It's the big, bad "B word" that no investor wants to hear: Bankruptcy.
When a company files for bankruptcy protection, chances are its shares will lose most—if not all—of their value, and that the company will be delisted from its exchange. That’s bad news for shareholders.
But here's a fact that may surprise some investors: the securities of companies in bankruptcy can and often do keep trading, as there is no federal law that prohibits trading stocks in bankrupt companies. What investors need to know, however, is that trading in the shares of a company under bankruptcy protection is incredibly risky and could result in loss of your entire investment.
If a company in your portfolio has filed for bankruptcy, here’s a look at what you should expect and why it’s so risky to trade in the delisted shares of bankrupt companies.
Chapter 7 vs. Chapter 11
Companies typically file for one of two types of bankruptcy protection under the federal tax code known as Chapter 7 or Chapter 11.
A Chapter 7 filing is the more nuclear option. It means that the company stops operating and all its assets are put up for sale by a court-appointed trustee, with the proceeds divvied up to the company’s debtors in order of the seniority of the debt.
|The Capital Structure: Who Gets Paid First|
|1. Secured (collateralized) bondholders|
|2. Unsecured bondholders|
|3. Holders of subordinated debt|
|4. Preferred stockholders|
|5. Common stockholders|
A Chapter 11 filing means that the company may undergo reorganization and continue to operate. Still, a Chapter 11 doesn’t rule out the possibility of the sale. The entire company may be sold in what is called a Section 363 sale with the court’s approval. That is generally not a good thing for shareholders, as there is typically not enough cash left over from the sale to compensate stock investors.
Chapter 11 Reorganization and Investor Compensation
When a Chapter 11 filing doesn't result in a Section 363 sale, however, it may provide a small glimmer of hope for investors seeking to recoup at least some of their money. That's because reorganization plans sometimes include provisions for shareholder relief.
To reorganize under Chapter 11, a company must negotiate a reorganization plan with a government-appointed committee of company stakeholders, which is typically made up of creditors and can also include company stockholders. The plan will stipulate how much of the company’s debt it will pay off, how much it will discharge, and it may also offer shareholders some sort of compensation for their shares.
The plan is typically put to a vote, but even if creditors or stockholders reject the plan, the court may still determine that the plan is fair and should be implemented. Learn more about how reorganization plans are structured.
In a small number of cases, shareholders may receive substantial compensation—such as cash or shares in the new company—if the company that filed for Chapter 11 protection was in relatively good health and chose to pursue bankruptcy protection for strategic reasons.
But more often than not, shareholders of bankrupt companies see little to no compensation for their investments. Cases in which old shares may be exchanged for shares in the newly reorganized companies are especially uncommon.
Trading After Bankruptcy: A High-Risk Gamble
Companies that file for Chapter 11 bankruptcy protection often fail to meet the listing requirements of the major exchanges—and are subsequently delisted. Still, they may continue to trade over-the-counter. Bankrupt companies typically have the letter "Q" appended to the end of their stock symbols to denote the bankruptcy.
Investors may also operate under the false assumption that once a company has emerged from bankruptcy, their old stocks will regain value. In fact, the opposite is most often true: most reorganization plans, once put into effect, cancel existing shares. Only "new" shares—those issued by the reorganized company under a new trading symbol—have value.
Investors should understand that buying common stock of companies in Chapter 11 bankruptcy is extremely risky and can lead to financial loss.