If a company you've invested in files for bankruptcy, good luck getting any money back, the pessimists say–or if you do, chances are you'll get back pennies on the dollar. But is that true? The answer depends on a number of factors, including the type of bankruptcy and the type of investment you hold.

Key Takeaways

  • Companies can file for either Chapter 7 or Chapter 11 bankruptcy if they're unable to pay their debts.
  • Chapter 7 simply liquidates the company's assets, while Chapter 11 allows the business to continue to operate under a reorganization plan.
  • If a company you've invested in declares bankruptcy, how much you're likely to get back will depend on the type of bankruptcy and the kind of investment, such as stocks versus bonds.

Types of Corporate Bankruptcy

The type of bankruptcy proceedings—Chapter 7 or Chapter 11—generally provides some clue as to whether the average investor will get back all, a portion, or none of their financial stake. But even that will vary on a case-by-case basis. There is also a pecking order of creditors and investors, which dictates who gets paid back first, second, and last (if at all). In this article, we'll explain what happens when a public company files for protection under Chapter 7 or Chapter 11 and how that affects its investors.

Chapter 7

Under Chapter 7 of U.S. Bankruptcy Code, "the company stops all operations and goes completely out of business. A trustee is appointed to liquidate (sell) the company's assets, and the money is used to pay off debt," the U.S. Securities and Exchange Commission notes.

But not all debts are treated the same. Not surprisingly, the investors or creditors who signed up for the least risk are paid first. For example, investors who hold the bankrupt concern's corporate bonds have a relatively reduced exposure to loss: They had already forgone the potential of participating in any excess profits from the company (as they would have had they bought its stock), in return for the safety of regular, specified interest payments on their bonds.

Stockholders, however, have the potential of reaping their share of a company's profits, as reflected in a rising share price. But in return for the possibility of greater returns, they take the risk that the stock might instead lose value. As such, in the case of a Chapter 7 bankruptcy, stockholders may not be fully compensated for the value of their shares. In light of this risk-return tradeoff, it seems fair (and logical) that shareholders are second in line to bondholders when a bankruptcy takes place.

Secured creditors assume even less risk than bondholders. They accept very low interest rates in exchange for the added safety of corporate assets being pledged against corporate obligations. Therefore, when a company goes under, its secured creditors are paid back before any regular bondholders begin to see their share of what's left. This principle is referred to as absolute priority.

Chapter 11

In a Chapter 11 bankruptcy, the company doesn't go out of business but is allowed to reorganize. A company filing Chapter 11 hopes to return to normal business operations and sound financial health in the future. This type of bankruptcy is generally filed by corporations that need time to restructure debt that has become unmanageable.

Chapter 11 allows the company a fresh start, but it must still fulfill its obligations under the reorganization plan. A Chapter 11 reorganization is the most complex and, generally, the most expensive of all bankruptcy proceedings. It is therefore undertaken only after a company has carefully considered all the alternatives.

Public companies tend to file under Chapter 11 rather than Chapter 7 because it allows them to continue to run their businesses and participate the bankruptcy process. Rather than simply turning over its assets to a trustee for liquidation, as it would have to in Chapter 7, a company entering Chapter 11 has the opportunity to retool its financial framework and, ideally, return to profitability. If the process fails, all of the company's assets are liquidated and stakeholders are paid off according to absolute priority, as described above.

When a company files for Chapter 11, it is assigned a committee that represents the interests of creditors and stockholders. This committee works with the company to develop a plan to reorganize the business and get it out of debt, reshaping it into a profitable entity. Shareholders may be given a vote on the plan, but that is never guaranteed. If no suitable reorganization plan can be devised by the committee and confirmed by the courts, shareholders may not be able to stop the company's assets from being sold off to pay creditors.

When a company files for Chapter 11 bankruptcy, investors have basically two choices: ride it out to the end, hoping the company will revive, or just bail out and take the loss.

How Bankruptcy Affects Investors

Clearly, nobody invests money in a company, whether through its stock or its debt instruments, expecting it to declare bankruptcy. However, when you venture outside of the risk-free realm of government-issued securities, you are accepting this added risk.

When a company begins bankruptcy proceedings, its stocks and bonds usually continue trading, albeit at extremely low prices. Generally, if you are a shareholder, you will usually see a substantial decline in the value of your shares in the time leading up to the company's bankruptcy declaration. Bonds for near-bankrupt companies are usually rated as junk.

Once the company goes bankrupt, there is a very good chance you will not get back the full value of your investment. In fact, there is a strong possibility that you won't get anything back at all.

As the SEC summarizes, "During Chapter 11 bankruptcy, bondholders stop receiving interest and principal payments, and stockholders stop receiving dividends. If you are a bondholder, you may receive new stock in exchange for your bonds, new bonds or a combination of stock and bonds. If you are a stockholder, the trustee may ask you to send back your stock in exchange for shares in the reorganized company. The new shares may be fewer in number and worth less. The reorganization plan spells out your rights as an investor and what you can expect to receive, if anything, from the company."

Basically, once a company files under any type of bankruptcy protection, your rights as an investor change to reflect the bankrupt status of the company. While some companies do indeed make successful comebacks after undergoing restructuring, many others don't. And if your stake in the pre-Chapter 11 company ends up being worth anything in the restructured firm, chances are it won't be as much as it used to be.

During a Chapter 7 bankruptcy, investors are even lower on the ladder. Usually, the stock of a company undergoing Chapter 7 proceedings becomes worthless and investors just lose their money. If you hold a bond, you might receive a fraction of its face value. What you'll receive depends on the amount of assets available for distribution and where your investment ranks on the priority list.

Secured creditors have the best chance of recouping the value of their initial investments. Unsecured creditors must wait until secured creditors have been adequately compensated before they receive any compensation. Stockholders usually receive little, if anything.

The Bottom Line

From an investor's point of view, there isn't much good to say about bankruptcy. No matter what type of investment you made in a company, once it goes bankrupt you are probably going to get less for your investment than you expected.

In general, Chapter 11 is better for investors than Chapter 7. But in either case, don't expect much. Relatively few companies undergoing Chapter 11 proceedings become profitable again after a reorganization; even if they do, it is rarely a quick process. As an investor, you should react to a company's bankruptcy the same way you would if its shares took an unexpected dive for other reasons: Recognize the dramatically reduced prospects of the company and ask yourself whether you still want to be committed. 

If the answer is no, let go of your failed investment. Holding on while the company undergoes bankruptcy proceedings may only lead to sleepless nights and perhaps even greater losses in the future. If nothing else, you may be able to take a capital loss on your taxes.