A "moral hazard"? A look at State aid and "bailouts"

Sean Giles: My name is Sean Giles I am an Associate in the EU, Trade and Competition team here at Gowling WLG and I am sitting with Bernardine Adkins who a Partner and Head of the team. We are on a cloudy Friday morning in a room without any windows recording this podcast and Bernardine is absolutely desperate for a coffee so we had better press on otherwise it could get very nasty!

Bernardine Adkins: Sean - a bit of an extensional question for you… Why are we here? What is this podcast about? Why did we decide to do this one?

Sean: Why are we here… I won't go into that, but for this podcast you have probably seen there are lots of things in the news this week about Thomas Cook going into administration. The government are saying they are unable to provide any State aid or support to Thomas Cook on the basis that doing so would be a moral hazard, whereby many other companies if they ever go into liquidation or financial difficulty they would be seeking some funds from the government. People have been up in arms about that because in Germany a subsidiary of Thomas Cook, Condor Airlines, have sought about €200 million reportedly in aid from German states which looks set to be granted according to news reports so we had better clear up what is going on. We had better clear up what is happening here.

Bernardine: OK well I think moral hazard is a fascinating concept and ultimately derives from way back with the turn of inspecting supervision of financial institutions. But basically moral hazard is obviously giving the equivalent of giving your teenage child a credit card and off they go. So there is a situation of moral hazard because they can spend money willy-nilly because no-one is ever going to say OK well now you need to clear that credit card bill at the end of the month. So they will not behave in a responsible way because they will never get the consequence of their actions.

What is interesting is that moral hazard is factored into the State aid rules especially in regard to rescuing and restructuring aid and because certainly the European Commission that oversees the grant of State aid has had its fingers burnt in the past. And I have to say it has been in respect of the French Air France in particular and also Credit Lyonnais when we first saw that expression actually articulated in a decision saying listen France and Credit Lyonnais you cannot keep coming back here. This has to be one time last time and that is an important facet of any rescue and restructuring aid that an EU government can grant is - yes support that failing business - but you can only do it one time, one last time. That guards against this notion of moral hazard that a company or firm will behave irresponsibly going "well if we take these huge risks and it all goes horribly wrong it does not matter, we are too big to fail the government is going to have our backs". That is factored it is one time, last time, if you mess up this time you cannot come back and putting it crudely dip your feet back into the State aid coffers.

Sean: In terms of that kind of factoring into the rules and regulations on State aid I mean that is reflected in the European Commission's guidance on restructuring aid which says that you may have to be undertaken difficulty, you have to demonstrate you are undertaking difficulty. Any aid that is to be granted to that undertaking difficulty must be notified to the Commission and the Commission has to assess that. Also those guidelines make it clear that if there are social costs to removing unviable aspects of the business - such as people losing their jobs or needing to be retrained to obtain skills to work in the restructured business potentially or another sector - then it is perfectly legitimate for the government to pick up those costs.

Bernardine: There is also another means of dealing with the State aid rules and that is actually to bypass them altogether, and to consider what they call the market investor principle. And that is something that the government could have considered. So basically what the law says is that if the government gives support or monies to a company and it is behaving in the same way as a rational private investor would have behaved, then it isn't State aid at all - and the European Commission does not get to oversee it to make sure it does not create an unfair distorted effect. So one of the facets is, the big question is "would a rational investor have done this?" and for that, obviously, a company has to pay back on a market rate basis, by reference to the risk, the money it has been loaned. So that is also always an option for a State where it is considering whether to give support is to say "well would a rational market investor have behaved in that way?" That was a case we had a few years ago concerned with Coventry City Council which gave a loan to the Ricoh Arena because it is lessee at the time, the SISU fund was basically not paying the rent and they were in distress and it was challenged. It said well "I think this is legal State aid" and in fact Coventry City Council won that case (the court and it was appealed and they won the appeal). The Court essentially said no, somebody held that asset and it was being distressed and the rents weren't being paid, so what would a rational private investor have done? The Court said it would have tried to keep that company afloat and ensured that it got the rents in so that loan was a very rational, something that a market investor would have done. And I have to say the case was quite extraordinary because the Court wasn't so much full of geeky EU lawyers like ourselves it was full of Coventry City Football Club fans, so I remember that case very well.

Sean: Yes and I think just to take a step back from the market economy operator principle, this goes back to the cloud of fog, fake news, misinformation, disinformation whatever you want to call it around what actually is State aid. I think it is important to look at the meaning of that in the first instance because if you are not within that definition then you don't need to worry about these things. So I think just to run through what the fundamental principle of State aid is and that it is some sort of gratuity, it is something for nothing that a State gives to a private enterprise because they like them, basically.

Bernardine: It has to be money doesn't it.

Sean: It has to be money or have a pecuniary aspect to it.

Bernardine: Yes.

Sean: And there are four broad elements to that so the first thing as you said it is a gratuity given by the State using State resources.

Bernardine: It can be quite weird the State resources as I remember a case way back in the day in the betting sector. The French government allowed, it was the PMU, to round up certain social payments and it was like half a centime sort of thing but over thousands and thousands of transactions it became the sizeable pot of money and that was deemed to be State aid because it concerns State resources.

Sean: And that also applies to things like non-collection of tax that we have seen with Apple and Ireland - and also Luxembourg has been a high profile case in the news. That kind of Apple case kind of reads on into this advantage and selectivity and picking somebody that you really like and as a government want that company to stay in your country and nowhere else and within the EU single market that is not allowed. That is supposed to be one market across the board with the EU.

Bernardine: So if it is a national provision that applies the board such as really low tax rate it does not have that selectivity so it is not State aid.

Sean: Exactly. But if you are you know being selective then you fall potentially within these rules depending on the broader facts obviously. The two final aspects and this is the kind of broader point is "is the Aid distortive, if it is aid, or liable to distort competition within the single market in the EU?" and "will it affect trade between EU Member States?". So if you are the UK picking Thomas Cook for no reason, i.e. it wasn't in difficulty you just gave it a £1 million and said you go away and do this, given that Thomas Cook operates across the EU you can see it is liable that sort of aid may affect trade between EU Member States.

Bernardine: It can be at quite at a local level, though, because if it potentially creates gives some person an advantage and it creates barriers to entry for somebody else in another State - it is quite an easy test to pass effectively. Obviously, the big question on our lips is Brexit.

Sean: Yes and that is something certain political parties and newspapers have been suggesting that once we are "unshackled" from the EU rules you will be free to subsidise whoever we want and we won't be limited in the aid that we can grant. But that's not really true is it? We have committed to copying and pasting all the EU rules into UK law.

Bernardine: That's right, that's right. We do have a and also with a no deal Brexit we are also still committing ourselves to comply with the equivalent of the EU rules. Obviously, they will then be transposed into national law and we do have a draft statutory instrument before Parliament, The State Aid (EU Exit) Regulations. It is a hell of a read, 78 pages long. It is quite funny how the UK, whenever it transposes over EU, law how much more difficult and impenetrable they make it. So essentially we are still, what it is doing is repatriating these EU rules. So it isn't going to be a free for all if we have a no deal. It's that UK businesses and also EU businesses with UK operations, yes you can still receive State aid but you essentially have to go through the same processes, look at the same possible prohibitions or exemptions, as well as we currently have. What I find interesting, and I think how are they going to do that, it is going to the be the Competition and Markets Authority, the CMA, which is the new name for the OFT, they are going to be the State aid authority which will essentially take over the current role of the Commission. Obviously there will be some technical adaptations so that these rules work in a domestic framework. Here's the CMA, it's a State body it's supposed to be essentially the police person of the State, constitutionally how is that going to work? So, say for example in an emotive situation such as Thomas Cook or British Steel, there is a lot public pressure you know stating "you must support this failing business" etc and the State does so, the CMA then goes and says "I'm sorry you are contrary to these rules which are ultimately derived from EU law", how is that going to work?

Sean: And that contrasts the current position where it is the Commission that receives the notifications of aid, and assesses that, and almost sits above those Member States so you don't have that similar level of conflict that potentially could arise by the State policing itself.

Bernardine: Yes , that's right you don't have that same constitutional question - because you have a hierarchy of norms there in that that UK is the sovereign Member State, national Member State and has agreed to abide by those EU rules and to give them a place in the domestic hierarchy. Even if these laws weren't passed something you pointed out, Sean, is that it is not a free for all, we still have the WTO rules, so how does this work?

Sean: This idea that WTO rules which are the default position of UK with the EU and when it leaves the EU without a deal which is the government's current trajectory, policy - we will see what happens. Unfortunately, WTO rules don't allow you to subsidise your industries. There is a specific Agreement on Subsidies and Countervailing Measures that basically says if you subsidise your industry, your businesses in your country unfairly then other Member States of the WTO (which is 164 members, so pretty much every country in the world) can retaliate to what you have done and complain. It just wouldn't be a good look for the UK as it seeks to establish itself as, you know, this great free trading nation that it puts itself out to be after Brexit, if it is unfairly subsidising industries and frankly annoying other WTO members.

Bernardine: Absolutely. Also the recipients of that of State aid are also risking, when they do import their products into the States in question who feel their national industry is comprised, they are at risk of being the subject of countervailing duties, trade defence instruments, whereby they have dumping measures put on to the cost of their products. Depending on where you come from economically, that can be problematic. Then let's just assume for a golden minute that the UK is able to agree a deal with the EU and we get this through Parliament… In terms of our long term relationship with the EU, the UK government is committed to a best-in-class free trade agreement. What I am currently struggling with at the moment is that the UK government has made it very, very clear that they wish to deregulate so they don't wish to be bound by the what we call the acquis communautaire - which is the rules around social, environmental, employment standards, climate change, tax matters, competition, etc. Yet what will be fundamental for the EU Member States to allow the UK to bring its goods and services into their market is that we are operating from what they call a "level playing field" in terms of our rules and regulations and so fundamental to that is that we have an aligned State aid regime.

So if the government, this government or a future government decides we are going to have a very different and much looser State aid regime I really think that is going to be very, very difficult in terms of how we are going to conclude a comprehensive free trade agreement.

I think people being realistic, businesses being realistic and trying to work out what on earth is this landscape going to be, should actually bear in mind we are likely to have this regime or a very similar regime set up outside which we have discussed is pretty flexible. It does allow aid to be granted albeit under certain circumstances but we need to acknowledge that this is not going anywhere. We are going to remain with this system for some time to come and given the landscape we have in the UK I would not be surprised if it is more litigious than it currently is and so that Coventry case with Ricoh Arena was an isolated case but I envisage that we will probably see more of those cases and more of those challenges. So I think you and I are going to be busy for some time to come Sean.

Sean: Well that is good. If we do struggle for sleep during that time, I guess we can always read the State aid statutory instrument to help send us off.

Bernardine: Absolutely if all else fails.