If there’s one word that traumatizes investors, it’s bankruptcy, and rightly so. Bankruptcies aren’t prominent, but they happen. You’ve probably heard of companies or individuals declaring bankruptcy. It’s not an ideal time because it means an individual or a company has reached financial insolvency. Most people try their best to avoid bankruptcy. However, what happens if you’re a shareholder in a company about to go belly up? Well, that’s not good.
It’s not uncommon for some organizations to file for bankruptcy after failing to pay their debts. For instance, the Administrative Office of the US Courts statistics shows that 13,160 companies declared bankruptcy in the 2022’s first quarter. This number decreased from the 14347 companies filing for bankruptcy in the fourth quarter of 2021, but it remains staggeringly high.
While it’s true that most companies declaring bankruptcy are small-to-medium-sized firms, publicly-listed corporations also sometimes declare bankruptcy. The case of Enron Corporation declaring bankruptcy in 2001 is an excellent example. Enron Corporation was an innovative energy company widely favored by Wall Street investors. Then, it went bust. The implications of the company’s bankruptcy were massive. For instance, it caused Arthur Andersen—one of the largest accounting firms the world has ever seen—to cease operations. The scandal also left a black mark on the US stock market.
If you’re reading this blog post, odds are you’re a shareholder in a publicly-listed company. Most publicly-listed companies file for Chapter 11 bankruptcy instead of Chapter 7 bankruptcy. These chapters vary significantly because Chapter 11 bankruptcy allows firms to continue operations. The court will likely assign a debtor to oversee business decisions and approve them as the business tries to regain profitability. On the other hand, filing for a Chapter 7 bankruptcy means the company goes out of business. The bankruptcy court will appoint a trustee to sell the company’s assets to pay creditors.
According to the SEC, a company’s stock can continue trading even if the organization has filed for Chapter 11 bankruptcy. Filing for a Chapter 11 bankruptcy usually means that the organization cannot meet the listing standards of the largest US stock exchanges, NASDAQ and NYSE. However, the company can likely continue trading on the OTCBB or Pink Sheets.
Investing in a company that’s filed for Chapter 11 bankruptcy is an extremely risky deal. Bankrupt companies will usually crate new shares to raise money for equity payments. The new shares are distributed to secured creditors first. These are creditors who have lent the company money with collateral assets. Then, the company issues shares to unsecured creditors. Finally, the company issues new shares to shareholders.
Most people think you cannot make money by investing in a bankrupt company. After all, a bankrupt company is a failing business. But the reality is generating sizable returns requires thinking outside the box, meaning you’ll need to devise creative ways to generate returns on failing companies.
It’s crucial to look at what the company does after bankruptcy rather than before it if you want to invest in it. Companies declaring bankruptcy often create an unhappy situation for everyone. Shareholders won’t receive dividends or generate returns on their investment. Creditors, likewise, struggle to regain the money they’ve lent. Creditors will usually dump the new shares the company issues after declaring bankruptcy on the secondary market, resulting in an excess supply of shares.
These shares receive minimal attention upon entering the market since most people stay away from bankrupt companies. As a result, these shares have no premium. This situation creates a good opportunity for investors to purchase cheap shares and hold onto them until the company rebounds by following the plan provided by the Chapter 11 trustee.
In short, investing in bankrupt companies is a long con that can sometimes pay off.
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