# Bankruptcy and Restructuring

> When companies cannot pay their debts, they restructure or go bankrupt. Learn Chapter 11 vs Chapter 7, the priority of claims and what happens to stocks.

Source: https://learn.tradelabsai.com/fundamentals/bankruptcy-and-restructuring/  
Track: Fundamental Analysis · Level: Intermediate · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "Bankruptcy and Restructuring", https://learn.tradelabsai.com/fundamentals/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

| Chapter | Purpose | Outcome |
|---|---|---|
| Chapter 11 | Reorganisation | The company keeps operating while it restructures debts under court supervision |
| Chapter 7 | Liquidation | A trustee sells assets and distributes proceeds; the business ends |
| Chapter 15 | Cross border cases | Coordinates with foreign proceedings |

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

| Priority | Claimants |
|---|---|
| 1 | Administrative claims and DIP lenders |
| 2 | Secured creditors (up to collateral value) |
| 3 | Priority unsecured claims (some taxes, wages) |
| 4 | General unsecured creditors and bondholders |
| 5 | Subordinated debt |
| 6 | Preferred stock |
| 7 | Common stock |

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](https://learn.tradelabsai.com/bonds-credit/distressed-debt/).

## What happens to the stock

**Example: Why "cheap" bankrupt shares are dangerous**
A retailer files for Chapter 11 with $5 billion of debt. Its shares fall from $8 to $1. Speculators buy, hoping for a rebound. Under the reorganisation plan, the company is valued at $3 billion; creditors receive all of the new equity, and the old shares are cancelled. Shareholders receive nothing. This outcome is common: in many large bankruptcies, existing equity has been wiped out entirely. In 2021, Hertz was a rare exception, where shareholders recovered value after a used car boom lifted the company's worth.

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

| Signal | Lesson |
|---|---|
| Rising debt and falling cash | [Balance Sheet](https://learn.tradelabsai.com/fundamentals/balance-sheet/) |
| Negative free cash flow for years | [Free Cash Flow](https://learn.tradelabsai.com/fundamentals/free-cash-flow/) |
| Interest coverage below 1 | [Operating and Financial Leverage](https://learn.tradelabsai.com/fundamentals/operating-and-financial-leverage/) |
| Credit downgrades to CCC or lower | [Credit Ratings](https://learn.tradelabsai.com/bonds-credit/credit-ratings/) |
| Bonds trading far below par | [Default Probability and Recovery Rate](https://learn.tradelabsai.com/bonds-credit/default-probability/) |
| Going concern warning from auditors | [Earnings Quality and Cash Conversion](https://learn.tradelabsai.com/fundamentals/earnings-quality/) |
| Missed interest payments or hiring restructuring advisers | |

## Famous bankruptcies

- **Lehman Brothers (2008):** the largest US bankruptcy, with about $600 billion of assets. See [The 2008 Financial Crisis](https://learn.tradelabsai.com/history/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](https://learn.tradelabsai.com/fundamentals/index-rebalancing/).

## Continue learning

- Next lesson: [Index Rebalancing](https://learn.tradelabsai.com/fundamentals/index-rebalancing/)
- Previous lesson: [Buybacks](https://learn.tradelabsai.com/fundamentals/buybacks/)
- Related: [Buybacks](https://learn.tradelabsai.com/fundamentals/buybacks/): Share buybacks are companies repurchasing their own stock. Learn how buybacks work, their effect on EPS, when they create value, the controversies and the evidence.
- Related: [Distressed Debt and Bankruptcy Trading](https://learn.tradelabsai.com/bonds-credit/distressed-debt/): Distressed debt is the bonds and loans of companies near default, bought at deep discounts. Learn how investors value it, the bankruptcy process and strategies.
- Related: [Default Probability and Recovery Rate](https://learn.tradelabsai.com/bonds-credit/default-probability/): Default probability is the chance a borrower fails to pay. Learn historical default rates, probabilities implied by spreads, the Merton model and recovery rates.
- Related: [Corporate Bonds](https://learn.tradelabsai.com/bonds-credit/corporate-bonds/): Corporate bonds are loans to companies that pay interest above government bonds. Learn investment grade vs high yield, spreads, covenants, callable bonds and risks.
- Related: [Credit Ratings](https://learn.tradelabsai.com/bonds-credit/credit-ratings/): Credit ratings from S&P, Moody's and Fitch grade the risk of default on bonds. Learn the scales, investment grade vs high yield, default rates by rating and limits.
- Related: [Earnings Quality and Cash Conversion](https://learn.tradelabsai.com/fundamentals/earnings-quality/): Earnings quality asks whether reported profits are real, repeatable and backed by cash. Learn accruals, warning signs, the Beneish model and famous frauds.