Investors need to be clear on what bankruptcy means
Investing in a company while they are in bankruptcy proceedings tends to be a popular strategy. The stock price is only small fraction of what it used to be and some company’s come out of bankruptcy as profitable companies with their stock prices returning to their former levels.
This gives stock investors the impression that if they buy stock at bankrupt levels that they can make a fortune if the company regains its previous profitability and the downside is limited to only a few cents.
This bankruptcy strategy is typically promoted through internet chat rooms, message boards and newsletters.
In principle this sounds like a good investing strategy but there are several issues which investors need to be aware of. There are certain situations where this highly speculative strategy works and in most other cases it does not work at all.
The first thing stock investors need to be aware of is Chapter 11 Bankruptcy Protection for U.S. companies.
Chapter 11 Bankruptcy Protection
Buying common stock in companies while under chapter 11 bankruptcy protection is pointless and is virtually guaranteed to lose the investors entire invested capital. Even buying preferred stock is ultra high risk. Buying corporate bonds at a sufficiently cheap price has a chance of being a profitable speculative investment as the bondholder is a creditor rather than an owner. This is a high risk strategy used by hedge funds.
What investors need to be aware of with chapter 11 bankruptcy is that the company is usually handed over to the creditors via newly issued stock. The purpose of this is to allow the creditors to recoup the monies owed to them. They do this as an alternative to liquidating the company under chapter 7.
While the new stock is issued to the creditors, the old stock is actually renamed with a different ticker symbol to denote that it is a company under chapter 11 bankruptcy protection. The stock is normally delisted from NYSE or NASDAQ and can be listed on an over-the-counter market such as the OTC Bulletin Board or the Pink Sheets.
Investors are frequently caught out since their
original stock is relisted on an OTC market
Should the company come out of chapter 11 bankruptcy protection profitably, the stock price that is shown is for the newly issued stock, which only trades after the company has exited bankruptcy.
The old stock which is what the speculative investors bought is usually canceled after being listed on an OTC market. Under some circumstances the old stock is not canceled but it is heavily diluted. Even if the old stock is not canceled it is not the same as the newly issued stock and they have different ticker codes.
The end result is that the creditors end up owing most and usually all of the company should it emerge from bankruptcy. Any stock bought by investors either no longer exists or is only worth a fraction of the newly issued stock.
Without Bankruptcy Proceedings
Bankruptcy is the formal approach for companies who can no longer pay its debts. Sometimes a company can work out a plan with its creditors without going through the bankruptcy court proceedings.
If the company’s management and its creditors can agree on a solution, then there is no bankruptcy proceeding and chapter 11 does not apply. In this case the stockholders still own the company but their stock may be diluted as the company may issue stock to the creditors as compensation for monies owed to them, but the stock issued is the same as the investors stock.
Usually the stock price of these companies is driven very down to low levels due to the company’s poor financials and can be well below tangible book value. The Z-score which measures the probability of bankruptcy is usually very low and may even be negative. Buying the company’s bonds at depressed prices also has a better chance of success.
Speculative investing with these financially distressed companies is still high risk but at least there is a chance that the investor can make a profit with the common stock if the company manages to return back to a profitable business. In this case the investors’ stock has not changed (unlike that with the chapter 11 bankruptcies) and the common stock can be sold if the stock price returns to its former levels. The risk is that the creditors are not satisfied with the amount of monies being recouped and the company ends up filing for bankruptcy protection under either chapter 7 or chapter 11.