Bankruptcy—the legal process for companies or individuals when they can't pay their debts—can be a pretty negative situation for those going through it. But for investors who are willing to do some research, it can present opportunities. Here, we'll take a look at exactly what happens during a bankruptcy, and how investors can profit from it. 

Key Takeaways

  • Investors need to be careful, but don't necessarily need to be avoid investing in a company that has emerged from bankruptcy; in some cases, these companies offer good investment possibilities.
  • Just as with any investment, potential investors should do their due diligence and research whether the company is in a stronger position post-reorganization and now offers a good buying opportunity.
  • Risks to investors of companies in bankruptcy include old problems resurfacing and the presence of vulture investors, who buy the stock during the bankruptcy process and dump it as soon as the company has reemerged.

The Decline

A company may need to enter bankruptcy due to a bad economic environment, poor internal management, over-expansion, new liabilities, new regulations, or a host of other reasons. The bankruptcy process is often lengthy and complex, and many complications can arise over settlement amounts and payment terms.

There are two types of bankruptcy that companies may file:

Chapter 7

This type of bankruptcy occurs when a company completely goes out of business and assigns a trustee to liquidate and distribute all of its assets to the company's creditors and owners.

In a Chapter 7 bankruptcy, debts are separated into classes or categories, with each class receiving priority for payment. Priority debts are paid first. Secured debts are paid next. Non-priority, unsecured debt is then paid with any funds remaining from the liquidation of assets.

Chapter 11

This is the most common type of corporate bankruptcy for public companies. In a Chapter 11 bankruptcy, a company continues normal day-to-day operations while ratifying a plan to reorganize its business and assets in such a way that will make it able to meet its financial obligations and eventually emerge from bankruptcy.

The process for a Chapter 11 bankruptcy is as follows:

  1. The United States Trustee Program (the bankruptcy arm of the Justice Department) first appoints a committee to act on behalf of shareholders and creditors.
  2. The appointed committee then works with the company to create a plan to reorganize and emerge from bankruptcy.
  3. Next, the company releases a disclosure statement after it is reviewed by the Securities and Exchange Commission (SEC). This statement contains the proposed terms of the bankruptcy.
  4. Owners and creditors will vote to approve or disapprove the plan. The plan can also be approved by the courts without owner or creditor consent if it is found to be fair to all parties.
  5. Once the plan is approved, the company must file a more detailed version of the plan with the SEC using an 8-K. This form contains more specific details regarding the payment amounts and terms.
  6. The plan is then carried out by the company. Shares in the "new" company may be distributed and payments made.

The Plan

Companies that go into bankruptcy often have crushing debt that cannot be paid off entirely in cash. As a result, public companies typically cancel their original shares and issue new shares in order to make equity payments for the agreed upon amounts.

The distribution of new shares occurs in the following order:

  1. Secured creditors: These are banks that have lent the company money with assets as collateral.
  2. Unsecured creditors: These are banks, suppliers and bondholders who have supplied the company with money through loans or products, but without collateral.
  3. Stockholders: These are the shareholders and owners of the company and usually emerge with nothing (or next to nothing).

A number of companies have thrived after emerging from bankruptcy, including General Motors, Chrysler, Marvel Entertainment, Six Flags, Texaco, and Sbarro. 

How to Invest in a Bankrupt Company

Achieving above-average returns often involves thinking outside of the box, but where could money possibly be made in a bankruptcy? The answer lies not in what takes place before, but rather what takes place after a company goes bankrupt.

A stock's price is not only a reflection of the company's fundamentals, but also a result of the market's supply and demand for shares. Sometimes fluctuations in supply and demand can create deviations away from the true fundamental value of a company. As a result, the share price may not always be an accurate reflection of the company's fundamentals. These are the types of situations in which wise investors look to invest, and they can occur from bankruptcies.

When a company declares bankruptcy, most people are not happy because owners lose almost everything they have and creditors gain back only a fraction of what they lent. As a result, when the company emerges from bankruptcy reorganization and issues new shares to these two groups of stakeholders, the shareholders are usually not interested in holding them for the long term. In fact, most of them dump the shares rather quickly on the secondary market.

Generally, this results in an excess supply of shares generated by apathetic or unhappy stakeholders, rather than fundamental issues. These new shares often enter the market with very little fanfare (no road show, IPO, pumping, etc.), which results in no added premium to the share price. This scenario creates value for those willing to pick up the cheap shares and hold them until they climb in value.

A company that has come through Chapter 11 bankruptcy is not necessarily damaged goods; it can emerge from the reorganization process leaner and more focused, therefore offering a good opportunity for some investors.

Risks of Investing in a Company After Bankruptcy

Despite how easy this process may seem, there is still a host of risks associated with investing in companies emerging from bankruptcy. For instance, a company's new shares might not accurately reflect the value of the new company, so selling may be justified. The problems that brought the company into bankruptcy in the first place may still exist, and the scenario could likely repeat itself.

Another threat to bankruptcy investing are so-called vulture investors. These are investment groups that specialize in buying large stakes (debt and bonds) in companies operating under Chapter 11 before new shares are issued so they are guaranteed a large amount of post-bankruptcy shares. These groups have already discovered the value, and are often the first sellers after the stock has recovered post-bankruptcy.

So, when is it a good time to invest? The key is doing in-depth research (or due diligence, as investors like to call it). Look for companies with solid fundamentals that only entered bankruptcy due to extreme circumstances. Failed buyouts, unfavorable lawsuits, and companies with identifiable liabilities (such as a weak product line) can make good post-bankruptcy investments. Stocks with a low market cap are more likely to be mispriced after a bankruptcy. What's more, stocks with low market caps and liquidity are often ignored by vulture investors and, therefore, may represent better values than those already picked up.

The Bottom Line

The bankruptcy reorganization process is long and complex. However, some public companies are able to emerge from it and become profitable again. These companies may represent some of the best undervalued investment opportunities for investors.