non-investment grade issuance and 11% of the total number of non‑investment grade bonds. As a result, in the past 6 years, payout‑related non‑investment grade bonds reached a total amount of USD 173 billion.

The increase in corporate borrowing has been consistent with the policy objectives of expansionary monetary policy and the related unconventional measures by major central banks in the form of quantitative easing implemented after the 2008 financial crisis. The OECD report “Corporate bond market trends, emerging risks and monetary policy” showed that compared with previous credit cycles, the pre‑COVID‑19 crisis stock of outstanding corporate bonds had lower overall credit quality, higher payback requirements and inferior covenant protection. It also emphasised that these features may amplify the negative effects that an economic downturn would have on the non-financial corporate sector and the overall economy. As described in Chapter 4, these effects were seen in the immediate aftermath of the outbreak as the total issuance of low quality non‑investment grade bonds almost vanished. The non‑investment grade market where highly leveraged companies borrow additional debt only reverted back in April following massive support measures introduced by central banks to address this segment of the market.

5.3.2. Disclosures related to debt financing conditions

As a growing portion of non-financial companies across industries and economies have become more leveraged in recent years, they also became more prone to default in case of a sudden downturn in economic activity. The failure to service debt obligations or the violation of a covenant starts a chain of events which often leads to bankruptcy or out‑of‑court restructuring of the company. As discussed in section 5.6 below, creditors or debt holders typically incur significant losses in both scenarios and shareholders, with their residual claim, also suffer.

Although companies periodically have to inform creditors and debt holders about their standing on each covenant in the debt contract, they do not have such an obligation towards shareholders, who may, in turn, remain unaware of an imminent covenant violation until it is too late. At the same time, the G20/OECD Principles recommends the disclosure of reasonably foreseeable material risks (OECD, 2015[9]). This would mean that companies that are moving closer towards their covenant thresholds, are supposed to give their shareholders prior notice if the risk of covenant breach is material. Consistent with this approach, in its guidance regarding the disclosures that companies should consider with respect to business and market disruptions related to COVID‑19, the US Securities and Exchange Commission explicitly advised companies to address whether they are at material risk of not meeting their covenants. Furthermore, companies were also asked to inform investors about whether their financing arrangements contained terms (e.g. senior debt restrictions, negative pledge covenants, etc.) that would limit their ability to obtain additional funding and whether these terms could result in liquidity challenges that would make the company unable to maintain current operations (SEC, 2020[10]).

It should be noted that given the complexity or ambiguity of some covenants, having basic information about them does not always result in a full understanding of the possible adverse actions that can be taken by the company in case of financial distress. There is anecdotal evidence of wealth transfers from a group of creditors of a company to another debtholder group, despite the fact that both groups have full access to the related debt contract in the first place. For instance, using a loophole in their debt contracts, two retailers in 2016 managed to move some of their valuable intellectual property assets, such as brand names and trademarks, out of the reach of existing debtholders by creating new subsidiaries to hold those assets, which were then used as collateral to back new debt. Existing debtholders who did not participate in the new financing saw their investment depreciate in value but their attempt to block the deal failed (Orr, 2017[11]).

Another recent practice is to agree with a subgroup of existing debtholders to take part in a new loan, which has higher priority than the debtholders that are intentionally left out of the deal (Bakewell, 2020[12]). Given that bondholders in their search for higher yields have accepted weaker covenants, such practices may become more prevalent in the future as more companies try to overcome their financial difficulties. Although the left-out debtholders may not be able to legally block the deal since it is structured in a way that complies with the debt contract, transferring benefits to one group of investors at the expense of another may adversely affect the amount, type and terms of credit available to a firm in the future. Short‑term benefits of favouring one group over another may have long-term consequences with respect to the company’s access to finance.

5.3.3. Duties and responsibilities of boards in times of crisis

Since the onset of the pandemic, corporate boards have been under intense pressure due to the uncertainty around the health crisis, the fast-changing regulatory landscape, and the wide variety of risks and challenges, including, but not limited to, employees’ and customers’ health and safety, business disruption, liquidity, regulatory compliance and cybersecurity. In this difficult setting, discontent about some actions of companies gradually began to be voiced by shareholders and other stakeholders through lawsuits. Interestingly, in the second quarter of 2020, average prices of insurance premiums paid to protect directors and senior corporate officials from lawsuits increased by around 60% in the United States and more than doubled in the United Kingdom, as COVID‑19 raised premiums, which were already on the rise because of an increase in lawsuits filed against companies (Williams-Alvarez, 2020[13]). The cost of insurance remained high in the second half of 2020 and put more pressure on companies, some of which had to decrease their coverage. Concerns were raised by business leaders about high insurance costs having a profound effect especially on smaller businesses (Thomas, 2021[14]).

Some shareholders have sued companies for understating or not properly disclosing pandemic-related risks and the known negative impact of the pandemic on company’s business and operations. One such litigation listed in the Stanford Law School’s Securities Class Action Clearinghouse Database is against a cruise company, which allegedly made a series of false and misleading statements about the company’s adherence to health and safety protocols and about the number of COVID‑19 cases on its ships in the wake of the pandemic. Similarly, a software company was sued for allegedly failing to disclose material information on the impact of the pandemic on its business and financial performance when such a financial distress could result in the cancellation of a pending merger agreement.

Another common reason for litigation is related to providing an overly optimistic picture of a company’s prospects for profiting from the coronavirus outbreak. According to the Stanford Database, in the United States, ten companies, nine of which are operating in the healthcare industry, are defendants in such lawsuits. Among them is a company which was sued by its shareholders for allegedly falsely claiming that the company’s vaccine development efforts were highly promising and would receive major government funding. Such announcements led to an artificially inflated stock price, in response to which corporate insiders sold their shares. Indeed, senior executives and board members from 11 healthcare companies, most of them smaller firms which were highly dependent on the success or failure of a single drug, are reported to have sold shares worth well over USD 1 billion between March and the end of July (Gelles and Drucker, 2020[15]). Companies have also been sued by employees for not following official guidance to prevent the spread of the virus.

Amid such developments, securities regulators warned investors about frauds involving claims that a company’s products or services will be useful in detecting, preventing and curing COVID‑19. Microcap stocks were viewed as especially vulnerable to such fraudulent actions due to having limited publicly‑available information. The US SEC, for instance, temporarily suspended trading on a total of 39 companies in the first year of the pandemic, if information about the company was evaluated to be inaccurate or unreliable (Canadian Securities Administrators, 2020[16]) (SEC, 2021[17]). Apart from the trading suspensions, the US SEC also took enforcement actions against companies that failed to properly disclose the effect of the pandemic on their business or against companies that falsely claimed to have a promising product or service to help end the pandemic.

Although most coronavirus-related lawsuits are yet to be concluded, their general focus on inaccurate or misleading disclosures, stock price manipulation, insider trading and noncompliance with emerging health regulations can provide an overall idea of the main governance weaknesses up to now. Assuming good faith on the part of directors, one reason for boards’ failure to effectively monitor management and prevent these adverse actions could be a lack of adequate information flow from management to directors at the beginning of the pandemic, leading to the late involvement of the board in the first place. Secondly, the unprecedented nature of the pandemic has likely made it more difficult for directors to act on a fully‑informed basis as there was too much information to digest in too little time. The time pressure could be especially high for directors serving on too many boards. Indeed, recently, one board member’s suitability for his duties was scrutinised by an investment management company because he was allegedly devoting his full time to one of his other board engagements in a company that was severely troubled due to the pandemic (Prnewswire, 2020[18]). Thirdly, it is unlikely that all directors possess the technical expertise to fully grasp the medical and regulatory developments surrounding the pandemic.

In addition to the events that led to litigation, boards are subject to challenges in several other areas, including executive remuneration, cybersecurity and insolvency. Firstly, given that many companies made lay-offs or put employees on short-time working schemes during the pandemic, executive remuneration has become a key area of scrutiny. Although some companies have announced temporary reductions in executive pay, many have already taken steps to reverse this measure. Still others are changing executive bonus plans, switching performance metrics and ignoring missed targets so that executives do not suffer a big drop in pay as a result of the pandemic (Temple-West, 2020[19]). Secondly, remote working arrangements for employees can increase cybersecurity risks since employees’ home computers and networks are typically less protected against cyberattacks. Thirdly, in an event of financial distress, it is becoming increasingly evident that the board should have the capacity to regularly evaluate and communicate how a crisis impacts their ability to meet upcoming debt maturities under different scenarios and different strategic alternatives to maintain business continuity.

5.3.4. The prevalence and challenges of company group structures

An important global development with respect to corporate ownership structures is the increase in ownership concentration at the company level. While this is a global development, the OECD report “Owners of the World’s Listed Companies” shows that there are important country and regional differences with respect to the different categories of shareholders that make up the largest shareholders at the company level; differences that again have implications for the focus of regulatory considerations and priorities. In a number of markets, company groups is the common and sometimes dominant pattern of shareholding. In several Asian economies for example, including India, Indonesia and Singapore, and in some other emerging markets such as Chile and Turkey, private corporations and holding companies hold more than 30% of the total equity capital in publicly listed companies. In other Asian economies, including Japan, Korea, Malaysia and Hong Kong (China) and several European markets, including Austria, France, Italy, Germany and Greece, private corporations on average hold between 18 to 34% of the capital.

To broaden the perspective, Figure 5.8 shows the share of companies where one private corporation or a holding company is the largest holder as well as the average size of its holding. The figure covers almost 22 000 listed companies from 29 jurisdictions with information by the end of 2020, of which 7 072 (32%) have another corporation as their largest shareholder. For example, 41% of companies in France have another corporation as the largest shareholder, holding on average 49% of the capital. Corporate ownership is quite strong also in Argentina, Chile, India, Indonesia, Malaysia and Turkey, where more than half of the companies have a corporation as the largest shareholder. These data seem to confirm the presence of private corporations and holding companies as an important category of owners in listed companies, and in many cases, also the presence of group structures that include one or several listed companies.

Figure 5.8. Corporations as the largest shareholders in 2020

Against this background, the OECD Corporate Governance Committee’s “Peer Review on Duties and Responsibilities of Boards in Company Groups” (OECD, 2020[20]), while noting the important advantages and benefits associated with carrying out entrepreneurial activity through affiliated but legally separate companies, also concluded that domination of an economy by groups, may slow the development of broader, deeper and more efficient national capital markets. From a corporate governance policy perspective, company groups present the same agency problems that face stand-alone companies with defined control. Notably, parent companies may attempt to appropriate undue private benefits of control. Since cooperation in pursuit of synergies is a key rationale for company groups, groups typically engage in frequent related‑party transactions. The more complex the structure of a group, the greater the opportunity for such transactions to be carried out in a less transparent fashion, which may unduly benefit some group companies at the expense of others. The peer review sheds light on aspects of the framework for board duties and responsibilities in company groups where the framework does not address or remains unclear around policy issues of relevance to company groups. This includes the inadequacies in disclosure related to capital and control structures and shareholdings of directors; and, the divergence with respect to the requirements for the parent company board oversight of key risks, including compliance risks.

The G20/OECD Principles state that “it is also a key principle for board members who are working within the structure of a group of companies: even though a company might be controlled by another enterprise, the duty of loyalty for a board member relates to the company and all its shareholders and not to the controlling company of the group” (OECD, 2015[9]). However, the COVID‑19 crisis put additional pressure on listed companies that are part of a group structure. Since not all sectors and economies are affected equally by the crisis, group companies that are in relatively stronger positions may be expected to play a key role in supporting the parent company or other companies in the group, in particular with respect to intra‑group financing.

5.3.5. Institutional investors as large owners and passive investing

On-going changes in the global equity market landscape and the functioning of capital markets have translated into changes also in the ownership structures of the world’s listed companies. One of the most important developments in this respect is the increase in institutional ownership, which was analysed and addressed during the 2015 review of the G20/OECD Principles. Since then, however, two major concerns have been voiced about their role in capital markets.

First, the overall increase in assets under management by institutional investors has also influenced their presence as owners in individual companies. While assets under management by institutional investors have increased during the last 15 years, many companies in OECD economies have left public equity markets. As discussed above in section 4.2, there has also been a decline in the number of newly listed companies during the same period. The result of these opposite trends is that an increasing amount of money has been allocated to a diminishing number of companies. Consequently, large passive institutional investors are today significant owners of sizeable listed corporations worldwide. This development has been particularly prominent in the United States, which is by far the largest public equity market in terms of market capitalisation globally. In the United States, the 3 largest institutional investors own on average 24% of the equity in a listed company. In Europe and OECD countries the average combined holdings of the 3 largest institutional owners is 16% and 14%, respectively.

The second concern is the influence on shareholder scrutiny and small growth company listings that comes with increased passive institutional ownership. When large institutional investors mainly practice passive index-based investing, it may be quite rational that they pay little attention to risks and opportunities in individual companies. As a consequence, insufficient resources may be spent on one of the capital markets’ key functions, namely to scrutinise individual corporate performance and allocate capital in a way that new companies can grow and develop as independent enterprises.

5.3.6. The management of ESG risks

The COVID-19 pandemic has brought increased attention to the importance of identifying systemic risks and unexpected shocks. At the heart of a dynamic economy is a corporate sector that is willing and able to assume risk. Consequently, as new types of risks emerge or become more salient, companies, their shareholders and society at large all have an interest in the proper identification, management and disclosure of these risks.

As discussed in the 2020 OECD Business and Finance Outlook (OECD, 2020[21]), lack of credible risk assessments not only increases uncertainty about expected performance and the long‑term viability of individual companies, it also leads to inefficient allocation of economic resources, adversely impacting corporate and economy‑wide resilience. The need for robust structures and procedures for risk management and high‑quality disclosure, including environmental and social issues, is well articulated in the G20/OECD Principles (OECD, 2015[9]). As the current pandemic brings new experiences at the company level, companies may for example be in need of new types of expertise, additional information channels, better analytical tools, and novel internal policies and practices specifically tailored to assessing the company’s ESG risks.

At the same time, material information related to ESG risks that may shed light on the future performance of the company should be disclosed to the public. For the scope of information disclosure, many jurisdictions apply the concept of materiality, which can be defined as information whose omission or misstatement could influence decisions taken by the users of the information. The G20/OECD Principles recognise that material information can also be defined as information that a reasonable investor would consider important in making an investment or voting decision (OECD, 2015[9]). They also point to the usefulness or obligation to provide information on issues that may have a significant impact on employees and other stakeholders.

As fiduciaries of the company and its shareholders, the board and its senior management are responsible for ensuring that the company has in place a comprehensive and robust approach to risk. According to the OECD Corporate Governance Factbook 2019 (OECD, 2019[22]), at least 90% of the 49 OECD and non‑OECD jurisdictions surveyed now require or recommend the establishment of an enterprise‑wide internal control and risk management system that goes beyond ensuring high quality financial reporting.

According to the G20/OECD Principles, it is the board of directors that should set the company’s risk appetite, specifying the types and the degree of risk that a company is willing to accept (OECD, 2015[9]). In order for board members to meet their fiduciary duties, they must ensure that the company’s internal policies, structures and procedures for risk management are up to the task of identifying, measuring and monitoring risks that could have a material impact on the company’s performance. The board should also ensure that the company’s approach and the system for managing ESG risks are aligned with the company’s business model and its value proposition. Importantly, directors should also ensure that their own board structure, composition and procedures accommodate the consideration of ESG risk within the firm’s overall risk appetite and approach to risk management.

5.3.7. Adoption of flexibility and proportionality in corporate governance frameworks

The decrease in listed companies and the lack of new listings in several markets have given rise to a discussion about the adequacy and relevance of the regulatory framework and administrative costs that listed companies are subject to compared to privately held companies. To be effective in promoting capital formation through the use of public equity markets, regulations must be designed to meet new and varying needs of companies and entrepreneurs. For that reason, the G20/OECD Principles state that when new experiences accrue and business circumstances change, the different provisions of the corporate governance framework should be reviewed and, when necessary, adjusted (OECD, 2015[9]).

Policy makers have been already following this approach for a very long time by allowing flexibility and proportionality mechanisms in their corporate governance frameworks. Regulators’ motivation for applying flexibility and proportionality has been to continue to stay relevant for companies from different sizes, sectors and listing status among others, as one‑size-fits-all regulation may make it hard to achieve the desired regulatory outcomes. The OECD Corporate Governance Committee’s “Peer review on flexibility and proportionality in corporate governance” provides useful examples of criteria for flexibility and proportionality across seven policy areas (OECD, 2018[23]).

5.4. Structural challenges in the corporate bond market

The trends observed in Chapter 4 on corporate bond issuance activity since the outbreak of the COVID‑19 crisis show that globally, the bond market continued to be a significant source of capital for non‑financial companies, although less so for non-investment grade issuers, especially those with lower ratings. However, there are also some structural challenges in the functioning of the market and in the credit rating system that may require further attention going forward.

5.4.1. The dominance of active issuers

In assessing the bond market’s viability as an alternative source of finance in times of crisis, it is important to consider whether the market remains readily accessible also to those companies with no or limited prior experience in this market. Having emergency access to the bond market and hence to an alternative creditor base other than banks can be critical for the financial health of a company, especially in times when banks shift towards lower risk tolerance.

For each year in the period between 2000 and 2020, Figure 5.9 provides a breakdown of corporate bond issuers based on their prior experience in the bond market. A company is defined as a first-time issuer if it never issued a bond or the issue in a given year is its first since 1980. A “returning issuer” is a company that made its previous bond issue more than 5 years ago. If a company has issued bonds in at least one of the past 5 years, it is defined as an “active issuer”.

Figure 5.9. Number and distribution of different types of corporate bond issuers

Both at the global scale and across all markets that are reported in Figure 5.9, the share of first‑time issuers among the total number of corporate bond issuers has declined over recent years. For example, the share of active issuers in the United States increased from 55% to over 70% during the period from 2000 to 2020. Importantly, the decline in first‑time issuers was particularly marked with the start of the pandemic in 2020. While “active issuers” constituted 66% of the total number of companies issuing bonds worldwide in 2019, their share increased to 68% in 2020. The share of “returning issuers” also increased from 4% to 5%. This occurred at the expense of “first-time issuers”, which saw their share decrease from 30% to 27%. The drop in first-time issuers’ share was especially sharp in March and April, when they constituted only around 15% of issuers. The increased dominance of active issuers in the corporate bond market is even more pronounced when considering their share of the total amount issued, where they captured an unprecedented 83% of all the money raised in 2020, while first-time issuers accounted for only 12% of total issuance.

Observations above from the global financial crisis and the COVID‑19 pandemic suggest that having an active, established relationship with the corporate bond market provides an advantage, especially in the immediate period after a crisis hits. However, in the second half of 2020, dedicated monetary policy to support corporate bond issuances enabled the share of first-time issuers to return to the pre‑crisis levels in the OECD area, particularly in the United States, while Europe, China and rest of the world experienced a decline of four to seven percentage points.

5.4.2. Bond market access by growth companies

With the start of the pandemic, some major central banks broadened the scope of their monetary policy interventions to include also companies that recently lost their investment grade rating but still hold a rating of at least BB. This focus on highly rated companies is a reasonable choice as it provides a simple proxy to distinguish otherwise viable companies from companies that are less likely to survive the current crisis. However, the rule can be over-simplistic and is likely to leave out growth companies that have viable business models but lack access to long-term capital for expansion.

Figure 5.10 reports how the size of a typical corporate bond issue and the percentage of small issues in the total number of issues have evolved over the past two decades across different groups of countries. The distribution of issue sizes is examined across 5 issue size brackets. It is reasonable to expect that for growth companies, the two lower issue size brackets, which correspond to less than USD 100 million, are the most attainable. Indeed, according to the previous 5-year issuance data by issuers with a relatively small asset size of less than USD 1 billion, 69% of the issues fall into the smallest issue size bracket and 17% fall into the second size bracket. Hence, the share of small issues in a given market provides a good proxy for the ability of that market to serve growth companies.1

Looking only at data from the OECD region, Panel A shows that over time, the median issue size experienced a jump in 2009, and started to decline after reaching USD 338 million in 2012. Since then, the median issue size stayed relatively stable in an interval between USD 119 to 151 million in the past five years. This decline has been accompanied by an increase in the share of small issues. Over the past five years, issues with a size smaller than USD 50 million accounted for 27% of the total number of issues, on average. Issues smaller than USD 100 million on average accounted for 43% of all issues during the past five years. With the pandemic, the median issue size increased by 25% from USD 121 to 151 million and the share of issues in the smallest size bracket remained stable at 27%.

However, a look at individual markets (Panels B-F) reveals that this is not a general trend. Notably, in the United States, the median issue size has instead increased successively and since 2014 remained above USD 500 million annually. Moreover, in the past decade the percentage of issues that are smaller than USD 50 million (USD 100 million) has never exceeded 4% (10%). Strikingly, in the first six months of 2020, the median issue size in the United States increased significantly to USD 600 million and issues greater than or equal to USD 500 million constituted 60% of all issues. Out of the 708 issues that have taken place in the first six months of 2020, only 13 were smaller than USD 50 million. This trend normalised to some extent for the full year 2020 data, the median issue size decreased to USD 574 million which is still 13% above of the 2019 median amount and the share of issuances with size greater than or equal to USD 500 million decreased to its 2019 value of 58%.

Figure 5.10. Median issue size and the distribution of issue sizes in the corporate bond market

Europe saw a decline in the median issue size from 2009 to 2018 when 12% of issues made by European companies had a size smaller than USD 50 million and an additional 16% were between USD 50 and 100 million. However, similar to the case in the United States, the median issue size in Europe jumped sharply in the first half of 2020 to USD 540 million and the corporate bond market became strongly dominated by large issues. Full year 2020 median issue size decreased to USD 407 million that is still 26% higher than that of 2019. Panels D to F show that median issue sizes are much lower in other markets.

An important factor for companies’ access to the corporate bond market is their credit ratings. In order to reach the large pool of institutional bond investors, a company’s bond issue needs to be rated by at least one of the established rating agencies. These external ratings obviously reduce the costs for diversified investors to assess the quality of each and every bond issue that they need to acquire. This begs the question of whether the size of the bond issuer has any impact on its credit rating and thereby access to the bond market.

Indeed, the scale of a company is typically an important factor for its credit rating. For instance, out of the five factors that Moody’s uses in its scorecard to determine the rating of a company, the “scale” factor, which is proxied by metrics such as total assets, total sales, fixed assets, etc., has a median weight of 20% in the final scorecard‑indicated rating of a company.2 Moody’s combines the scale factor with 4 other factors, which are (i) leverage and coverage, (ii) profitability, (iii) business profile and (iv) financial policy. Hence, even if one risk factor indicates a low rating category, this can be compensated by another risk factor that indicates a higher rating category, resulting in a final rating between the two rating categories.

Holding other factors constant, a larger company size is associated with a higher rating. For instance, according to Moody’s rating methodology for the restaurant industry, which is one of the most severely affected industries by the pandemic, the weight of the scale factor is 20%. Within this factor, there are 3 sub‑factors that proxy for size: revenues (10%), number of system-wide restaurant units (5%) and revenue by geographic region (5%). According to the rating methodology published in 2011 for the restaurant industry, the minimum number of restaurant units required to receive an investment grade score (Baa) was 3 000 and the threshold for total revenues required for an investment grade rating was USD 3 billion. With the 2015 update to the methodology, the threshold for the number of restaurant units was increased to 5 000 and that for total revenues was increased to USD 5 billion, both changes re-enforced the importance of size in credit ratings.

Another possible barrier for smaller growth company issuers are the fees associated with obtaining a rating. This fee is paid by the issuing company and can sometimes be quite a significant cost. According to S&P Global Ratings’ disclosure of ratings fees in 2020,3 a fee of up to 7.1 basis points of the transaction value is charged for most transactions involving US corporations, with a minimum fee of USD 110 000. This means that for any issue of less than USD 155 million, the effective fee will be higher than 7.1 basis points. While this fee structure may constitute an entry barrier for smaller companies, larger companies may instead benefit from discounts. S&P, for example, states in its disclosure that it will consider “alternative fee arrangements for volume issuers and other entities that want multi‑year ratings services agreements”, which is likely to further benefit frequent and larger issuers.

The empirical evidence presented above shows that although there has been a global tendency towards a relative increase in the number of smaller issues, this tendency does not hold for all markets. Moreover, the crisis has triggered a sharp move towards larger issues and issuer sizes in many parts of the world, provoking questions about the market’s ability and the effectiveness of related policies to equally serve mature and established large companies as well as smaller and less established growth companies.

5.4.3. Credit rating stability

External credit ratings play a pivotal and increasingly important role in the corporate bond market by influencing the investment decisions and asset allocation of financial and non‑financial institutions in a number of different ways. One is through regulations that use external credit ratings to define quantitative limits and risk-based capital requirements. Frequently, credit ratings also dictate investment choices through self-defined policies that focus exclusively or primarily on buying investment grade bonds, as in the case of central banks (e.g. BoE, BoJ and ECB) and non-financial corporations. Importantly, large bond investors, such as investment funds are typically bound by rating-based indexes and investment mandates that are defined with reference to ratings. This includes, cross-border investments in corporate bonds, which now constitute a significant share of the market, which are also likely to follow rating- or index-based strategies.

Supported by a low-interest-rate environment, the mechanics of the credit rating system have allowed companies to increase their leverage ratios and still maintain a BBB rating - the lowest rating in the investment grade category - which has come to dominate the investment grade category. Between 2017 and 2020, BBB rated bonds made up 52% of all new investment grade bonds issuance. The worsening of within‑rating median leverage ratios during the past decade appears to be offset by simultaneous increases in median interest coverage and profitability ratios. The improvement in interest coverage ratios can be partly attributed to the unprecedentedly low levels of interest rates.

Despite the significant increase of BBB rated bonds, there was a declining number of downgrades relative to upgrades up to the COVID‑19 outbreak, which may suggest that credit rating agencies (CRAs) are mindful of downgrading BBB issuers due to their special status just above the non-investment grade category. Figure 5.11 clearly shows that for all CRAs, the one-year 1-notch downgrade probability is lowest for bonds rated BBB-, which is the lowest rating before crossing the line to non‑investment grade. The probability of a 1-notch downgrade within a year ranges between 8 to12% for the AA category; between 7 to10% for the A category and falls below 5.6% for BBB‑ rated issuers. The probability jumps back to above 7% for BB+ rated issuers in the case of S&P and Fitch and moves up less sharply in the case of Moody’s. These patterns stay the same if the probability of multiple‑notch downgrades is considered and irrespective of whether moving to default is considered as a downgrade event or not.

Figure 5.11. Historical average one-year 1-notch downgrade probability from a given rating

If rating agencies are extra cautious to re-rate bonds that are in the vicinity of the investment / non‑investment grade boundary as is suggested by Figure 5.11, one might expect that the 1‑notch upgrade probability is lowest for the BB+ category. However, for S&P and Moody’s, the probability of an upgrade within a year is actually highest for BB+ rated issuers. Although for Fitch-rated issuers, the one-year 1‑notch upgrade probability is the highest for B- rated issuers followed by B+ and then by BB+ rated issuers. It should be noted that issuers rated BB+ by Fitch have a higher 1‑notch upgrade probability compared to those rated BB+ by S&P and Moody’s (13.6% vs. 11.5% and 10.2%, respectively) (Çelik, Demirtaş and Isaksson, 2020[24]).

In addition to concerns among credit rating agencies, the downgrade/upgrade probability pattern may also reflect that companies with BBB status pay extra close attention to their rating metrics in order to maintain their rating status and borrowing costs. Similarly, highly‑rated non‑investment grade issuers actively seek to improve some key rating factors in order to move up the rating ladder to reach the investment grade level. Such efforts to actively keep or improve the credit rating may take different forms. It may for example include steps to improve those financial ratios that most significantly influence credit ratings (e.g. leverage) and work closely with the rating agency to ensure that all the necessary information is effectively communicated. It may also include discussions with the credit rating agency to communicate non-financial factors that would warrant a favourable credit evaluation.

5.5. The importance of efficient insolvency systems for recovery

As a first response to the sharp decline in company incomes and the liquidity challenges that followed, governments and central banks around the world provided generous support to a broad range of companies. Given that the impact of the pandemic is not likely to be short‑lived and as liquidity challenges are likely to eventually turn into solvency problems for some companies, distinguishing between viable and non-viable companies is becoming increasingly important for a better allocation of available resources. Under such circumstances, an insolvency regime that lays the foundation for an efficient and swift exit of non-viable companies and successful restructuring of viable companies is crucial. The differences in insolvency regimes across countries will likely affect how companies and investors in different countries navigate the pandemic.

A country’s insolvency regime and its level of enforcement are likely to affect, among other things, costs incurred during and the length of the insolvency process, whether a company emerges from the proceedings as a going concern or whether its assets are sold piecemeal, and as a result, the ultimate recovery rates. A cross-sectional comparison of the average performance of countries’ insolvency frameworks with respect to these measures is not straightforward since the typical bankruptcy case could vary widely across countries. To overcome this problem and allow a reliable cross-sectional comparison, a survey of insolvency practitioners from 88 countries studied the most likely outcome in their country of a hypothetical insolvency case involving a defaulted hotel, whose financial conditions were clearly detailed in the survey (Djankov et al., 2008[25]). The survey was later adopted by the World Bank and has ever since been updated annually as part of its Ease of Doing Business research. Figure 5.12 shows the most recent data from this survey for G20 countries except for Saudi Arabia for which 2019 data are not available.4

Figure 5.12. Insolvency outcomes for an identical hypothetical case across countries

According to the figure, insolvency procedures are, on average, time‑consuming, costly and lead to low recovery rates, with some significant variation across countries. The cost of the proceedings is reported in Panel A as a percentage of the value of the debtor’s estate and includes court fees and government levies, fees of insolvency administrators, auctioneers, assessors and lawyers and all other related fees and costs. Across the 18 countries, the average cost is 12.1% with Japan and Korea at the lowest end (4% each) and China, Italy, and Indonesia at the highest end (22% each). Furthermore, it takes an average of 1.8 years for creditors to recover their claims for the given hypothetical case, again with a wide variation across countries (5 years in Turkey and less than a year in Canada and Japan). In the hypothetical case that is defined in the survey, the efficient outcome is to keep the defaulted hotel as a going concern instead of selling its assets piecemeal. However, 5 countries (Argentina, China, Russia, South Africa and Turkey) out of 18 fail to achieve this preferred outcome. The ultimate recovery rate, which is calculated as a function of the costs, time to resolution and the outcome (piecemeal sale vs. going concern) of the proceedings, has an average of 61%. Australia, Canada, Japan, Korea, the United Kingdom, and the United States reach recovery rates higher than 80%. In contrast, Argentina, Brazil and Turkey have the lowest recovery rates ranging from 19 to 11%.

Naturally, a distressed company’s and its debt investors’ choice of restructuring process (out‑of-court versus through bankruptcy) will be a function of their expectations about these outcomes. Becker and Josephson (2016) argue that poorly functioning bankruptcy procedures may force viable but insolvent companies to restructure out of court, where banks tend to have a bargaining advantage over other creditors (Becker and Josephson, 2016[26]). Consistent with this argument, they find that inefficient bankruptcy procedures in a country, as proxied by measures of bankruptcy recovery, are related to less bond issuance by higher risk borrowers. They also find that improvements in the bankruptcy process are associated with increases in the bond share of corporate debt, especially for high-risk firms. Hence, inefficient insolvency regimes may be one important reason for the near absence of corporate bond markets in many countries.

In addition to ensuring favourable outcomes with respect to the different dimensions reported in Figure 5.12, it is also important to design an insolvency regime in a way that facilitates an orderly exit or restructuring of a distressed firm. It should also give creditors, debtors and other investors the right incentives to take appropriate actions promptly after financial difficulties arise, thereby enhancing the likelihood of a successful restructuring. Although insolvency regimes vary significantly between different countries, several international best practices have emerged. The main elements of these best practices for corporate insolvency regimes include: (i) a clear trigger to induce either the debtor or the creditor to initiate insolvency proceedings; (ii) the possibility to choose between an efficient liquidation and an opportunity to rehabilitate, depending on which one of the two options maximises firm value; and (iii) a design that discourages debtors and debtholders’ strategic behaviour that would result in suboptimal overall outcomes (Adalet McGowan and Andrews, 2018[27]).

Based on these best practices, Adalet McGowan and Andrews (2018) built a composite indicator to provide an aggregate measure of the key features of insolvency regimes that may impact the timely initiation and resolution of insolvency proceedings (Adalet McGowan and Andrews, 2018[27]). The indicator was formed using responses to an OECD questionnaire and is available for two years, 2010 and 2016. On a scale of 0‑3, the lower the score the more efficient is the insolvency regime with respect to personal costs to failed entrepreneurs, better mechanisms to aid prevention and streamlining and lower barriers to restructuring. According to Figure 5.13, which plots this indicator for 33 countries for which complete data are available for both years, the cross‑country differences in the design of insolvency regimes are significant and the countries widely vary both with respect to the aggregate indicator and its three subcomponents. As of 2016, the United Kingdom, France, Japan, Russia, and the United States had the lowest values, indicating that their insolvency regimes performed well in all three subcomponents analysed. In contrast, the Czech Republic, Estonia, Hungary and the Netherlands were on the other end of the spectrum with scores exceeding 2 out of 3.

Figure 5.13. OECD indicator of insolvency regimes

The figure shows that 14 of the 33 countries have improved their insolvency regimes from 2010 to 2016. The countries that experienced the biggest improvements were Chile, Germany, Greece, Japan, Portugal and Slovenia. However, there remains a large scope for reform in many countries. Recent research shows that such reforms to insolvency regimes may reduce the share of capital sunk in “zombie” firms, which in turn facilitates the reallocation of capital to more productive firms (Adalet McGowan, Andrews and Millot, 2017[3]). Furthermore, using this insolvency regime indicator for 11 European countries, Andrews and Petroulakis (2017) show that improvements in bank health are more likely to be associated with a reduction in zombie congestion in countries where insolvency regimes do not unduly impede corporate restructuring (Andrews and Petroulakis, 2017[28]). These positive effects could be especially relevant during the COVID‑19 crisis, as there is already some evidence of a steep increase in 2020 in the share of unviable companies (Rennison, 2020[29]).

Although reforms to improve insolvency frameworks are desirable, the actual performance of an insolvency framework is greatly dependent on the efficiency of the judicial system within which it applies. In addition to the cross‑country differences that may exist, the efficiency of the judicial system may temporarily be overloaded due to an extraordinary surge in default cases that need to be resolved. In particular, it has been noted that the efficiency of the judicial system has a significant impact on the costs of the financial distress and the outcome of the bankruptcy. In the case that the bankruptcy courts are busy, time constraints might limit the effective handling of the cases, therefore leading to higher costs. Moreover, the smaller firms tend to be liquidated more than the larger firms in the case of busy courts rather than restructured (Iverson, 2018[30]). Therefore, inefficiency in the judicial system leads to liquidation of a higher number of viable firms than desired, more important is that smaller companies are more adversely affected in this process. Indeed, leading bankruptcy scholars in the United States addressed a letter to the US Congress in May 2020, strongly recommending that the capacity of the bankruptcy system should be strengthened to prepare for what the scholars feared could be “a flood of large corporate bankruptcies arising out of this pandemic”. In particular, the scholars suggested appointing additional temporary bankruptcy judges and increasing the budgets of bankruptcy courts so that they can recall retired judges, and employ additional clerks together, with other necessary personnel needed to enhance the capacity of the bankruptcy system.5 If such legal bottlenecks occur due to the pandemic, this may increase the costs of formal bankruptcy proceedings and push companies and investors more towards out-of-court arrangements such as distressed exchanges even if such arrangements are not the optimal choice for their specific case.

As described in Chapter 3, many jurisdictions made temporary changes to their insolvency practices. These temporary changes were helpful in protecting otherwise‑viable companies from filing for insolvency due to the difficulties arising from extraordinary health measures associated with the coronavirus outbreak. However, if such temporary changes remain in force for an unnecessarily long time, they may undermine one of the most significant aims of insolvency regimes, which is to ensure a timely initiation of insolvency proceedings. Such delays in the initiation of insolvency processes can, in turn, increase costs, erode the final value of the firm and make it less likely that viable firms are successfully restructured. The decision to retain, remove or change the scope of such measures and the timeframe to do so should take into account these potential distortions.

5.6. Corporate bond debt, recovery and distressed exchanges

As the rising number of rating downgrades and default since the start of the COVID‑19 outbreak are likely to stay elevated, it is increasingly important to understand the determinants of recovery rates and to consider how recovery rates may evolve during this default cycle. A well-documented characteristic of recovery rates is their negative correlation with default rates. Figure 5.14 plots annual default rates in the non‑investment grade category and bond recovery rates in each year from 1985 to 2020. There is a strong negative correlation (-0.75) between the two series with recovery rates reaching their lowest values in years when default rates are the highest.

Figure 5.14. Historical non-IG default rate and bond recovery rate (%)

A number of factors may influence the inverse relationship between default and recovery rates. First, default and recovery rates are likely to depend on the same systematic factor so that an adverse macroeconomic condition that causes default rates to increase will also depress recovery rates. Second, when there is a surge in corporate defaults, the amount of distressed debt securities in the market exceeds the absorbing capacity of investors who are interested in distressed debt, leading to a decline in secondary market prices (Altman et al., 2005[32]). Third, industry-wide distress typically lowers the economic value of a defaulting company’s real assets and may also trigger fire sales, which further decrease recovery rates. Particularly low valuations may occur when the most likely bidders for a defaulting company’s real assets are its competitors, which are also in financial distress when industry conditions are poor (Acharya, Bharath and Srinivasan, 2007[33]).

5.6.1. The length of the default cycle and recovery rates

According to Figure 5.14, the highest annual rate of default for the non‑investment grade category (12.1%) was reached during the 2008 financial crisis. Assuming that the trailing 12‑month global non‑investment grade default rate follows paths comparable to those in prior default cycles, Moody’s on August 2020 announced that in February 2021 this rate would likely range between the peaks of the previous recessionary default cycles which is 9.7% and 13.3% and that the absolute number of issuers that will default is expected to be similar to the number in the prior crisis due to the larger non-investment grade universe of the recent stock (MIS, 2020[34]). However, according to the projections made in January 2021, the current default cycle is expected to peak at a lower rate than those associated with the last three recessions and therefore will be relatively mild compared to the prior recessionary default cycles. In this respect, it is projected that the rate of default of speculative-grades will peak at 7.3% in March 2021, and then will decline to 4.7% by December 2021 (MIS, 2021[31]).

Assuming default rates will follow a similar path to those in prior default cycles could be simplistic as this time the path to recovery is highly uncertain and depends on exogenous factors such as the probability of prolonged waves of infections. While the world economic output is forecast to decline by 3.4% in 2020, which is a sharper contraction than that observed during the 2008 financial crisis (OECD, 2021[35]). A slow recovery from the health crisis may prolong the default cycle, which may, in turn, exert downward pressure on recovery rates. A longer default cycle would likely mean a higher number of defaulting companies over an extended period of time, and a corresponding increase in the total amount of defaulted debt. Furthermore, initial out-of-court restructurings of defaulted debt might fail, and companies may re-default before the downturn ends and have to file for bankruptcy in a difficult environment, again leading to lower recovery rates than would be achieved in a more benign credit cycle. Evidence from three major default cycles that took place in the past 30 years shows that longer default cycles are associated with lower recovery rates (MIS, 2020[36]).

Another distinctive implication of this downturn is that a longer default cycle may have very different implications for different industries. For the industries that are most severely affected by social distancing rules, a lengthening of the cycle may cause many companies to struggle for survival. In particular, more than one‑fifth of the viable firms from the sectors of accommodation and food service activities, and arts and entertainment are expected to become distressed as a result of the COVID‑19 driven shock (OECD, 2021[37]). The retail, restaurant, media and entertainment sectors, which historically reached slightly lower recovery rates than the average industry both in the United States and in Europe, may see their relative recovery rates decrease even further (S&P, 2019[38]) (S&P, 2020[39]).

5.6.2. The rise of distressed exchanges

A company in default can resolve its financial distress through an out‑of‑court restructuring or by going through formal bankruptcy procedures. An out‑of‑court restructuring practice that re‑emerged in the corporate bond market in 2008 and has significantly increased its prevalence in the subsequent period is the use of distressed exchanges (Altman and Karlin, 2009[40]) (MIS, 2020[41]). In distressed exchanges, an issuer offers a new or restructured debt consisting of a new package of securities, cash or assets to its creditors or bondholders, who voluntarily may accept the offer. Such exchanges have the effect of reducing the original debt burden of the issuer and hence help avoid a bankruptcy or payment default. The offer can involve a debt‑for‑debt, debt-for-cash or debt-for-equity exchange.

As seen in Figure 5.14 above, although the default rates surged to an all-time high in 2009, the average bond recovery rate was 33.9%, which was remarkably higher than the recovery rates observed in 2001 (21.7%) and 1990 (25.8%). The relatively high rates of recovery reached during the 2008 financial crisis are partly attributed to the increased share of distressed exchanges in the total number of defaults during that period. Figure 5.15 shows that while distressed exchanges made up only 11% of initial defaults on average in the period from 1970 to 2007, they represented 23% in 2008 and reached 42% of initial defaults by 2010. In return, the share of bankruptcy filings declined from 45% to 21% from 2008 to 2010. The share of distressed exchanges has remained elevated in the last decade and accounted for around 40% of annual number of defaults on average.

Figure 5.15. Distribution of default event types (%)

Based on corporate default data from 2008 to 2020, Panel A of Figure 5.16 shows that, globally, 38.8% of default events were settled with a distressed exchange. Calculating this same ratio for different regions shows that the frequent use of distressed exchanges is a common phenomenon. Distressed exchanges made up 38.75% of defaults by US companies, and 43.9% of defaults by European companies. On the other hand, in the rest of the economies, distressed exchanges are less frequently used. Panel B shows that a vast majority of distressed exchanges that took place between 2008 and 2020 were carried out by US (67%) and European companies (16%).

Figure 5.16. Use of distressed exchanges in different regions (2008-2020)

Creditors and bond investors tend to agree to distressed exchanges because the recovery after a distressed exchange is likely to be greater than in a bankruptcy situation. Panel A of Figure 5.17 contrasts average recovery rates from distressed exchanges to those from bankruptcies for the period between 1987 and the first quarter of 2020. Across all three debt classes, distressed exchanges generate higher recovery rates relative to bankruptcies on average. While average recovery rates in distressed exchanges reach 71% for senior unsecured bonds and 66% for subordinated bonds, the recovery rates for these securities are only 39% and 20%, respectively, when the company goes through a bankruptcy. Also notable is that the gap between distressed exchanges and bankruptcies widens as one moves from more senior to more junior debt.

Figure 5.17. Average recovery rates: distressed exchanges vs. bankruptcies 1987-2020Q1

As distressed exchanges allow investors to recover more in the first place, investors have a tendency to postpone troubles in the hope that the economy will eventually turn and allow the distressed company to overcome its financial problems. This tendency to postpone could be especially strong during the pandemic as there exists some hope for an efficient treatment or vaccine that would then lead to a quick recovery. In general, there is no guarantee that a distressed exchange will not eventually fail and lead to a re‑default later on. Indeed, according to Moody’s 30-year default data, 41% of distressed exchanges led to a subsequent default, which was either a bankruptcy or another distressed exchange (MIS, 2020[36]). Panel B of Figure 5.17 reports how recovery rates change when re-defaults are concerned. Although recovery rates for distressed exchanges are almost identical when re-defaults in Panel B are compared with the rates reported in Panel A, re-defaults of bonds that result in bankruptcy generate sharply lower recovery rates. For senior unsecured bonds, 21% is recovered on average when there is a re-default into bankruptcy, and for subordinated bonds the recovery rate is a mere 14%.

Focusing on the post‑2008 financial crisis era, Table 4.1 reports the distribution of re-default events based on the type of their prior default. According to the table, the most common type of re-default event is bankruptcies preceded by distressed exchanges, which constitutes 45% of the total number of re-defaults. Distressed exchanges after an initial distressed exchange constitute 29% of re‑default events. Re-defaults of prior bankruptcies, on the other hand, are less common.

		Type of re-default
		Distressed exchange	Bankruptcy
Type of prior default	Distressed exchange	29%	45%
Type of prior default	Bankruptcy	2%	24%

Source: (MIS, 2020[36]).

Data from Table 5.1 indicate that when a distressed exchange leads to a re‑default, it ends up in bankruptcy 61% of the time. This is concerning given the low average recovery rates reported in Panel B of Figure 5.17 for re‑defaults into bankruptcy. Given that the recent high levels of recovery rates are mainly supported by the frequent use of distressed exchanges, if the financing conditions for distressed exchanges deteriorate or if the frequency of distressed exchanges re‑defaulting into bankruptcies increases, recovery rates could decline rapidly, with overall negative effects on resilience.

5.6.3. Weaker covenants

Covenants are clauses in a bond contract that are designed with a purpose to protect bondholders against actions that bond issuers can take at their expense. Empirical evidence indicates that they succeed in achieving this purpose since stronger covenants generally lead to higher recovery rates. In particular, it is argued that covenants that restrict an issuer’s investment and financing policy protect existing bondholders against adverse management actions and lead to higher recoveries (Jankowitsch, Nagler and Subrahmanyam, 2014[43]).

In the low interest rate environment of the past decade, bond investors became increasingly willing to forego their own protection by agreeing to weaker covenants to reach higher returns. Figure 5.18 below presents the covenant protection index for bonds issued in the US market by non-financial companies. The higher the index, the stronger the covenant protection. According to the figure, the large gap that existed between the covenant protection indexes of investment- and non-investment grade bonds in the beginning of the 2000s narrowed until 2012. This was mainly due to a decline in the covenant protection index of non-investment grade bonds, which reached its lowest value at 30% in 2012, after which it began increasing, reaching 37% in 2019. This was the highest level since 2011.

Figure 5.18. Covenant protection index for bonds issued in the United States by non‑financial companies

In the first 3 quarters of 2020, however, the covenant protection index for non-investment grade bonds reversed its course and experienced a rapid decline, dropping to 33%. In addition to a trade-off between bondholder protection and higher yields, this decline may partly be attributable to the increased share of higher rated bonds in the non-investment grade category. In contrast, the index for investment grade bonds remained unchanged from 2019 to 2020. As a result, the gap between the indexes of investment and non‑investment grade bonds narrowed to its lowest value since 2012.

The overall impact of weaker covenants on the ultimate recovery rates during this downturn remains to be seen. One drawback of a weak covenant structure is that it may allow distressed companies to undertake actions at the expense of existing debt holders (e.g. raising more debt, distributing value to equity holders, transferring assets to subsidiaries, etc.). Extended periods with such self-serving actions are likely to affect recovery rates negatively. However, if weak covenants allow a company to defer default until a time when liquidity conditions improve, then recovery prospects may actually improve. Furthermore, the weakening in covenants would make it easier for issuers to execute distressed exchanges, which tend to obtain higher recovery rates. For instance, a negative pledge covenant is typically used to ensure that other creditors do not obtain a more senior claim over the assets of an existing debtor. The lack of this covenant type in a senior unsecured bond indenture allows the issuer to exchange such bonds for more senior second-lien bank debt, and hence subordinating bondholders who do not participate in the exchange (MIS, 2020[41]).

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Notes

← 1. Using issue size as a proxy for the bond market accessibility of smaller growth companies has its limitations since large companies can also choose to make small issues. An alternative measure could be to use asset size of issuers to distinguish between small and large issuers. The drawback of using this alternative measure would be that not all issuers have their asset size information available in the dataset. Nevertheless, it should be noted that the main results continue to hold when the analyses here are reproduced by using issuer sizes instead of issue sizes.

← 2. The median weight of the scale factor reported here is its weight in the median industry across 43 non‑financial industries for which Moody’s provides a rating methodology as of August 2020. Actually, Moody’s has rating methodologies for five more non-financial industries but they are not included when calculating the median weight, because the rating factors that they use are not consistent with the other 43 industries.

← 3. www.standardandpoors.com/usratingsfees

← 4. Because the estimates reported in the figure are formed based on the hypothetical and rather simple insolvency case, they should not be viewed as what the average recovery outcome would be across all bankruptcy cases in a given country. However, these estimates still provide a helpful overview of the relative rank of countries across these performance measures. The details on the hypothetical insolvency case can be found at the website www.doingbusiness.org/en/methodology/resolving-insolvency.

← 5. The complete letter is available at http://blogs.harvard.edu/bankruptcyroundtable/files/2020/06/Small-Business-Letter-Final-5.26.20-pm.pdf.

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