Bankruptcy is a word that few people like to hear, but it can present great opportunities for investors willing to do a little hands-on research. Bankruptcies are a process that occurs when companies can no longer afford to make payments on their debt. Often, this comes as a result of a bad economic environment, poor internal management, over-expansion, new liabilities, new regulations and a host of other reasons.

This article will take a look at exactly what happens during a bankruptcy, and how investors can profit from it. 

The Decline

The bankruptcy process is often lengthy and complex. While understanding how it works from a theoretical standpoint may be easy, there are many complications that arise when it comes to 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, unsecured debt is separated into classes or categories with each class receiving priority for payment. Secured debt is backed or secured by collateral to reduce the risk associated with lending. 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. (This plan will be discussed in greater detail later.)
  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 via the Form 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 are distributed and payments are made.

The Plan

Companies that go into bankruptcy often have crushing debt that cannot be paid off entirely in cash (after all, the company is bankrupt). As a result, public companies typically disband 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 loaned 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.

Notice that the shareholders are at the bottom of the list. Unfortunately, they are almost always stuck with next to nothing after a company emerges from bankruptcy.

So, where's the value? Let's take a look.

The Investment

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 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 in the long term. In fact, most of them dump the shares rather quickly on the secondary market.

Overall, this results in excess supply of shares that are generated not from bad fundamentals, but rather from apathetic or unhappy stakeholders.  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.

The Risks

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 be likely to repeat itself.

Another threat to bankruptcy investing is 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 a good time to invest? The key is doing some good old 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 bad product line) typically make good post-bankruptcy investments. Stocks with a low market cap are more likely to be mispriced after a bankruptcy. Furthermore, 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 successful investors to profit from in today's market.

(For more insight, see An Overview of Corporate Bankruptcy.)

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