An Introduction to Corporate Bankruptcy

When a company files for Chapter 7 or Chapter 11, investors are frequently disadvantaged.
If a company in which you’ve invested goes bankrupt, the pessimists say you’ll have a hard time getting your money back–and even if you do, the odds are that you’ll only get pennies on the dollar back. Is this, however, correct? There are a variety of factors to consider, including the type of bankruptcy you experienced and the type of investment you currently have.

The Most Important Takeaways

  • If a company is unable to pay its debts, it can file for bankruptcy under either the Chapter 7 or Chapter 11 bankruptcy codes.
  • Chapter 7 bankruptcy simply liquidates the company’s assets, whereas Chapter 11 bankruptcy allows the company to continue operating under the terms of a reorganization plan.
  • If a company in which you’ve made an investment goes bankrupt, the amount of money you’re likely to receive depends on the type of bankruptcy and the type of investment you made, such as stocks versus bonds, among other factors.

Corporate Bankruptcy Comes in a Variety of Forms

The type of bankruptcy proceeding—Chapter 7 versus Chapter 11—generally provides some indication of whether the average investor will receive all, a portion, or none of their financial investment back in most cases. Even this, however, will vary from case to case depending on the circumstances. There is also a ranking system for creditors and investors, which determines who gets paid first, second, and last in terms of repayment (if at all). In this article, we’ll go over what happens when a publicly traded company files for Chapter 7 or Chapter 11 bankruptcy protection, as well as how this affects its investors and stockholders.

Chap. 7 (Second Edition)

In accordance with Chapter 7 of the United States Bankruptcy Code, “Eventually, the company ceases all operations and goes out of business completely. It is decided that the assets of the company should be liquidated (sold), and the proceeds are used to pay off the debt “According to the Securities and Exchange Commission of the United States,

However, not all debts are treated in the same manner. It should come as no surprise that the investors or creditors who took on the least amount of risk are paid first. For example, investors who hold corporate bonds issued by a bankrupt company have a significantly reduced risk of loss because they have already given up the possibility of participating in any excess profits generated by the company (as they would have if they had purchased the company’s stock) in exchange for the security of receiving regular, specified interest payments on their bonds.

Stockholders, on the other hand, have the potential to profit from a company’s profits, which is reflected in the rising value of the company’s stock. However, in exchange for the possibility of higher returns, they are willing to accept the risk that the stock’s value will plummet instead. As a result, in the event of a Chapter 7 bankruptcy, stockholders may not receive a full recovery of the value of their investments in the company. After taking into consideration this risk-return tradeoff, it appears fair (and logical) that shareholders are placed second in line after bondholders in the event of a bankruptcy filing.

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Secured creditors, in comparison to bondholders, bear even less risk. They are willing to accept extremely low interest rates in exchange for the added security provided by corporate assets pledged as collateral against corporate obligations. As a result, when a company goes bankrupt, its secured creditors receive their money first, before any regular bondholders receive their share of the remaining assets. Absolute priority is the term used to describe this principle.

Chapter 11 bankruptcy

In a Chapter 11 bankruptcy, the company is not forced to close its doors, but rather is given the opportunity to reorganize. A company that files for Chapter 11 bankruptcy hopes to resume normal business operations and be in good financial standing in the future. In most cases, businesses file for Chapter 11 bankruptcy because they require additional time to restructure debt that has become unmanageable.

Earlier this year, U.S. Bankruptcy Judge Robert Drain approved a $4.5 billion settlement of the Chapter 11 bankruptcy of OxyContin manufacturer Purdue Pharma LP. The settlement was approved on September 1, 2021 by Judge Drain. Purdue Pharma will be dissolved as a result of the settlement, and a new public benefit company will be established to fund opioid addiction treatment and prevention. It protects the former owners, the Sackler family, from legal claims arising from the opioid epidemic. The Sackler family will pay a total of $4.5 billion over nine years, including federal settlement fees, as part of the agreement. Purdue also agreed to release 30 million documents related to the case, which is a significant amount of information.

Although Chapter 11 provides the company with a fresh start, it is still required to meet the obligations set forth in the reorganization plan. When it comes to bankruptcy proceedings, a Chapter 11 reorganization is the most complicated and, in most cases, the most expensive. Therefore, it is only implemented after a company has thoroughly considered all of the alternatives.

Chapter 11 bankruptcy filings are more common than Chapter 7 filings among publicly traded companies because it allows them to continue operating their businesses while also participating in the bankruptcy process. An organization that enters Chapter 11 has the opportunity to restructure its financial structure and, ideally, return to profitability, rather than simply handing over its assets to a trustee for liquidation, as it would be required to do in a Chapter 7 proceeding. It is important to note that if this process fails, all of the company’s assets will be liquidated and all stakeholders will be compensated in the order of absolute priority as described above.

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As part of the bankruptcy process, a committee is formed to represent the interests of creditors and stockholders in a company filing for Chapter 11. This committee collaborates with the company to develop a strategy for reorganizing the business and getting it out of debt, with the goal of transforming it into a profitable entity. Shareholders may be given the opportunity to vote on the plan, but this is not always the case. A failure to develop and get approved by the court of competent jurisdiction may result in shareholders losing their ability to prevent their company’s assets from being sold in order to pay creditors.

In the event that a company files for Chapter 11 bankruptcy, investors have two options: either ride it out to the bitter end in the hopes of seeing the company revived, or simply bail out and take the loss.

How Bankruptcy Affects the Investment Community

Everyone understands that no one invests money in a company, whether through its stock or its debt instruments, with the expectation that the company will go bankrupt. Nonetheless, when you venture outside of the risk-free realm of government-issued securities, you are voluntarily accepting the additional risk.

In most cases, when a company declares bankruptcy, its stock and bond prices continue to trade, albeit at extremely low levels. The value of your shares will typically decline significantly in the period leading up to the company’s bankruptcy declaration, if you are a shareholder in a failing company. Bonds issued by companies that are on the verge of going bankrupt are typically rated as junk.

You have a very good chance of not receiving the full value of your investment if the company goes bankrupt after you make your investment. In fact, there is a good chance that you will not receive anything at all as a result of your efforts.

According to the SEC’s summary, “The payment of interest and principal to bondholders is suspended, and dividend payments to stockholders are suspended during Chapter 11 bankruptcy proceedings. If you are a bondholder, you may receive new stock in exchange for your bonds, new bonds in exchange for your bonds, or a combination of stock and bonds in exchange for your bonds.

A stockholder may be asked to send back their stock in exchange for shares in the reorganized company if the trustee determines that you are a stockholder. It is possible that the new shares will be fewer in number and worth less. The reorganization plan outlines your rights as an investor as well as what, if anything, you can expect to receive from the company as a result of the restructuring.”

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To put it simply, once a company files for any type of bankruptcy protection, your rights as an investor change to reflect the fact that the company is in bankruptcy protection. While some businesses do make a successful comeback after going through a restructuring process, many others fail miserably. And, if your stake in the pre-Chapter 11 company turns out to be worth anything in the restructured company, it’s likely that it won’t be worth nearly as much as it was previously.

During a Chapter 7 bankruptcy, investors are pushed even further down the financial food chain. In most cases, the stock of a company that is going through Chapter 7 bankruptcy becomes worthless, and investors simply lose their money. If you own a bond, you may be eligible to receive a portion of the bond’s face value. What you’ll receive will be determined by the amount of assets available for distribution and the position of your investment on the priority list, among other factors.

A secured creditor has the best chance of recouping the full amount of their initial investment. Unsecured creditors must hold off on receiving any compensation until secured creditors have been adequately compensated. Stockholders typically receive little, if anything, in return for their investment.

What’s the bottom line?

There isn’t much good to say about bankruptcy from the perspective of an investor. No matter what type of investment you made in a company, if that company goes bankrupt, you will almost certainly receive less money in return for your investment than you anticipated.

In general, Chapter 11 is preferable to Chapter 7 in terms of benefits to investors. But, in either case, don’t hold your breath. Companies that go through Chapter 11 reorganization are extremely unlikely to become profitable again; even if they do, it is not always a straightforward process. Investors should respond to a company’s bankruptcy in the same way they would if its stock price dropped unexpectedly for some other reason: Recognize that the company’s future prospects have been drastically reduced and ask yourself whether you still want to be committed to the company.

If the answer is no, you should consider abandoning your failed investment. Keep working while the company goes through bankruptcy proceedings may result in sleepless nights and, in the worst-case scenario, even greater losses in the future. At the very least, you may be able to deduct a capital loss from your income taxes.

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