On October 15, Sears (SHLDQ)—once the largest retail store in the US—declared bankruptcy. And Sears isn’t alone among other well-known companies that have filed for bankruptcy recently. Toys R Us, Bertucci's, Brookstone, Nine West, Claire's, The Bon-Ton Stores, and Mattress Firm all declared Chapter 11 bankruptcy this year and are attempting to resuscitate their flagging businesses.
Despite the relatively significant number of high-profile cases, US business bankruptcies have actually been in a long-term downtrend since the big spike during the Great Recession (see table).
Retail stores have been among the hardest hit in 2018, and many think that trend could continue into 2019 with numerous other traditional brick and mortar retailers being on the list of potential bankruptcy filers.
Bankruptcy and stocks
Investors who own shares of Sears, or any other company that has declared bankruptcy, face a difficult choice: Do you hang onto the shares or do you cut your losses and try to get what you can?
It's entirely possible that an investment will lose money and, in the worst case scenario, it could go to zero. Unfortunately, the shares of a company that declares bankruptcy are at heightened risk of the latter occurring.
Obviously, you would rather own strong investments that align with your investment objectives and risk constraints. However, many investors own stocks with poor prospects for the future. The reasons can be many. Maybe the company is relatively new and not established in the market yet. Maybe it's a long-term investment that has had its ups and downs in the past but has a track record of surviving tough times. Or maybe it's a smaller, speculative position.
If for some reason you end up owning stock of a company that is not on firm footing, it is critically important to understand all of its risks, and to determine if the investment is appropriate for your strategy.
Typically, a publicly traded company will exhibit several signs of distress well in advance of declaring bankruptcy. Significant and persistent declines in reported earnings and revenues, failure to raise needed investment capital, credit rating downgrades, and other company-specific events can indicate the company is experiencing severe problems.
Of course, any of these occurrences would warrant a reevaluation of the company to determine if you still want to bear the risk and if it aligns with your investment strategy.
If you own and have decided to hang onto the shares of a company that is exhibiting these signs, but you remain concerned about the possibility of bankruptcy, one tool that provides an easy-to-assess output is the Altman Z-score. This score determines the probability of bankruptcy using multiple financial ratios to assess a company's liquidity, profitability, leverage, and activity.* The higher a company's Z-score, the less likely it is to declare bankruptcy in the near future, and the lower a company's Z-score, the more likely it is to declare bankruptcy. You may be able to find this information in financial reporting databases or it might be provided by credit management companies.
Many companies will explore all other available options in order to avoid having to declare bankruptcy. This can entail seeking an investment (perhaps via a cash infusion, an acquisition, or some other type) to help stabilize the company, exploring a sale of the entire company or some of its major assets, restructuring, or downsizing. However, if these other paths are unsuccessful, filing for bankruptcy may be the best (or only) option.
Federal bankruptcy laws govern how US companies go out of business or attempt to recover from severe financial distress when they are struggling to pay their debts. For investors, there are 2 main forms of bankruptcy to be familiar with under the Bankruptcy Code: Chapter 7 and 11.
Banks and bondholders first
If a company files for Chapter 7, this means the company stops operations and a trustee is tasked with selling any assets the company owns in order to repay what it can to creditors and investors. In the event you own stock of a company that files Chapter 7 bankruptcy, it will likely become worthless and it is unlikely you will recover any of your investment (see sidebar).
Under Chapter 11 bankruptcy, there is slightly more hope that the company can survive and your stock will not become worthless—although it is still unlikely. Chapter 11 allows a company to "reorganize" so that it might become profitable once again. Under Chapter 11, management runs the day-to-day business operations, but significant decisions are made by a bankruptcy court.
Your options under Chapter 11
Assuming a company of the stock you own declares Chapter 11 bankruptcy, what can you do?
First, it's important to know that once bankruptcy is filed, stockholders will not receive previously scheduled dividend payments and bondholders will not receive principal and interest payments.
One option is to stand pat and maintain your ownership in the stock. In an optimal scenario, the company could negotiate a deal with its creditors under bankruptcy protection laws, reorganize and recover, and/or receive emergency funding from investors (or from the government, in rare instances, as was the case during the financial crisis for the banking and automobile industry).
For example, in June 2009, General Motors (GM) declared Chapter 11 bankruptcy, and was rescued by the US government. To date, General Motors is the largest company to ever declare bankruptcy that is still in operation, having $82 billion in assets at the time.
Regardless, stockholders may be asked by the court-appointed trustee to send back old stock in exchange for new shares. The trustee may send back fewer shares that are worth less than the old shares. The trustee will also inform existing shareholders of their new rights, and if anything is expected to be received from the company.
Typically, a company operating under bankruptcy laws will no longer qualify for listing on major exchanges like the Nasdaq or New York Stock Exchange. It is likely to be delisted from those major exchanges, and it may continue to trade on the OTC Bulletin Board (OTCBB) or Pink Sheets. OTCBB/Pink Sheets is a service that allows companies (typically those that are penny stocks or foreign companies who are not listed on a major exchange) to trade, and there are no reporting requirements for these companies. In this event, the stock will be a 5-letter ticker symbol that ends in "Q".
For example, if a company's ticker symbol on a major exchange used to be "WXYZ," it may be listed on the OTCBB or Pink Sheets under "WXYZQ." If new shares have been issued, then the company could have multiple types of shares trading at the same time under different names and ticker symbols.
In the case of General Motors, after it declared bankruptcy on June 1, 2009, the old shares were delisted from the NYSE on June 2. The original shares that were listed under the symbol GM began trading on the Pink Sheets/OTCBB as Motors Liquidation Company GMGMQ (the current ticker symbol for the old shares is MTLQU). A new entity was created on July 10, 2009—with the aid of the US government—to acquire the operational assets of the company. General Motors completed their IPO in 2010, and the new shares now trade under the original GM ticker symbol.
Investing in bankruptcy-declared stocks
Some risk-taking investors consider buying stocks of companies that have declared bankruptcy. The thinking here may be to a take a flier on ultra-cheap companies, potentially for pennies on the dollar compared with what it may have previously been worth—essentially, that the future post-reorganization value will exceed the currently depressed share price.
Investing in companies that are operating under any bankruptcy procedures is not a strategy that is advisable for individual investors, regardless of their ability to accept losses, given the significant probability of failure. In fact, even if a company can reorganize under bankruptcy laws and continue to operate, in many instances the creditors and lenders will become the new owners and the plan for reorganization will effectively cancel the existing shares—making them worthless.
In addition to maintaining ownership, another option for an investor who owns shares of a company that has declared bankruptcy is to attempt to sell the shares—likely at a significant loss relative to the initial investment. If the investor determines that the company is unlikely to reorganize, or even if it does, that the existing shares will be deemed worthless, this may be the best option.
It is worth noting that one problem an investor may encounter is difficulty finding a buyer at a desirable price or at all, given the significant risks associated with these investments.
More importantly, it can be hard to get research and information on the prospects for companies that enter bankruptcy. Recall that OTCBB/Pink Sheets listed stocks have no reporting requirements. Consequently, investors who choose to own bankrupt companies are essentially on their own. Investing in bankrupt companies is truly speculative and should only be done rarely (if ever), unless the investor is a specialist in researching and investing in financially distressed companies. And even for those who do venture down this path, it should be done with a small portion of the total portfolio, with an acknowledgement of the possibility for a total loss.
Owning stocks (or bonds) involves risk, and that risk should be mitigated via diversification. But if you've been investing long enough, you probably already know that it's possible to have individual positions that can go to zero.
Managing an investment position of a company operating under bankruptcy laws is a difficult task. In all likelihood, most or all of the investment will be lost. If there are any positive aspects of incurring a loss, it is that those losses may be used to offset gains made by other investments for tax purposes. The best course of action is to continually monitor your portfolio, and own companies that align with your investment strategy.
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