Do shareholders lose all their equity once Chapter 11 bankruptcy is filed?

When a company files for Chapter 11 bankruptcy, the management of the company is still in charge of the daily operations. That said, significant business decisions, especially those pertaining to debt or debt securities, are sent to the bankruptcy court for approval.

Obtaining Chapter 11 bankruptcy protection simply means that a company is on the verge of bankruptcy, but believes that it can once again become successful if it is given an opportunity to reorganize its assets, debts and business affairs. Although the Chapter 11 reorganization process is complex and expensive, most companies (if given the choice) prefer Chapter 11 to other bankruptcy provisions such as Chapter 7 and Chapter 13, which cease company operations and lead to the total liquidation of assets to creditors. Filing for Chapter 11 gives companies one last opportunity to be successful.

While the firm is in Chapter 11, its stock will still have value, but there is a temporary trading freeze. Although the stock will be delisted, over the counter (OTC) trading may still occur. In other words, the equity a broker has invested in the firm is not valued at zero, but their true value cannot be easily determined since the shares are no longer publicly traded. When a company that is going through bankruptcy proceedings is listed on the pink sheets or OTCBB, the letter "Q" is added to the end of the company's ticker symbol to differentiate it from other companies.

Under a Chapter 7 bankruptcy, all assets are sold for cash. That cash is then used to pay off legal and administrative expenses that were incurred during the bankruptcy process.

Once a company proceeds to file for Chapter 7 bankruptcy, the company's creditors are paid in a specific order. Generally, investors or creditors are paid in the following order:

1) Secured creditors
2) Unsecured creditors
3) Shareholders

Usually, little to nothing is leftover for shareholders after the more senior creditors are paid.

When a corporation is on the verge of bankruptcy, its stock value will reflect the risk that a Chapter 11 may become a Chapter 7.

For example, a company traded at $50 may trade at $2 per share due to bankruptcy speculation. If Chapter 11 is actually filed, the stock price may fall to 10 cents. This value is composed of the potential income that shareholders may receive after liquidation and a premium based on the possibility that the firm may restructure and begin to operate successfully in the future. Private investors can buy and sell these 10-cent shares in the OTC market. The actual value does not reach zero unless the probability of restructuring is so low that a Chapter 7 filing is sure to follow.

However, if the company restructures and emerges from Chapter 11 as an improved organization, its share price may rise to higher levels than previously witnessed.

(For more, check out "What are the Differences Between Chapter 7 and Chapter 11 Bankruptcy?")