Bankruptcy, the legal process for companies or individuals when they cannot pay their debts, can be quite a negative situation for those who go through it. But for investors who are willing to do a little research, it can present opportunities. Here, we will see exactly what happens during a bankruptcy and how investors can benefit from it.
- Investors should be careful, but they should not necessarily avoid investing in a company that has emerged from bankruptcy; in some cases, these companies offer good investment possibilities.
- As with any investment, potential investors should do their due diligence and investigate whether the company is in a stronger position after the reorganization and now offers a good buying opportunity.
- The risks for investors in bankrupt companies include old problems that resurface and the presence of vulture investors, who buy the shares during the bankruptcy process and dispose of them as soon as the company has resurfaced.
A business may need to file for bankruptcy due to a bad economic environment, poor internal management, excessive expansion, new liabilities, new regulations, or a number of other reasons. The bankruptcy process is often long and complex, and many complications can arise regarding settlement amounts and payment terms.
There are two types of bankruptcies that businesses can file:
This type of bankruptcy occurs when a business closes completely and assigns a trustee to liquidate and distribute all of its assets to the creditors and owners of the business.
In a Chapter 7 bankruptcy, debts are divided into classes or categories, with each class receiving priority for repayment. Priority debts are paid first. Secured debts are paid next. The non-priority unsecured debt is then repaid with the remaining funds from the asset liquidation.
This is the most common type of corporate bankruptcy for public companies. In a Chapter 11 bankruptcy, a business continues its normal day-to-day operations while ratifying a plan to reorganize its business and assets in such a way that it can meet its financial obligations and eventually emerge from bankruptcy.
The process for a Chapter 11 bankruptcy is as follows:
- The United States Trustees Program (the bankruptcy arm of the Department of Justice) first appoints a committee to act on behalf of shareholders and creditors.
- The appointed committee then works with the company to create a plan to reorganize and emerge from bankruptcy.
- The company then publishes a disclosure statement after the Securities and Exchange Commission (SEC) reviews it. This statement contains the proposed terms for bankruptcy.
- Owners and creditors will vote to approve or disapprove of the plan. The plan can also be approved by the courts without the consent of the owner or the creditor if it is found to be fair to all parties.
- 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 on the amounts and terms of payment.
- The company then carries out the plan. Shares in the “new” company can be distributed and payments made.
Businesses that file for bankruptcy often have overwhelming debts that cannot be paid in full in cash. As a result, public companies generally cancel their original shares and issue new shares to make principal payments in the agreed amounts.
The distribution of new shares occurs in the following order:
- Secured creditors: These are banks that have lent money to the company with assets as collateral.
- Unsecured creditors: These are banks, suppliers and bondholders that have provided money to the company through loans or products, but without endorsement.
- Shareholders: These are the shareholders and owners of the company and they usually come up with nothing (or almost nothing).
Several companies have prospered 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 you make money in bankruptcy? The answer lies not in what happens before, but in what happens after a company fails.
The price of a share is not only a reflection of the fundamentals of the company, but also the result of the supply and demand of shares in the market. Sometimes fluctuations in supply and demand can create deviations from a company’s true fundamental value. As a result, the stock price may not always be an accurate reflection of the company’s fundamentals. These are the types of situations that savvy investors seek to invest in, and they can occur through bankruptcies.
When a business goes bankrupt, most people are unhappy because owners lose almost everything they have and creditors get only a fraction of what they borrowed. As a result, when the company exits bankruptcy reorganization and issues new shares to these two stakeholder groups, shareholders are often not interested in holding them for the long term. In fact, most of them pour the shares fairly quickly into the secondary market.
Generally, this results in an oversupply of shares generated by apathetic or disgruntled stakeholders, rather than fundamental problems. These new stocks often enter the market with very little fanfare (no road show, IPO, pumping, etc.), resulting in an additional premium to the share price. This scenario creates value for those who are willing to pick up the cheap stocks and hold them until they go up in value.
A business that has gone through Chapter 11 bankruptcy is not necessarily a damaged product; it may emerge from the reorganization process more agile and focused, thus offering a good opportunity for some investors.
Risks of Investing in a Business After Bankruptcy
Despite how easy this process may seem, there are still a number of risks associated with investing in companies emerging from bankruptcy. For example, new shares in a company may not accurately reflect the value of the new company, so the sale may be justified. The problems that brought the company out of business in the first place may still exist, and the scenario is likely to repeat itself.
Another threat to bankrupt investment 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 number of shares after bankruptcy. These groups have already figured out the value and are often the first sellers after the shares rally after bankruptcy.
So when is a good time to invest? The key is to do some in-depth research (or due diligence, as investors like to call it). Look for companies with strong fundamentals that only filed for bankruptcy due to dire circumstances. Failed acquisitions, unfavorable judgments, and companies with identifiable liabilities (such as a weak product line) can make good investments after bankruptcy. Stocks with a low market capitalization are more likely to be priced incorrectly after bankruptcy. What’s more, vulture investors often ignore stocks with low market limits and liquidity, and therefore may represent better values than those they have already earned.
The bottom line
The bankruptcy reorganization process is long and complex. However, some public companies can get out of it and become profitable again. These companies can represent some of the best undervalued investment opportunities for investors.