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Implications of Bankruptcy to Investors

What happens to a company's investors when a public company files for corporate bankruptcy (i.e. goes bankrupt)? This is a pressing concern among investors, especially in light of the recent economic recession and stockmarket crash.

To learn the answer, read on. This article explains the corporate bankruptcy process and its impact on investors.

Implications of Chapter 7 Bankruptcy to Investors

When a company you've invested in opts for liquidation bankruptcy or Chapter 7 bankruptcy, investors have not much recourse but wait for the trustee's decisions regarding the company's assets.

Once the company's assets have been liquidated, the trustee uses the proceeds according to a set order:

Administrative and legal fees are paid off first.
Secured creditors (i.e. creditors who hold company assets as collateral for the company's loans) like banks, credit unions and other financial institutions get paid next. They are paid with the proceeds from the sale of the collateral they hold. In case the sale of the collateral is not enough to cover the company's outstanding debt, the secured creditor files a claim for the remaining balance.
Unsecured creditors (i.e. creditors who do not hold company assets as collateral) are notified by the trustee about the company's bankruptcy. Such unsecured creditors then file a claim with the trustee and are paid if and when there's money left over after paying off the company's secured debts.
Shareholders (i.e. stockholders) usually don't get paid anything. They get paid only after all of the company's debts have been paid off. If this happens, they are notified by the trustee so they could file their claims.

There's logic to this order of payment. Secured creditors naturally come first because they hold land titles and other documents that prove their claim on certain company assets. In other words, they loaned the company money on the assurance that they would not be much at risk even in case of the company's default.

Stockholders get paid last because they are actually part-owners of the bankrupt company. Unsecured creditors like bondholders, on the other hand, are just plain creditors.

Bondholders have bond certificates to prove that they've been promised interest and principal payment. Stockholders, on the other hand, are listed as owners. As owners, they earn a lot when a company does well. On the downside, they must take the greatest risk and become partly responsible (at least to the extent of their investment in the company) for the company's debts.

Thus, if a company files for Chapter 7 bankruptcy, bondholders are in a better position than stockholders. Of course, when the going's good, stockholders are in a better position than bondholders.

Implications of Chapter 11 Bankruptcy to Investors

To understand the implications of a Chapter 11 bankruptcy to investors, we must first understand how it works.

Chapter 11 Bankruptcy Procedures

Upon a company's filing of Chapter11 bankruptcy, the bankruptcy court (particularly the U.S. Trustee) organizes acommittee or several committees that will work with the company on a companyreorganization plan (i.e. rehabilitation plan). Each committee represents aparticular group or groups of stakeholders. There may be a committee forunsecured creditors, secured creditors, stockholders, and company employees.

The reorganization plan is thenpresented for the approval of the stakeholders. Not all stockholders are giventhe right to vote. In this case, you should still receive a summary of disclosuresand the procedures for filing an objection. If you have been invited to voteyou should receive, in addition to the plan and objection procedures:

a copy of the reorganization plan
a full disclosure document that would help you decide whether to go for or against the plan
hearing/voting date and venue
your ballot

After the stakeholder consultation, the plan is submitted to the bankruptcy court for confirmation. It usually takes a few months for a plan to be confirmed. In case the creditors and stockholders do not agree with the plan, the court has the discretion to approve the plan just as long as it complies with the Bankruptcy Code and it can be demonstrated that it is as fair as possible to the aforementioned stakeholders.

In some cases, the company may call a meeting among its stakeholders for the purpose of coming up with an organization plan before it files for Chapter 11 bankruptcy. This shortens the time between corporate bankruptcy filing and reorganization plan confirmation.

Once the plan has been confirmed by court, the company proceeds according to the reorganization plan. If this plan calls for important business decisions like the sale of company assets, shareholders are often notified.

If reorganization is successful, the company fully recovers but cancelled stock remains canceled. If unsuccessful, the company can file for Chapter 7 bankruptcy. Shareholders (often of the newly issued stock) are notified when this happens.

What Chapter 11 Bankruptcy Means to Investors

For both bondholders and stockholders, company reorganization under Chapter 11 generally means a loss. For starters, as soon as a company files corporate bankruptcy under Chapter 11, bondholders stop receiving interest and principal payments. Likewise, stockholders stop receiving dividends.

Nevertheless, there is hope for future recovery. As mentioned above, a Chapter 11 bankrupt company can continue its business operations. If everything goes smoothly and according to plan, investors may be able to recoup some or all of their losses. It's a slow process, however, and such recovery usually takes a long time.

Bondholders versus Stockholders

Under a Chapter 11 bankruptcy, bondholders are in a better position than stockholders. Remember the set order of repayment? Creditors come before owners. It is no different when it comes to Chapter 11 bankruptcy.

Company reorganization may involve the issue of new stock to replace existing stock. In this case, secured creditors and unsecured creditors (including bondholders) usually become the owners of the newly issued stock. Such stock is offered in exchange for more favorable loan terms or in lieu of cash.

In the long run, therefore, bondholders have a chance of recouping their investment. They may have to wait a bit (and everything may still end up in Chapter 7 bankruptcy) but they have a fighting chance of getting their investment back.

Stockholders get the shorter end of the stick. When new stock is issued as part of a company's reorganization plan, old stock is often cancelled and owners of this stock are disenfranchised.

The following things may happen to stockholders:

They don't get to vote in the company reorganization plan, although they may file their objections.
They lose all their shares and lose their investment.
They manage to hold on to their shares, but the company is declared insolvent and their shares become virtually worthless.
Their shares are recalled and restructured. They are offered shares in the newly issued stock in exchange for their shares in the old stock. Typically, however, these new shares are fewer and of far less value than their old shares. In this case, though, at least they don't lose all of their investment. If they can wait a long time, moreover, they may even recoup their losses.

Trading of Stock from Chapter 11 Bankrupt Companies

Stock by a company being reorganized under Chapter 11 of the federal bankruptcy laws may still continue to trade in the market. In case the company is unable to meet the major markets' eligibility requirements, its stock may still be traded in minor exchanges (Pink Sheets).

In case a company's reorganizationplan calls for a new stock issue, two types of stock from the company may be available in the market. The old stock is identifiable by a ticker symbol that ends in Q. The new stock, on the other hand, doesn't end in the letter Q.

It should be noted, however, that the company's new stock may or may not be issued by the company itself. If the new stock ends in the letter V, this indicates that the stock issue was authorized by the company, but the company did not issue the stock itself.

Potential Investors

As a general rule, investing instock issued by companies involved in a Chapter 11 bankruptcy is highly risky. This applies even if you are buying newly issued stock (post-reorganization stock). If the company fails in its efforts to rehabilitate the company, you would lose your investment.

The risks are compounded when investing in a company's old stock (or pre-reorganization stock). If new stock is issued, old stock is often cancelled or becomes virtually worthless.

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