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Filing for chapter 11 bankruptcy protection simply means that a company is on the verge of bankruptcy but believes that it can once again become successful if it is given an opportunity to reorganize its assets, debts and business affairs. Although the chapter 11 reorganization process is complex and expensive, most companies, if given the choice, prefer chapter 11 to other bankruptcy provisions such as chapter 7 and chapter 13, which cease company operations and lead to the total liquidation of assets to creditors. Filing for chapter 11 gives companies one last opportunity to be successful.

Understanding Chapter 11 Bankruptcy

While chapter 11 can spare a company from declaring total bankruptcy, the company's bondholders and shareholders are usually in for a rough ride. When a company files for chapter 11 protection, its share value typically drops significantly as investors sell their positions. Furthermore, filing for bankruptcy protection means that the company is in such rough shape that it would probably be de-listed from the major exchanges such as the Nasdaq or the New York Stock Exchange and relisted on the pink sheets or the Over-The-Counter Bulletin Board (OTCBB).

When a company going through bankruptcy proceedings is listed on the pink sheets or OTCBB, the letter "Q" is added to the end of the company's ticker symbol to differentiate it from other companies. For example, if a company with the ticker symbol ABC was placed on the OTCBB due to chapter 11, its new ticker symbol would be ABCQ.

Under Chapter 11, corporations are allowed to continue business operations, but the bankruptcy court retains control over significant business decisions. Corporations may also continue to trade company bonds and stocks throughout the bankruptcy process but are required to report the filing with the Securities and Exchange Commission within 15 days. Once Chapter 11 bankruptcy is filed, the federal court appoints one or more committees that are tasked with representing and working with creditors and shareholders of the corporation to develop a fair reorganization. The corporation, along with committee members, creates a reorganization plan that must be confirmed by the bankruptcy court and agreed upon by all creditors, bondholders and stockholders.

Sometimes after a reorganization, a company will issue new stock that is considered different from the pre-reorganization stock. If this occurs, investors will need to know whether the company has given its shareholders the opportunity to exchange the old stock for new stock, because the old stock will usually be considered useless when the new stock is issued.

Throughout the duration of the reorganization, bondholders will stop receiving coupon payments and/or principal repayments. Furthermore, the company's bonds will also be downgraded to speculative-grade bonds, otherwise known as junk bonds. Since most investors are wary of buying junk bonds, investors that want to sell their bonds will need to do so at a substantial discount.

After the reorganization process and depending on the terms dictated by the debt restructuring plan, the company may require investors to exchange their old bonds for shares and/or new bonds. These new issues of stocks and bonds represent the company's attempt to create a more manageable level of debt.

(For more on this, see What Is A Corporate Credit Rating? and Junk Bonds: Everything You Need To Know.)

If the plan for reorganization fails and the company’s liabilities start to exceed its assets, then the bankruptcy is converted into a chapter 7 bankruptcy.

How Division of Assets Differs Under Chapter 7 Bankruptcy

Under a chapter 7 bankruptcy, all assets are sold for cash. That cash is then used to pay off legal and administrative expenses that were incurred during the bankruptcy process. After that, the cash is distributed first to senior debt-holders and then unsecured debtholders, including owners of bonds. In the extremely rare event that there is still cash left over, the rest is divided among the shareholders.

On the other hand, if the reorganization plan ends up being successful and the company returns to a state of profitability, then multiple things could happen to investors’ pre-reorganization bonds or stock. In the case of bonds, investors may be obligated to exchange their old bonds for a combination of new bonds or stock, depending on the conditions required by the debt restructuring plan. In addition, the coupon and principal repayments on the new debt instruments would resume.

Stockholders, however, tend not to be so lucky. After restructuring, the company usually issues new stock, making the pre-reorganization stock worthless. In some cases, holders of the old stock are allowed to exchange their securities for a discounted amount of the new stock, which is dictated by the plan of reorganization.

For further reading on this topic, see An Overview of Corporate Bankruptcy.

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