The Redemption Option: Discussion and Valuation Considerations from the ABI Commission's Proposed Chapter 11 Reform
AIRA Journal, Vol. 29, No. 4
The American Bankruptcy Institute (ABI) Commission to Study the Reform of Chapter 11 recently undertook a lengthy study to identify ways to improve the process of reorganization. The commission's final report and recommendations made proposals regarding different facets of the chapter 11 process. A recent AIRA Journal article, authored by Vice President Chris Feige and Konstantin Danilov, focuses on one of these proposals, the so-called "redemption option."
In " The Redemption Option: Discussion and Valuation Considerations from the ABI Commission's Proposed Chapter 11 Reform " (Vol. 29, No. 4, 2015), the authors describe the rationale behind the proposal and the technical aspects of its application in practice. "The redemption option is a proposal intended to correct potential unfairness resulting from the valuation of a reorganized company on one particular date during chapter 11 proceedings. Because a reorganized firm's value is often crystallized during a downturn in the economy, senior creditors often get the majority of the equity in the reorganized firm, and therefore capture the firm's future upside, while junior creditors and equity holders receive nothing," the authors explain. The junior stakeholders "therefore have an incentive to delay the confirmation of the reorganization plan, in hopes that the reorganization value increases, and they can negotiate to receive some value. The redemption option seeks to remedy this by paying junior creditors for the potential future upside they forgo when they accept the reorganization valuation as of a certain date."
The authors also describe the step-by-step calculation of the residual option value using a real-world example. They note that although the use of "call option framework to model the value of the implicit option held by junior creditors is a valid approach," the calculation of the value "is heavily dependent on assumptions about volatility." The authors conclude that there will likely be significant disagreement between opposing stakeholders regarding the valuation of the residual option, which will likely necessitate expert input and may result in additional litigation.