What Is a Back Stop?
In corporate finance and investment banking, a back stop is a crucial mechanism that provides last-resort support, ensuring any unsubscribed shares in a securities offering are purchased. This safeguard helps companies guarantee a certain amount of capital during an issuance, often with the backing of an underwriter or major shareholder, such as an investment bank.
Key Takeaways
- A back stop acts as a safety net in a securities offering by covering the unsubscribed portions of shares.
- Companies seeking to raise capital through an issuance typically secure a back stop from underwriters or major shareholders to ensure the capital target is met.
- Back stops function as a kind of ‘insurance’ to support the offering, mitigating the risk of unsold shares.
The Function of a Back Stop
Back stops effectively serve as pseudo-insurance, ensuring that a predetermined portion of securities will be purchased by specific organizations, usually investment banking firms. When investment banks act as back stops, they usually enter into a firm-commitment underwriting agreement with the issuing company, promising to acquire a set amount of unsold shares.
By participating in such agreements, the underwriters assume full responsibility for any initially unsold shares, thus guaranteeing the required capital is provided in exchange for these securities. This shifts the risk of unsold shares from the issuer to the underwriter. If all shares are bought through traditional investment routes, such agreements become void, as their conditions have been satisfied.
Types of contracts between an issuer and underwriters can vary, including revolving credit loans to improve issuer credit ratings or letters of credit guaranteeing the funds.
Special Considerations
When the underwriting organization buys any shares as per the agreement, these shares are considered part of its investment portfolio and are subject to standard market activity rules. There are no restrictions imposed by the issuing company on how these shares may be traded.
The underwriting entity may hold or offload these securities according to regulatory frameworks.
Example of a Back Stop
Consider a rights offering scenario where “Company ABC will provide a 100 percent back stop of up to $100 million for any unsubscribed portion of Company XYZ’s rights offering.” If XYZ aims to raise $200 million but only secures $100 million through investors, ABC will purchase the remaining $100 million.
Back Stops in Bond Issues
Similar to equities, a back stop in a bond issue ensures unsold or unsubscribed bonds will be purchased at a predetermined price by the underwriting bank or syndicate.
Who Are Backstop Purchasers?
When an underwriting bank or investment banking syndicate opts not to back stop a new issue, external backstop purchasers may be brought in to cover any unsubscribed portions. These entities often buy at a lower price and may charge fees to ensure coverage, subsequently selling off holdings over time for profit.
Understanding Volcker Rule Backstop Provisions
The Volcker Rule aims to mitigate conflicts of interest between commercial and investment banking affiliates. It stipulates that an underwriting bank is prohibited from back stopping an issue if it poses significant risk to the bank or financial stability, preventing high-risk behavior that could harm customers or financial systems.
Related Terms: underwriter, investment bank, rights offering, bond issue, Volcker Rule, backstop purchasers, firm-commitment underwriting
References
- Cornell Law School Legal Information Institute. “17 CFR § 255.7 - Limitations on Permitted Proprietary Trading Activities”.
