What is Chapter 11 Bankruptcy?

Chapter 11 of the United States Bankruptcy Code grants protection from creditors to reorganizing businesses and some individuals. Chapter 11 is available to all types of businesses, such as corporations, sole proprietors, and partnerships. Under Chapter 11, the firm's management oversees daily operations. However, the company directs significant business decisions (e.g., debt or debt securities decisions) to the bankruptcy court for approval.

Key Takeaways

  • Chapter 11 bankruptcy allows businesses and some individuals to reorganize while receiving protection from creditors.
  • Stock values are adversely affected by bankruptcy speculation, and even more so by the actual filing.
  • After filing for Chapter 11, trading of the company's stock will cease temporarily.

Understanding Chapter 11 Bankruptcy

Obtaining Chapter 11 bankruptcy protection means that a company is on the verge of bankruptcy but believes that it can once again become successful if given an opportunity to reorganize its assets, debts, and business affairs. Although the Chapter 11 reorganization process is complex and expensive, most companies 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 another chance at success.

While the firm is in Chapter 11, its stock will still have value, but there is a temporary trading freeze. Although the stock will be delisted, over-the-counter (OTC) trading may still occur. In other words, the equity a broker invested in the firm is not valued at zero, but their true value cannot be easily determined since the shares are no longer publicly traded. When a company is listed on the pink sheets or Over-the-Counter Bulletin Board (OTCBB), the letter "Q" is added to the end of the company's ticker symbol to differentiate it from other companies.

Under Chapter 11, liquidation is possible and is more favorable to creditors and debtors than Chapter 7 as they have more involvement in the distribution of the proceeds.

The Alternative: Chapter 7

Under Chapter 7 bankruptcy, all assets are sold for cash. That cash is then used to pay off legal and administrative expenses incurred during the bankruptcy process.

Once a company files for Chapter 7 bankruptcy, the company pays its creditors in a specific order. Generally, the company pays investors or creditors in the following order:

1) Secured creditors
2) Unsecured creditors
3) Shareholders

Usually, little to nothing is leftover for shareholders after paying the more senior creditors.

Equity Values: Chapter 11 vs. Chapter 7

When a corporation is on the verge of bankruptcy, its stock value reflects the risk of Chapter 11 becoming Chapter 7.

For example, a company traded at $50 may trade at $2 per share due to bankruptcy speculation. After filing Chapter 11, the firm's stock price may fall to $0.10. This value is composed of the potential income that shareholders may receive after liquidation and a premium based on the possibility that the firm may restructure and begin to operate successfully in the future. Private investors can buy and sell these 10-cent shares in the OTC market. The actual value does not reach zero unless the probability of restructuring is so low that a Chapter 7 filing is sure to follow.

However, if the company restructures and emerges from Chapter 11 as an improved organization, its share price may rise to higher levels than previously witnessed.