The last few weeks have seen some high-profile bankruptcies, with rental car major Hertz, retailers JCPenny and Neiman Marcus, and Latin America’s largest airline LATAM filing for Chapter 11 protection as sales collapsed on account of the Coronavirus pandemic and the associated lockdowns. There’s a real possibility that we could see more high-profile failures as the economy slips into what looks like a deep recession. In fact, LATAM’s bankruptcy filing has raised questions about the survival chances for American Airlines while also bringing the liquidity position of peers United Airlines and Delta Airlinesunder the scanner.
But what does filing for bankruptcy mean for a particular company as well as its stakeholders? Below, we try to answer some common questions about the broader bankruptcy process and the potential outcome for shareholders and bondholders.
What happens in bankruptcy?
- Companies file for bankruptcy under federal laws, when they are in deep financial distress and don’t have the cash to pay their immediate debt obligations.
- There are typically two routes companies can take:
- Most public companies opt for Chapter 11 bankruptcy, which allows them to reorganize their business (renegotiate with debt holders, cut costs, etc.) as they look to become profitable again.
- The second route is Chapter 7 bankruptcy, in which case the company will go out of business and liquidate its assets to repay its obligations.
Does the company need to shut down operations?
- For example, Hertz can continue to rent cars, and JC Penny can keep its stores open.
- Although things can change as the bankruptcy progresses, some companies can cease to exist at the end of the process, while others can also re-emerge stronger.
Do debt holders get their money back? Is it a good idea to buy bonds in a company that might go bankrupt?
- Typically, under bankruptcy laws, secured creditors such as banks are compensated first, after which other creditors such as bondholders and suppliers have a claim.
- Bondholders will stop receiving interest and principal payment.
- Moreover, creditors may not be paid in cash. They could actually receive new stock in the company, in exchange for their bonds, new bonds, or some combination of debt and equity in the new company.
- Overall, investing in the debt of a company that is bankrupt is a risky proposition, although the upside could also be high.
What happens to common shareholders? Why does the stock not go to zero?
- Generally, common shareholders should not count on being compensated meaningfully, even if a company emerges successfully from bankruptcy.
- In many cases, a reorganization plan cancels existing equity shares, as creditors are paid from a company’s assets before common stockholders, and largely become the new owners in the company.
- Even when shareholders participate in the bankruptcy plan, their stake is substantially diluted.
- However, stocks often trade at levels above zero after a company files for bankruptcy, as investors bet on a small probability that equity holders will be able to extract some value from the business.
Are there companies that have emerged successfully from bankruptcy & what was the outcome for shareholders?
- In the past, many companies have emerged from bankruptcy - stronger than before.
- But the fate of common shareholders has not been very positive.
- For instance, GM emerged from bankruptcy protection with a bailout from the U.S. government and went for a new IPO in 2010, allowing the U.S. Treasury to cut its stake in the company. However, shareholders of GM prior to 2009 were largely wiped out.
- Notably, though, shareholders of American Airlines’ parent AMR Corp had it a lot better, as shares that fell to as low as $0.20 as the company filed for bankruptcy, were worth several dollars after the company merged with U.S. Airways. [2]
- That said, cases such as American Airlines are more the exception than the rule.
JC Penny filed for bankruptcy earlier this month. Do retailers such as Guess and Abercrombie & Fitch have sufficient cash to survive the Covid-19 recession?
This article originally appeared on Forbes.
