Bankruptcy and Restructuring

When a company cannot meet its debt obligations, it must restructure its finances, either through negotiations with creditors or through a formal bankruptcy process. For shareholders, bankruptcy usually means large or total losses, because equity holders are last in line. For creditors and distressed investors, it is a negotiation over how the remaining value is divided. Understanding the process helps traders recognise warning signs and avoid the common mistake of buying "cheap" shares of bankrupt companies.

Out of court restructuring#

Before filing for bankruptcy, companies often try to fix their finances privately:

• Debt exchanges: swapping existing bonds for new ones with lower interest or longer maturities.
• Debt for equity swaps: creditors receive shares, diluting existing shareholders.
• Covenant waivers and amendments with lenders.
• Asset sales and new financing.

Out of court deals are faster and cheaper but require agreement from enough creditors.

US bankruptcy chapters#

Other countries have their own regimes, such as administration in the UK.

How Chapter 11 works#

1. Filing: an automatic stay stops most creditor collection efforts.
2. Debtor in possession financing (DIP): new loans with priority keep the company running.
3. Plan of reorganisation: proposes how claims will be paid.
4. Creditor voting and court confirmation.
5. Emergence: the company exits with a new capital structure, often with former creditors as owners.

The priority of claims#

Under the absolute priority rule, each class must be paid in full before the next receives anything, though negotiated plans sometimes give junior classes small recoveries. See Distressed Debt and Bankruptcy Trading.

What happens to the stock#

Shares of bankrupt US companies are usually delisted from major exchanges and trade over the counter, often with a "Q" added to the ticker.

Warning signs before bankruptcy#

Famous bankruptcies#

• Lehman Brothers (2008): the largest US bankruptcy, with about $600 billion of assets. See The 2008 Financial Crisis.
• General Motors (2009): reorganised with government support; old shareholders wiped out.
• Enron (2001) and WorldCom (2002): accounting frauds.
• FTX (2022): a crypto exchange bankruptcy, with customer recoveries later paid from asset sales.

Frequently asked questions#

What is the difference between Chapter 11 and Chapter 7?#

Chapter 11 is a reorganisation where the company keeps operating while restructuring debts; Chapter 7 is a liquidation where assets are sold and the business closes.

What happens to shareholders in bankruptcy?#

They are last in line and are often wiped out, since creditors must be repaid first.

Should I buy shares of a bankrupt company?#

It is very risky. In most large bankruptcies, existing shares end up worthless as creditors take ownership of the reorganised company.

Next, learn how index changes move stocks in Index Rebalancing.