What Is Chapter 11 Bankruptcy?

When a company files for Chapter 11 bankruptcy, it is asking for protection from creditors while it reorganize its business and restructures its debt. Chapter 11 is available to 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 and restructure debt 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, the company's stock will be delisted from the major exchanges.

Understanding Chapter 11 Bankruptcy

Obtaining Chapter 11 bankruptcy protection means that a company is on the verge of needing to cease operations, 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 Chapter 7, under which companies totally cease operations and leads to the total liquidation of assets to creditors. Filing for Chapter 11 gives companies another chance at success.

The Alternative: Chapter 7 Bankruptcy

Under Chapter 7, the company ceases operations and all assets are sold for cash. That cash is then used to pay off legal and administrative expenses incurred during the bankruptcy process. Then the company pays its creditors in the following order:

1) Secured creditors
2) Unsecured creditors
3) Shareholders

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

What Happens to Stock When a Company Goes Bankrupt?

While the firm is in Chapter 11, its stock will still have some value, though the price will likely plummet and the stock will stop paying dividends. It may be delisted on the major exchanges, but over-the-counter (OTC) trading may still occur. 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 indicate that it is undergoing bankruptcy proceedings.

If a company manages to emerge from Chapter 11 bankruptcy stronger than before, current shareholders may or may not benefit from the turnaround, as old stock may get canceled during the bankruptcy process, and new shares issued.

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 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 or if the company does indeed end up in Chapter 7.

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.