A company faces bankruptcy when it can no longer pay its expenses since it effectively has no working capital left and its long-term liabilities are reaching its total assets value. The company’s revenue is insufficient to cover its expenses. The Z-score which measures the probability of bankruptcy is usually very low and may even be negative.
Bankruptcy is the end result for a financially distressed company. Unfortunately for the stockholders this means loss of ownership of the company and their invested capital is basically lost. Bondholders are also affected and usually receive very little if any of the bonds face value and their invested capital is also mostly lost.
When a U.S. listed company can no longer pay its debts, management files for bankruptcy protection through the U.S. Federal Bankruptcy Court. There are two different types of bankruptcy proceedings that can be filed under the U.S. Bankruptcy Code. These are chapter 7 and chapter 11 and they have different outcomes for the company and its stockholders.
Which ever chapter a company files for, the bankruptcy court requires the creditors to agree that it would the most appropriate outcome for them. The creditors’ main interest is in receiving the highest dollar rate of what is owed to them.
Chapter 7 Bankruptcy
The main reason management files for chapter 7 bankruptcy protection is when the company’s liabilities are greater than its assets and the company has no hope of continuing its business operations. The creditors will likely agree and the bankruptcy court will assign a trustee.
Chapter 7 bankruptcy results in the company being liquidated with all its assets sold off to pay its creditors. If there are insufficient proceeds any remaining debt owed to creditors is null and void. There is no further claim by creditors and the company ceases to exist.
Creditors include secured creditors, unsecured creditors and bondholders. Under the bankruptcy code there is a hierarchy of creditors’ claims as follows:
Hierarchy of creditors’ claims:
- Secured creditors have priority. These are creditors who already have claims over assets (such as real estate) in the event of default. Proceeds from the company’s liquidation are used to pay secured creditors first. If there are insufficient proceeds to cover all the secured creditors then they are all paid a pro rata rate.
- Unsecured creditors are next in line if there are any proceeds remaining. These are creditors who have provided funding or goods based on good faith that they will be paid. If there are any proceeds remaining then the unsecured creditors are paid. If there are insufficient proceeds to cover all the unsecured creditors then they are all paid a pro rata rate.
- Bondholders are next in line there are any proceeds remaining. Bonds are loans to the company and if there are any proceeds remaining then the bondholders are paid. If there are insufficient proceeds to cover all the bondholders then they are all paid a pro rata rate.
After all the creditors have been paid, if there are any proceeds remaining from the company’s liquidation then the excess is returned to the stockholders on a pro rata rate. The preferred stock is paid first and any remaining funds is then paid to the common stockholders.
Usually companies file for chapter 7 bankruptcy protection when their liabilities exceed their assets and as such there is normally no excess left over for the stockholders. Thus the stockholders normally do not receive anything back from their invested capital.
Chapter 11 Bankruptcy
Management normally files for chapter 11 bankruptcy protection when the company’s liabilities are less than its assets and the company has a good chance of continuing its business operations. The main reason creditors agree to this filing is when the outcome will provide a higher dollar return in recovering what’s owed to them
The company outlines a plan to reorganize its business operations and a repayment plan is worked out to the creditors’ satisfaction. The creditors agree to provide the company with interim relief from their claims and the plan is lodged with the bankruptcy court for approval.
The company cannot make any acquisitions or sell any part of its business or sell any assets while under chapter 11 bankruptcy protection. The company can only perform its normal business operations.
Chapter 11 is more common than chapter 7 with management maintaining control of the company and stockholders retaining ownership while under bankruptcy protection. However in most cases the company will no longer comply with the listing requirements for NYSE or NASDAQ and the company will likely be delisted. The company might be then listed on an over-the-counter market like the OTC Bulletin Board or the Pink Sheets. If the company is not listed then the stockholders cannot sell their shares other than with a private transaction. Bear in mind that a company under chapter 11 bankruptcy protection is almost worthless from an investment point of view.
Some companies will come out of chapter 11 bankruptcy and continue to operate as a profitable business. This is might happen when a company issues new stock as part of its reorganization plan to finance its operations. The reorganization plan may issue new stock to its creditors and it may cancel the existing shares once the chapter 11 is completed.
Even if the existing shares are not canceled, the new stock issued may have substantially more shares than the existing shares. Thus the existing shares may be diluted to such an extent that they have very little equity per share value, making them almost worthless even if the company does manage to operate profitably in the future.
The newly issued stock has a different ticker code to the existing stock and they are not interchangeable. The existing stock is given a new ticker code while the company is under chapter 11 bankruptcy protection (assuming the company is still listed). The newly issued stock does not trade until the company comes out of bankruptcy.
The end result is that even if the company operates profitably after it emerges from bankruptcy, the original shares either no longer exists of if they do then they are heavily diluted. The best case is that the existing shares are worth very little and they are not the same shares as the newly issued stock.
If the company does not operate profitably and the creditors are not receiving their agreed payments as specified in the repayment plan, then the Chapter 11 bankruptcy protection will be converted to a Chapter 7 and the company will be liquidated.