Bankrupt [CapiPedia]

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====== Bankrupt ======
To be bankrupt is to be in a legal state where a person or company cannot repay the [[debt|debts]] they owe to their [[creditors]]. It’s not just about having a bad quarter or running low on cash; it's a formal declaration made in a court of law. This happens when a company's [[liabilities]] (what it owes) are greater than its [[assets]] (what it owns), and it's unable to meet its financial obligations as they come due. For a business, filing for bankruptcy protection is a drastic step, but it provides a structured process to deal with overwhelming debt. It can either lead to the company's complete shutdown and sale of its assets or a major reorganization to give it a fighting chance at survival. For investors, particularly stockholders, a bankruptcy filing is almost always catastrophic news, as it signals a high probability that their investment will become worthless.
===== What Happens When a Company Goes Bankrupt? =====
When a company files for bankruptcy, it enters a court-supervised process designed to resolve its debts in an orderly fashion. This process stops all collection efforts from creditors, giving the company what's called an "automatic stay" – a moment of breathing room to figure out its next steps. The path it takes largely depends on the type of bankruptcy it files for, with two chapters of the U.S. Bankruptcy Code being most relevant for investors.
==== The Two Main Paths: Liquidation vs. Reorganization ====
=== Chapter 7: The Final Curtain Call ===
This is the end of the road. Under a [[Chapter 7]] bankruptcy, the company ceases all operations and goes into liquidation. A court-appointed trustee takes over, sells off all the company's assets – from office chairs to patents – and uses the cash raised to pay back creditors. As you'll see below, [[common stock|common stockholders]] are the very last to be paid, and in a Chapter 7 filing, there is almost never anything left for them. For the average investor, this means your shares become worthless pieces of paper (or, more accurately, worthless digital entries).
=== Chapter 11: A Second Chance? ===
A [[Chapter 11]] bankruptcy is a reorganization. Unlike Chapter 7, the company aims to stay in business. Management typically remains in place and works with creditors to create a reorganization plan to restructure its debt and operations. This might involve selling off unprofitable divisions, renegotiating labor contracts, or arranging new financing. While it sounds hopeful, don't be fooled. A key part of most Chapter 11 plans is to cancel the old [[equity]] and issue new shares. This means that even if the company survives and eventually thrives, the original stockholders are usually wiped out completely.
===== The Pecking Order: Who Gets Paid First? =====
When a bankrupt company's assets are distributed, there's a strict hierarchy of who gets paid. This is known as the "absolute priority rule." It’s crucial for investors to understand because it determines who gets their money back and who is left with nothing.
  - 1. **[[Secured Creditors]]:** These are lenders who have a claim on specific collateral. Think of a bank that gave a mortgage on the company's headquarters. They are first in line and get to claim that specific asset or its value.
  - 2. **[[Unsecured Creditors]]:** This is a large group that includes bondholders, suppliers who sold goods on credit, and landlords. They have no claim on specific assets and are paid from whatever is left after secured creditors are satisfied.
  - 3. **[[Preferred Stock|Preferred Stockholders]]:** These equity holders have a higher claim than common stockholders but are still behind every single creditor.
  - 4. **[[Common Stock|Common Stockholders]]:** We, the common stockholders, are dead last. In almost every bankruptcy case, the money runs out long before it gets to this level.
The brutal reality is that by the time a company is bankrupt, its assets are usually worth far less than its debts, leaving nothing for shareholders.
===== A Value Investor's Perspective on Bankruptcy =====
Value investors, following the principles of people like [[Benjamin Graham]] and [[Warren Buffett]], are focused on preserving capital and minimizing risk. From this standpoint, bankruptcy is the ultimate failure of risk management and the ultimate destroyer of value.
==== Is It Ever a Good Idea to Invest in a Bankrupt Company? ====
For 99.9% of ordinary investors, the answer is an emphatic **No**.
Some highly specialized hedge funds engage in what’s called [[distressed debt]] investing, or "vulture investing." They buy a company's bonds (its debt), not its stock, after a bankruptcy filing. Their goal is to gain influence over the reorganization process or buy the debt so cheaply that they can profit even from a partial repayment. This is an incredibly complex, high-stakes game played by experts.
//Buying the common stock of a bankrupt company in the hopes of a miraculous recovery is not investing; it's pure speculation.// The odds are overwhelmingly stacked against you, as the existing shares are almost certain to be cancelled.
==== Red Flags: How to Spot a Company Headed for Trouble ====
A true value investor’s goal is to avoid bankruptcies altogether. By carefully analyzing a company’s [[financial statements]], you can spot warning signs long before disaster strikes. Keep an eye out for:
  * **Rising Debt Levels:** A company that is piling on more debt than its business can support. A consistently high or rising [[debt-to-equity ratio]] is a major red flag.
  * **Negative Cash Flow:** The company is consistently spending more cash than it generates from its core business ([[operating cash flow]]). A business that can't generate cash can't survive.
  * **Falling Profit Margins:** Intense competition or a failing business model can crush a company's profitability, making it harder to service its debt.
  * **Frequent Asset Sales:** A healthy company invests for the future. A struggling one may be forced to sell its crown jewels just to stay afloat.
  * **Low [[Altman Z-score]]:** For those who like quantitative tools, this is a formula developed by Professor Edward Altman specifically to predict the probability of a company going bankrupt. A score below 1.8 indicates a business in distress.