Bankruptcy and how it affects the stock market

If investing in bankrupt companies sounds taboo, that’s because it is very risky. In the stock market, risk is inevitable, but the risk associated with bankrupt stocks is much steeper than you might realize.

TL;DR

  • Chapter 11 bankruptcy means a company will attempt to reorganize and reemerge from their debts. Only 10–15% of these companies successfully reorganize.
  • Chapter 7 bankruptcy means the company is dead.
  • In either situation, common shareholders are unlikely to receive any returns on their investment. Whatever assets are left usually go to taxes, lenders, creditors, bondholders and preferred shareholders.
  • A handful of outcomes could occur if you’ve invested in bankrupt stocks. Most commonly, you won’t get anything, but there’s a chance you’ll get a diluted payout.
  • It’s a good idea to stay informed on proceedings if you’ve invested in bankrupt stocks.

Different types of bankruptcy & why they matter for investors

Not all bankruptcy is created equal. Here are two different types of bankruptcy, and how they affect investors of the company:

  • Chapter 11 bankruptcy: A company declares Chapter 11 bankruptcy when they want a chance to reorganize themselves and recuperate from their financial struggle. If approved, the court protects the company from creditors until the company submits a thorough financial recovery plan.

Why investors should care: It’s possible that your shares will survive if a company manages to pull itself up by its bootstraps (despite the fact that only about 10–15% of these result in successful reorganizations). It’s also possible that a company will cancel any existing shares, along with other potential outcomes.

  • Chapter 7 bankruptcy: A company declares Chapter 7 bankruptcy when they’re done with the whole thing. Basically, they’re dead and gone from the publicly traded company sphere. They sell their assets and, typically, any remaining revenue goes to the creditors.

Why investors should care: When a company dies, your stock dies with it. It’s unlikely for shareholders to receive payout in this instance.

Regardless of which type of bankruptcy we’re talking about, bankrupt stocks are hard to maneuver. Investing in bankrupt companies leaves you particularly vulnerable to investment loss.

Why it’s risky to invest in a company with bankruptcy news

We don’t want to scare you, but education goes a long way in the investment world.

According to the US Securities and Exchange Commission (SEC), investing in bankrupt companies is “likely to lead to financial loss.” 

In these circumstances, a publicly traded company goes bankrupt because its revenue isn’t on par with its debts. Over time, this creeps up on the company, ultimately causing it to make the radical decision of bankruptcy. You can imagine that any surviving companies will be indebted to taxes, lenders, creditors, bondholders and preferred shareholders — in that order.

It sounds harsh, but it’s the truth. Common shareholders get what’s called a “residual claim” of the company’s assets (AKA “equity claim”), which means anything that’s left over after all prior obligations have been paid in full. When you divvy up the remaining assets after liquidation between all common shareholders, you’re often left with a small amount of money — if anything at all.

Oftentimes, a company is unable to pay all prior obligations in full, which leaves common shareholders without payout. And even when the wealth does manage to trickle all the way down the food chain, it’s likely not the full value. 

It’s not an ideal situation, but a common shareholder’s stocks don’t hold much weight in situations of corporate bankruptcy. Unfortunately, the powerful people tend to get paid first.

When it comes to Chapter 11 bankruptcy, a company can continue to trade shares on certain platforms. There’s no federal law prohibiting securities trading during bankruptcy proceedings. However, companies are not able to continue trading on markets like Nasdaq or the New York Stock Exchange due to strict listing standards.

This goes to show: just because the federal law doesn’t prohibit it doesn’t mean investing in bankrupt companies is a smart move. Of course, your agency as an investor is everything — but it’s worth knowing what you’re getting yourself into. To this extent, Public displays safety labels on bankrupt companies and other risky stocks.

What happens to my stock when a company goes bankrupt?

There are a few different paths your stock could take when a company goes bankrupt, but none of them are particularly appealing. And they all have one thing in common. The common shareholder doesn’t have a say in what happens.

  • While a Chapter 11 bankrupt company may re-emerge on the other side, it’s common for creditors and bondholders to take possession of all shares (yes, even yours). 
  • Even if they do manage to reorganize themselves, the court can legally say a shareholder gets nothing. Why? Because they decided that the company is insolvent (AKA their liabilities are greater than their assets), effectively deeming all stocks worthless.
  • Remember that thorough financial recovery plan that every company must submit in order to be considered for Chapter 11 bankruptcy? Often, that plan includes a clause effectively cancelling all existing shares (and setting up new common stocks), and that’s a move made by the company itself.
  • Consider an instance where both the company and court retain existing shareholders’ rights to equity. It’s likely that these shares will be significantly diluted. This could mean fewer shares, less value or both.
  • Common shareholders may receive bankruptcy payouts, which align with the proportion of ownership they have in the company in relation to the company’s remaining assets after liquidation. For example, if you own .1% of the company and they have $50,000 left to give, you get $50.
  • According to the SEC, stocks under Chapter 7 bankruptcy are usually worthless, meaning your money is gone. Any bonds may receive a fraction of their face value, but it’s not likely. In the unlikely event there’s money leftover, stockholders will be notified and can file a claim. However, they won’t be notified if money runs out before it gets to them.

What should you do if you’ve invested in bankrupt stocks?

For some, avoiding bankrupt stocks is too little too late. After reading this, you may wonder what point there is in trying to collect your due from a bankrupt corporation. Despite how out of reach or minimal your payouts may seem, it’s worth it to stay informed.

Contact the company, your broker and the SEC to find out more information about the bankruptcy proceedings. You can reach out to the bankruptcy court if the company has filed for Chapter 7 and didn’t file a report with the SEC. The US Trustee at the Department of Justice and a bankruptcy attorney are other options.

Bottom line

Investing in bankrupt companies comes with more risk than most corporations. This risk compounds even more when you’re dealing with Chapter 7 bankruptcy, where payout for common shareholders is unlikely. With Chapter 11 bankruptcy, investors have a chance for relief. If you’ve invested in bankrupt stocks, it’s a good idea to stay informed during bankruptcy proceedings. And moving forth, you can use earnings reports to make informed investing decisions based on a company’s financial health before taking the leap.

Rachel Curry is Pennsylvania-based content writer and journalist talking all things finance. She likes to give meaning to numbers by humanizing them. You can connect with her on Twitter at @writingsofrach.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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