Anatomy of Bankruptcies: A Cautionary Tale

by the Schwab Center for Financial Research
December 15, 2008

When you watch the stock of a famous American company plummet, you may think you see a bargain of a lifetime. But before you buy any beaten-up stock, ask yourself why it's cheap. If the stock is down because of weak fundamentals, a looming bankruptcy could wipe out most if not all shareholder equity. In other words, you could lose your entire investment.

How rare are bankruptcies? Check out the statistics: So far this year, 121 publicly traded companies have filed for Chapter 11 bankruptcy protection or Chapter 7 liquidation.¹ That's a 55% increase from 78 for all of last year.²

When a company files for bankruptcy protection, its creditors have significant rights, but shareholders typically find themselves between a rock and a hard place. Here's what to expect as an equity investor if a company you own seeks bankruptcy protection.

Chapter 11
A company may file for Chapter 11 bankruptcy protection when it's on the verge of insolvency but thinks it could make a successful comeback if given the opportunity to reorganize its assets, debts and other business affairs.

Although Chapter 11 protection allows a company to remain in business, its stockholders stop receiving dividends, and the price of its stock usually falls considerably to reflect the expectation that there may be very little value left in the company after bankruptcy to distribute to stockholders. Indeed, rather few firms in Chapter 11 become profitable again.

In addition, the company's stock may be delisted from major stock exchanges, such as the Nasdaq, if the company fails to meet certain requirements, including minimum share price. Then investors are left to trade their shares in the less liquid "over-the-counter" (OTC) market, via broker-dealers who negotiate with one another over the phone or computer instead of on a centralized stock exchange.

The company's reorganization plan details what you can expect to receive, if anything, from the company. Sometimes the plan may require you to exchange your stock for new shares in the reorganized company. However, even if your new shares are worth something, history has shown that odds are they'll be worth much less than your original investment.

Chapter 7
In a Chapter 7 bankruptcy, there is no reorganization. The company actually stops all operations and goes completely out of business. Assets are liquidated, typically for pennies on the dollar, and common stockholders are last in line to be paid.

The normal order is: the government, financial institutions, creditors (like suppliers), bondholders, preferred shareholders and—in last place—common shareholders. Unfortunately, shareholders oftentimes end up receiving nothing. Moreover, the stock of a company in Chapter 7 bankruptcy proceedings typically becomes worthless.

If you decide to buy a beaten-up stock for the remote possibility of gains, remember it's a speculative investment and be prepared for the possibility of severe losses. So understand the considerable risks involved and make sure you only use money that you can afford to lose.

Who gets paid in a Chapter 7 bankruptcy?
The general rule is that entities that agreed to take the least risk, through a senior claim on revenues or some other guarantee, are repaid first. So, secured creditors, who lent the company money using company assets as collateral, would likely get paid before unsecured creditors. Stockholders own the company and take greater risk, claiming the benefit leftover from everyone else, and so are last in line to be repaid if the company fails.

The order of debt repayment will usually be:

Government entities
Financial institutions
Other creditors (such as utility companies and suppliers)
Bondholders
Preferred shareholders
Common shareholders

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

1. 2008 public company bankruptcy statistics are as of December 10, 2008. Source: www.bankruptcydata.com.
2. Market Watch, 2007 Public Company Bankruptcies Surpassed, According to BankruptcyData.com, September 17, 2008.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The types of investments mentioned here are considered extremely risky and not suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation and understand the risks involved before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

(1208-4025)

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