Backstopped Rights Issue in Chapter 11: Should Backstop Parties Pay?

Backstopped rights offerings in Chapter 11 are controversial. They have raised many legal issues regarding vote buying, bad faith, unreasonable fees, and unequal treatment. These concerns are difficult to address without a proper valuation model. Standby underwriting contracts are typically valued as put options. In Chapter 11, backstop contracts are more complex because backstop parties are insiders and structure contracts to secure upside for themselves. The paper shows that a backstop contract can be valued as a weighted long-short portfolio of call and put options. The backstop fee, calculated to prevent wealth transfers between parties, can be positive or negative depending on the portfolio’s weights and the option values. The (distribution-free) model derives the conditions that yields a zero fee. Backstop contracts are designed to be more about upside capture than downside protection. As such, they should command a negative fee. Backstopped rights offerings in Chapter 11 allow a coalition of creditors to tunnel equity at the expense of minority creditors. The model shed lights on incentives, conflicts of interest between parties and the relevance of wealth transfers to estimate ex-post returns and recoveries.