Corporate bankruptcy: An overview

If a company you've invested in files for bankruptcy, good luck getting any money back, the pessimists say – or if you do, chances are, you'll get back pennies on the dollar. But is that true?

Alas, there's no one-size-fits-all answer. Different bankruptcy proceedings or filings generally give some idea as to whether the average investor will get back all or a portion of his financial stake, but even that is determined on a case-by-case basis. There is also a pecking order of creditors and investors of who get paid back first, second and last. In this article, we'll explain what happens when a public company files for protection under U.S. bankruptcy laws and how it affects investors.

Chapter 7
The U.S. Securities and Exchange Commission states that under Chapter 7 of U.S. Bankruptcy Code "the company stops all operations and goes completely out of business. A trustee is appointed to liquidate (sell) the company's assets, and the money is used to pay off debt."

But not all debt is created equal. Not surprisingly, the investors or creditors who have taken the least risk are paid first. For example, investors who hold the bankrupt concern's corporate bonds have a relatively reduced exposure: They already had forgone the potential of participating in any excess profits from the company, in return for the safety of getting specified interest payments.

Equity holders, however, have the full potential of seeing their share of the company's retained earnings, which would be reflected in the stock's price. But the tradeoff for this possibility of boosted returns is the risk that the stock may lose value. As such, in the case of a Chapter 7 bankruptcy, equity holders may not be fully compensated for the value of their shares. In light of the risk-return tradeoff, it seems fair (and logical) that shareholders are second in line to bondholders when a bankruptcy does occur.

Secured creditors, who are even more risk-averse than regular bondholders, accept very low interest rates in exchange for the added safety of corporate assets being pledged against corporate obligations. Therefore, when a company does go under, secured creditors are paid back before any regular bondholders begin to see their share of the pie. This principle is referred to as absolute priority. (For more insight, read the Stocks Basics Tutorial.)

Chapter 11
This proceeding of the U.S. Bankruptcy Code involves not a closure, but a reorganization of the debtor's business affairs and assets. The company undergoing Chapter 11 expects to return to normal business operations and sound financial health in the future; this type of bankruptcy is generally filed by corporations that need time to restructure debt that has become unmanageable.

Chapter 11 gives the company a fresh start, dependent on its fulfillment of obligations under the reorganization plan. A Chapter 11 reorganization is the most complex and, generally, the most expensive of all bankruptcy proceedings. It is therefore undertaken only after the company has carefully analyzed and considered all alternatives.

Public companies tend to try to file under Chapter 11 rather than Chapter 7 because it allows them to still run their businesses and control the bankruptcy process. Rather than simply turning over its assets to a trustee, a company undergoing Chapter 11 has the opportunity to retool its financial framework and be profitable again. If the process fails, all assets are liquidated and stakeholders are paid off according to absolute priority.

Keep in mind that Chapter 11 isn't a get-out-of-jail-free card. When a company files for Chapter 11, it is assigned a committee that represents the interests of creditors and stockholders. This committee works with the company to develop a plan to reorganize the company and to get it out of debt, reshaping it into a profitable entity. Shareholders may be given a vote on the plan, but as their priority is second to all creditors, this is never guaranteed. If no suitable reorganization plan can be prepared by the committee and confirmed by the courts, shareholders may not be able to stop their company's assets from being sold off to pay creditors. (For related reading, check out "Finding Profit in Troubled Stocks.")

As an investor, you are between a rock and a hard place if your company faces bankruptcy. Clearly, nobody invests money into a company, whether through its stock or its debt instruments, expecting it to declare bankruptcy. However, when you venture outside of the risk-free realm of government-issued securities, you are accepting this added risk.

When a company is going through bankruptcy proceedings, its stocks and bonds usually continue trading, albeit at extremely low prices. Generally, if you are a shareholder, you will usually see a substantial decline in the value of your shares in the time leading up to the company's bankruptcy declaration. Bonds for near-bankrupt companies are usually rated as junk.

When your company goes bankrupt, there is a very good chance you will not get back the full value of your investment. In fact, there is a chance you won't get anything back. Here is how the SEC summarizes what may happen to stock- and bondholders during Chapter 11:

"During Chapter 11 bankruptcy, bondholders stop receiving interest and principal payments, and stockholders stop receiving dividends. If you are a bondholder, you may receive new stock in exchange for your bonds, new bonds or a combination of stock and bonds. If you are a stockholder, the trustee may ask you to send back your stock in exchange for shares in the reorganized company. The new shares may be fewer in number and worth less. The reorganization plan spells out your rights as an investor and what you can expect to receive, if anything, from the company."

Basically, once your company files under any type of bankruptcy protection, your opportunities and rights as an investor change to reflect the bankrupt status of the company. While some companies do indeed make successful comebacks after undergoing restructuring, you need to realize that the risks you accepted when you invested in the company can become reality. And if your stake in the pre-Chapter 11 company ends up being worth anything in the restructured firm, chances are it won't be as much as it was when you first entered your position and it won't be in the same form.

During Chapter 7 bankruptcy, investors are considered especially low on the ladder. Usually, the stock of a company undergoing Chapter 7 proceedings is usually worthless, and investors lose the money they invested. If you hold a bond, you might receive a fraction of its face value. What you receive depends on the amount of assets available for distribution and where your investment ranks on the priority list.

Secured creditors have the best chances of seeing the value of their initial investments come back to them. Unsecured creditors and shareholders must wait until secured creditors have been adequately compensated before they receive any compensation for the loss of their higher-yielding investments. Because equity owners are last in line, they usually receive little, if anything.

From an investor's point of view, there isn't much good to say about bankruptcy. No matter what type of investment you made in a company, once it goes bankrupt you are probably going to get a lower return on your investment than you expected. As an individual investor, you don't have any more say in a company's restructuring plan than you do in any other corporate actions on which shareholders vote.

In general, Chapter 11 is better than Chapter 7, but in either case, you shouldn't expect much of your investment back. Relatively few firms undergoing Chapter 11 proceedings are able to be profitable again after a reorganization; even if they do, it is not a quick process. As an investor, you should react to a company's bankruptcy the same way you would if one of your stocks took an unexpected dive: Recognize and accept the dramatically reduced prospects of the company, and ask yourself whether you still want to be committed. 

If the answer is no, let go of your failed investment; holding on while the company undergoes bankruptcy proceedings will only lead to sleepless nights and perhaps even greater losses in the future.