What Happens to Stock When a Company Files Bankruptcy
The risk of business failure is quite high. For the period between 2015 and 2019, 119,781 businesses filed for bankruptcy (both Chapter 11 and 7). When a company goes bankrupt, it is seldom good for stockholders or bond owners.
What this means for investors is that there will always be a risk of an investment drastically losing value, or becoming completely valueless. When choosing investments, you should do your due diligence to determine the likelihood of the issuing entity declaring bankruptcy.
When businesses declare bankruptcy, Chapter 7 and 11 are the two main types filed. These chapters also dictate how businesses proceed through a bankruptcy filing, and how they are supposed to treat their obligations to creditors and investors. Note that bankruptcy is not always a bad thing—many firms have emerged from one form of bankruptcy able to continue operations.
- 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 have obligations to their creditors and stockholders, each of which receives payment in a predetermined order.
Stock Prices in a Volatile Economy
Economies are influenced by many different factors: Political maneuvering, natural disasters, wars, social unrest, and even global pandemics have an effect on a nation's economy. The coronavirus pandemic of 2020 caused businesses to shut down, which in turn provoked investors to panic and begin selling their stocks in anticipation of a market crash. This induced stock prices to plummet in very short order—the market turned from a bull to a bear in record time.
The Effect on Businesses
For businesses that were teetering on the edge of financial trouble, the coronavirus was the last straw—many finally collapsed and filed for chapter 11 bankruptcy. JC Penny was forced to close many of its stores after struggling financially for years; J Crew filed for Chapter 11 in May 2020.
While the stock market recovered from the shock of the pandemic, many businesses struggled. It is likely that during the following years of economic recovery, many more businesses affected by the virus will fail.
The Effect of Volatility on Investors
Initially, stock prices plummet as external influences cause investors to panic. While this causes losses in the short term, there is a good chance that prices will continue their overall trend of rising in the long term. If history is any indicator, the stock market will return better than it was; but it can take months or years to recover to previous levels.
In the Dow Jones Industrial Average, for instance, it can be seen that prices have dropped and fallen over and again; however, the trend is one of a continuous price rise.
The smaller downtrends and uptrends in indexes such as the Dow Jones are the types of trends that create market volatility, which then creates uncertainty among investors. In the latest crisis, if you were not in the initial wave of investors that sold off their stocks at the beginning and held on to yours, your choices became limited.
One of the choices you have in this circumstance is to continue holding your investment. The strategy behind this is to ride out the downturn until prices reverse and begin increasing. Historically, as seen in the Dow Jones graph, prices eventually return better than they were before the market dipped.
Or, you could try to sell your stocks when the market begins a downward trend. You will run the risk of losing money if you take this action, but many investors use this time to switch to other investment instruments such as bonds and precious metals, which tend to keep their value when stock prices drop. If you time it right, you might be able to keep your portfolio's net worth or minimize your losses—but the chances of timing the market just right are slim.
If you are an investor, it helps to know what can happen to companies and the stocks and bonds they issue if they file for either Chapter 11 or Chapter 7 bankruptcy during volatile times. This can allow you to make investment decisions and create plans to deal with both the good and bad investing circumstances, and possibly come out none-the-worse for wear.
What to Know About Chapter 11
Chapter 11 bankruptcy is the first choice of most companies. This is largely in part because Chapter 11 allows the business to continue operating and try to recover from the financial losses they have sustained. There are many factors involved in a restructuring that can influence whether a company can recover and whether their stock will be worth holding:
- A company can develop a reorganization plan that allows them to continue operating
- Creditors and stockholders must approve the reorganization plan—a bankruptcy judge has the authority to accept the plan even if the creditors and stockholders reject it.
- 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 from creditors by the court, preventing creditors from disrupting the operations of the company.
- Once the reorganization is complete, the company can come out from under the protection of the bankruptcy court and resume normal operations.
What Happens to the Company
A Chapter 11 filing assumes there is a possibility the company can emerge from the process as a viable operating company. The reorganization of the company generally includes the redistribution of debt and assets to try to help the company get back on its feet.
The capital generated from the reorganization/liquidation are used to pay off creditors and shareholders in a specific order:
- Secured creditors
- Unsecured creditors
Stocks and Bonds in Chapter 11
Per the payment priority order, bondholders are third in line, and stockholders are last. The company should notify owners of both types of instruments, and then communicate their plan with their creditors.
As a stockholder, you might be given the right to vote for the actions the company is going to take, as well as receive any legal notifications for hearings and deadlines.
Once the plan is approved, the company suspends dividends to stockholders and premiums to bond owners. You might be issued new stocks, bonds, or a combination of them both, per the reorganization plan.
One way creditors are paid off is through issuing a new class of stock as repayment of debt.
Stocks may or may not continue to be traded on the major exchanges. Generally, they will not meet the requirements to stay listed on public exchanges. However, they may still be able to trade on over-the-counter bulletin boards (OTCBB) or over-the-counter (OTC) markets, such as OTCQX or OTCQB.
If a company comes through Chapter 11 with its original stock intact, it might be an investment worth considering. You should make a determination whether 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.
What to Know About Chapter 7
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, which is a complete liquidation of all company assets. While a business can file a Chapter 7 without first filing Chapter 11, it generally occurs after the bankruptcy protection of Chapter 11 has failed.
Secured creditors 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 are those 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.
There are two types of stockholders (owners of the company)—preferred and common. Preferred stockholders receive a preference for a payout over common stockholders if there is any from the leftover capital from the debt payoffs.
Stockholders receive a proportionate share of any money left after the creditors are paid. If you own stock in a company that goes into Chapter 7 bankruptcy, the odds are high that your stock will become valueless.
What Happens to the Company?
Chapter 7 bankruptcy is the type of bankruptcy that comes to mind when most people think of a business closing. In Chapter 7, the business will liquidate all of its assets, pay off any creditors it can, shut down its operations, and close the doors.
Stocks and Bonds in Chapter 7
In Chapter 7 bankruptcy, stockholders are left empty-handed. Stocks from fully bankrupted companies are worthless, once assets are liquidated and creditors paid off. If this happens, you should be eligible to claim the loss as a capital gains loss and not deduct it as a bad debt loss.
Bondholders are creditors—as such, they are in-line to receive payback from a company in liquidation. However, they may not receive much after all other creditors are paid.
How to Profit From a Bankruptcy
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 the company has a successful turnaround, you may be sitting on a very low-priced stock that could register an impressive rise.
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.
Talk to a Financial Advisor
If your portfolio has been struck by a business bankruptcy, check with a qualified financial advisor to help you come up with a restructuring plan for recouping your losses.
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 a financial structure they can recover from. A financial advisor can help you determine whether it is beneficial to keep any stocks from a company that has filed Chapter 11.
Unfortunately, it can be more difficult for an investor to recoup losses after losing the value of an entire holding.
The Bottom Line
Developing an investment strategy to combat volatility through diversity and education is the best method to make it through a volatile economy with minimal losses. As you consider investments, make sure you understand their financial structure (whether they are financed by debt or equity) and can create a plan for each of your investments, keeping in mind every type of external market influencer.
Administrative Office of the U.S. Courts. "Bankruptcy Filings Continue to Decline." Accessed May 22, 2020.
J Crew. "J Crew Group to Deleverage Balance Sheet Position J.Crew and Madewell for Long-Term Growth." Accessed May 22, 2020.
JC Penny. "JCPenney to Reduce Debt and Strengthen Financial Position Through Restructuring Support Agreement." Accessed May 22, 2020.
The U.S. Securities and Exchange Commission. "Bankruptcy: What Happens When Public Companies Go Bankrupt." Accessed May 22, 2020.
Internal Revenue Service. "Losses (Homes, Stocks, Other Property)." Accessed 22 May, 2020.