What Happens to Stock When Company Files Bankruptcy
Bankruptcy Is Not Good News for Stocks or Bonds
When a company goes bankrupt, what happens to investors holding its stock or bonds? Is buying the stock of a bankrupt company a good idea? The bottom line is bankruptcy is seldom good for stockholders or bond owners. However, many firms have emerged from one form of bankruptcy stronger and able to continue operations.
In this article, we will first get an overview of bankruptcy and why companies choose this route (if they have a choice). Then, we will take a closer look at the two main types of corporate bankruptcy, and the rights or options investors have when a company files bankruptcy.
Essential Bankruptcy Facts
- Bankruptcy is a form of reorganization or liquidation under the guidance of federal law.
- The bankruptcy laws cover both companies and individuals, although there are major differences.
- There are two major types of corporate bankruptcy: Chapter 11 and Chapter 7.
- In both cases, companies are in a financial pickle and can no longer continue as a viable business.
Simply stated, they owe more money than they are worth. In most cases, the companies are not able to pay for day-to-day expenses such as payroll, utilities, supplies and so on.
Some companies are allowed to declare a form of bankruptcy before they are completely destitute.
Companies may choose this action or may be forced into it by a creditor that is demanding a payment the company can’t make.
Bankruptcy laws offer an orderly way for the company to attempt to get back on its feet (Chapter 11). When that is not possible or fails, Chapter 7 bankruptcy structures a liquidation that pays creditors in the fairest distribution possible.
Stockholders are owners of the company and are last in line to receive any proceeds from liquidation. In addition, bond owners may only receive pennies on the dollar.
Main Forms of Corporate Bankruptcy: Chapter 11 and Chapter 7
Which form of bankruptcy a company chooses may determine the fate of stockholders and bond owners. Ultimately, the end of a bankruptcy process, regardless of whether it is Chapter 11 or Chapter 7, may not make any difference to investors.
Let’s take a brief look at both types of filings.
Essential Chapter 11 Facts
- Chapter 11 bankruptcy is the first choice of most companies.
- Under Chapter 11, a company can develop a reorganization plan and continue operating.
- Existing debts and contracts, including contracts with unions, are renegotiated.
- The company, under the guidance of a trustee appointed by the federal bankruptcy court, works out a plan to settle its obligations.
- While in bankruptcy, the company is protected for creditors by the court, preventing creditors from disrupting the operations of the company.
- However, creditors and stockholders must approve the reorganization plan. The bankruptcy judge has the authority to accept the plan even if the creditors and stockholders reject it.
- Once the reorganization is complete, the company can come out from under the protection of the bankruptcy court and resume normal operations.
- A Chapter 11 filing assumes there is a possibility the company can emerge from the process as a viable operating company.
Essential Chapter 7 Facts
Companies that either fail in their Chapter 11 reorganization or have no hope of resuming as a viable business may file a Chapter 7 bankruptcy.
Chapter 7 reorganization is a complete liquidation of all company assets.
The proceeds are used to pay off creditors in a specific order:
- Secured Creditors: These are creditors whose loans are backed by some form of collateral, such as land, factories, machinery and so on. Banks or other lenders that finance tangible assets make up this group.
- Unsecured Creditors: These are creditors that have lent money to the company without specific collateral. Banks that provide lines of credit or short-term loans fall into this group along with bondholders.
- Stockholders: These are the owners of the company. They would receive a proportionate share of any money left after the creditors are paid. This usually means the stockholder gets nothing because the assets are much less valuable than the debts.
The bankruptcy court will see that the assets are sold for the highest possible price and distribute the proceeds according to the schedule above.
If you own stock in a company that goes into Chapter 7 bankruptcy, the odds are extremely high (practically 100 percent) that your stock will be worthless.
What to Do If You Own Stock or Bonds in a Company That Files Bankruptcy?
When a company files for Chapter 11 bankruptcy protection, stockholders and bond owners are notified by the company. Chapter 11 bankruptcy allows a company to continue functioning, but creditors and shareholders must approve the reorganization plan. This plan will call for the renegotiation of contracts with suppliers, unions and any other creditors.If creditors and shareholders don’t approve the plan, a bankruptcy judge can OK the plan if it appears to provide for an equitable resolution of debts.
Once the plan is approved, the company suspends dividends to stockholders and premiums to bond owners. The stock in a company filing Chapter 11 may continue to trade, however in many cases the stock will not meet the minimum requirements for listing on a major exchange. One way creditors are paid off is through issuing a new class of stock as repayment of debt. For all practical purposes, the stock you hold will be worthless or close to it. If this happens, you may be eligible to deduct the cost of your loss (usually to offset up to $3,000 in capital gains).
Check with Tax Advisor
You should check with a qualified tax counselor for what your individual situation will allow. In rare cases, the original stock may retain some value if no new stock is issued and the company comes out of Chapter 11 in sound financial shape. If the company files Chapter 7 bankruptcy, you can be almost certain you have lost all your money invested in the company’s stock.
As noted in Part 2 of this series, bondholders are second in line for proceeds in either reorganization (Chapter 11) or liquidation (Chapter 7). Under the best of circumstances, bond owners may receive pennies on the dollar in a Chapter 11 and could possibly receive some of the proceeds from Chapter 7 liquidation. It is unlikely that bondholders will see their original principal returned. Should you buy the stock of a company in bankruptcy? This may seem like an unusual question, but some investors look for companies in Chapter 11 that have a good chance of emerging intact from bankruptcy.
If a company comes through Chapter 11 with its original stock intact, it might be an investment worth considering. You should make a determination that the company has a good chance of continuing as a viable entity. Buying stock in a company in bankruptcy usually means you are getting the stock at rock-bottom prices. If the company has a successful turn around, you may be sitting on very low-priced stock that could register an impressive rise.
Company Could Tank
Of course, the company could ultimately tank even after Chapter 11. Buying stock in a bankrupt company or one that is about to file bankruptcy is a risky proposition. You may lose your entire investment. If you believe the company will emerge “leaner and meaner” and be in a position to make impressive gains, it makes sense to consider such an investment. However, this investment should be with money you can afford to lose. In most cases, a company in Chapter 11 bankruptcy has a very good chance of slipping into Chapter 7 when things don’t work out.