What Happens To The Stock of a Company That Goes Bankrupt?

Investing

When a publicly-listed company declares bankruptcy and goes into liquidation, the company’s shareholders may be entitled to a portion of the assets, depending on what type of shares they hold. However, the stock itself is worthless, and cannot be sold.

The owners of common stock shares are last in line for a share of the firm’s liquidated assets, so the hope is a faint one.

Key Takeaways

  • If a company declares Chapter 11 bankruptcy, hang on. It is asking for a chance to survive and recover. Your shares may recover with it.
  • If it declares Chapter 7, the company is dead and so are your shares. You’re last in line for repayment of your investment.
  • Owners of common stock often get nothing when a company enters liquidation.

What Bankruptcy Means

Two types of bankruptcy are recognized by U.S. law, and the differences are important to shareholders. In either case, the company files for bankruptcy because it is in such deep financial trouble that it is unable to pay its immediate obligations. Business as usual is impossible because it can no longer even pay its suppliers. It has only two options:

  • Chapter 11 bankruptcy signals that the company is asking the court to protect it from its creditors until it files a detailed plan for how it intends to recover financially. If the court accepts the plan, the company may renegotiate its debts, drastically cut its costs, and resume doing business. Over time, it may thrive and emerge from bankruptcy (or not).
  • Chapter 7 bankruptcy means that the company has shut its doors for good. Its assets will be sold and the entire proceeds will be distributed to its creditors in a strict order of precedence.

What It Means to Shareholders

If it’s a Chapter 11 bankruptcy, common stock shares will be practically worthless at the moment, and the shareholder won’t be able to sell the shares because no one would want them. There is at least a chance that the company will indeed recover and their shares will regain some of their value.

If it’s a Chapter 7 bankruptcy, the stock is defunct. The common shareholders may, at best, get a portion of their value back when the assets are distributed. They rarely get anything at all.

Once a company is in liquidation, bankruptcy law determines the order of the distribution of assets.

Note that all of the above is true for preferred shares as well as common shares. But preferred shares are farther up in the line for repayment in case of liquidation. (The vast majority of shares are common stock. A preferred share is a hybrid of a stock and a bond that pays regular dividends.)

Who Gets Paid and When

Once a company is in liquidation, the law determines how the assets are distributed.

The usual order of debt repayment begins with any government taxes that are owed. Next in line are financial institutions that extended loans, other creditors such as suppliers and utility companies, bondholders, preferred shareholders, and, last of all, common shareholders.

Bondholders are paid before shareholders because they’ve lent the company money. Common shareholders are deemed to have only a residual claim on the assets of the company.

Example of Bankruptcy Payout

The amount of the payment a common shareholder will receive is based on the proportion of ownership they have in the bankrupt firm.

For example, suppose that a common stockholder owns 0.5% of the firm in question. If the firm has $100,000 to pay to its common shareholders after liquidation, that owner would receive a cash payment of $500.

Weighing Bankruptcy Risks

Moody’s and Standard & Poor’s provide company ratings that take into account the risk of bankruptcy.

Ratios such as a company’s debt-to-equity and book value can give investors a sense of what they might receive in the event of bankruptcy. Watch for cash flow issues, and rising operating expenses at a time when revenue remains stagnant.

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