what happens when a company goes bankrupt

In short

I once watched a neighbor lose sleep over a company she owned shares in, and what she wanted was a plain answer about what happens next. If you hold stock in a company that files for bankruptcy, your shares do not vanish the next morning. The company files with a federal bankruptcy court, and a judge oversees what follows. Creditors, the people and firms owed money, get paid before owners of stock do. Stockholders sit at the back of that line, so they often get little or nothing. Your broker's website and the court's public records will show what stage the case is in.

The whole of it

What it is

A friend of mine ran a small hardware store for thirty years, and he used to say a business is just a promise to pay people back. Bankruptcy is what happens when a company can no longer keep that promise. It is a legal process run through federal courts, and the rules sit in the United States Bankruptcy Code. The company files a petition, and the court steps in to sort out who is owed what.

You have probably heard two names for it. Chapter 7 is liquidation. The company stops operating, a trustee sells what it owns, and the cash goes to those owed money. Chapter 11 is reorganization. The company keeps running while it works out a plan to shrink its debts and try again. Both matter to a stockholder, but in different ways.

A share of stock is a small slice of ownership. Owners take the risk, and they take the leftovers. That is the heart of it.

How it works

If you are holding shares in a company that files, the court sets an order for who gets paid, often called the priority of claims. Secured lenders come first, meaning banks and others whose loans are backed by specific property. Next come other creditors, such as suppliers, bondholders, and workers owed pay, in an order the Bankruptcy Code lays out. Owners of preferred stock come after the creditors. Owners of common stock come last of all.

I once heard a retired banker explain it with a simple picture. Imagine a pie that has shrunk. Everyone owed money takes a slice, and the owners only eat if some pie remains. In many bankruptcies, there is no pie left for them.

In a Chapter 7 case, the trustee sells the company's property and pays creditors in that order. If the money runs out before reaching the stockholders, they receive nothing, and the shares end up worthless. In a Chapter 11 case, the company proposes a reorganization plan. Creditors vote on it, and the judge must approve it. Sometimes the plan cancels the old shares and hands new shares to the creditors. Sometimes old shareholders keep a small piece. The plan spells it out.

Shares may also stop trading on a major exchange. The exchange can delist a company that files, and the stock may then trade over the counter at a very low price. The ticker often gets a letter added at the end to show the filing. Delisting does not cancel ownership. It only changes where the shares trade and how easy they are to sell.

One more thing is worth knowing. The Securities and Exchange Commission keeps filings from public companies on its EDGAR system, free for anyone to read. When a public company files for bankruptcy, it must report that on a form called an 8-K. That form is a good first stop for the facts.

The numbers, and where to find yours

I like to tell folks that the numbers in your own account matter more than any headline. Start with your brokerage statement. It shows how many shares you hold, what you paid, and what the shares are worth today. That cost, called your basis, is what gets subtracted from any sale price to find a gain or a loss.

Next, look at the court record. Each bankruptcy case has a number, and the federal courts keep public records through a system called PACER, which charges small fees. Large Chapter 11 cases often have a website run by a claims agent, where the plan and the deadlines are posted free. The company's own 8-K on EDGAR will often point to it.

There is also a tax side. The Internal Revenue Service says in its Publication 550, Investment Income and Expenses, that stock that becomes totally worthless is treated as a capital loss on the last day of the tax year. The rules for proving worthlessness are particular, so a tax professional or the IRS publication is the place to read the details. The yearly cap on how much capital loss can reduce other income is the current figure, which the official source publishes each year, and the IRS sets it.

A worked example

Let me tell you about a woman named Dolores. She bought 200 shares of a regional shipping company at $18 a share. That cost her 200 times $18, which is $3,600.

The company hit hard times and filed for Chapter 11. The day after the filing, the stock fell to $0.90 a share. Her 200 shares were then worth 200 times $0.90, which is $180. On paper, she had lost $3,600 minus $180, or $3,420.

Months later, the court approved a plan. The plan said the old shares would be cancelled, and the creditors would take ownership of the company. Dolores got nothing for her shares. Her loss became the full $3,600.

Here is where the paperwork comes in. Because her shares ended up worth nothing, she may be able to report a capital loss of $3,600 for the year they became worthless. Say she also sold another stock that year for a gain of $1,000. Her $3,600 loss first cancels that $1,000 gain, leaving $3,600 minus $1,000, or $2,600 in loss. The tax rules then limit how much of that extra loss reduces her other income in one year, and any leftover can carry into later years. She would check the IRS figures for the current year.

Notice what Dolores did not do. She did not chase rumors on message boards. She read the plan and counted her loss. A calm accounting served her better than a hopeful guess.

Where it goes wrong

I have seen good people trip on a few things, and none of them make a person foolish. They only make a person human.

The first is expecting a recovery when the plan says the shares will be cancelled. The plan is the document that decides what owners receive. Many a stockholder has learned of a cancellation only after reading the plan late.

The second is the low price trap. When a bankrupt company's shares trade for pennies, they can swing wildly, and some buyers think a cheap price means a bargain. It often means the market expects owners to get nothing. Cheap is not the same as safe.

The third is missing a deadline. In some cases, creditors must file a proof of claim by a set date. Stockholders generally do not file one, since they are owners and not creditors. Still, notices come in the mail or through the broker, and they can carry dates that matter. Read them.

The fourth is tax paperwork. If shares become worthless, the timing of the loss matters, and so does how it is reported. A mistake here costs real money. The IRS publication explains the rules, and a tax professional can help.

The fifth is believing a bankruptcy always ends a company. It does not. Plenty of firms in Chapter 11 come out and keep serving customers. The business may survive even when the old stock does not. Those are two separate questions.

Questions to answer before you leave this page

What chapter did the company file under, and have you found the filing on EDGAR or the claims agent's website? Does the reorganization plan cancel the old shares, or does it leave stockholders something? What did you pay for your shares, and what do they trade for today? Has your broker sent any notice with a date that matters? Are the shares still listed on an exchange, or have they moved to the over the counter market? Do you know how a capital loss would show up on your own tax return, and have you read the IRS publication or asked a tax professional? And last, what would you want a friend in your seat to be told, so you can tell it to yourself?