What Is Corporate Bankruptcy?

In an ideal world, companies would manage their money in a manner that allows them to stay current on their bills. In reality, that doesn't always happen. Once a company finds itself unable to pay its outstanding debts, it has the option to file for bankruptcy -- which could really hurt investors like you. Here, we'll review what happens when a publicly traded company files for bankruptcy, how creditors are treated during a corporate bankruptcy, and what steps you can take to protect yourself from financial losses.

Notable corporate bankruptcies

You might think of corporate bankruptcies as uncommon occurrences, but they happen all the time. In fact, there are plenty of big companies that have filed for bankruptcy. Take Lehman Brothers, which filed for bankruptcy back in 2008. With $691 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history at that time and helped spur the Emergency Economic Stabilization Act of 2008.

Also notable was the General Motors bankruptcy filing in 2009. At the time of its filing, the company showed roughly $82 billion in assets and $172 billion in debt.

And who could forget the 2001 Enron bankruptcy and the scandal associated with it? The Texas-based energy company's attempts to cover up its financial mismanagement and debt resulted in a host of criminal charges for its leadership team and paved the way for the Sarbanes-Oxley Act, which resulted in stricter reporting and disclosure requirements for public companies.

Types of corporate bankruptcy

There are two types of bankruptcy a company might file for:

Chapter 7, a liquidation-type bankruptcy.
Chapter 11, a reorganization.

As an investor, you'll generally be hurt less by a Chapter 11 bankruptcy, though the extent to which you'll lose money will ultimately depend on the circumstances and company finances at hand.

Chapter 7 bankruptcy

A Chapter 7 bankruptcy is known as a liquidation because under this section of the bankruptcy code, a company ceases to operate upon filing, and a trustee is appointed to sell off, or liquidate, the company's assets. The trustee then uses the proceeds from those sales to pay off as much as possible of the company's outstanding debt.

Chapter 7 bankruptcies start out just like Chapter 11: The debtor will file its schedule of assets and liabilities, schedule of current income and expenses, statement of financial affairs, and schedule of contracts and current leases. But whereas companies that file for Chapter 11 continue to operate, companies that file for Chapter 7 effectively relinquish full control to a trustee, who is then charged with winding down operations in an orderly fashion, seeing that assets are sold off, and distributing funds according to creditor priority.

Chapter 11 bankruptcy

A Chapter 11 bankruptcy is known as a reorganization. Unlike Chapter 7, filing for Chapter 11 protection does not require a company to stop operating and shut down. Rather, the company is allowed to keep operating, but all financial decisions must be approved by a bankruptcy court before they're implemented. Keep in mind that Chapter 11 filings can be voluntary -- meaning, initiated by troubled companies themselves -- or involuntary, meaning initiated by creditors.

The goal of Chapter 11 is to bring a company back to a place of financial strength so that it can stay operational in the long run. At the start of the process, the debtor must file several key documents with the bankruptcy court. One important document is its schedule of assets and liabilities, which spells out its existing debt. The debtor must also file a schedule of current income and expenses, a schedule of contracts and current leases, and a statement of financial affairs.

At the same time, the U.S. trustee (part of the U.S. Department of Justice responsible for overseeing bankruptcy cases) will monitor the progress of the bankruptcy proceedings, as well as the debtor's operations. The U.S. trustee is also responsible for making sure all court fees and documents are submitted accordingly. Just as important, the U.S. trustee will make sure that a creditors' committee is formed to represent the interests of the parties the debtor in question owes money to. The trustee will conduct creditor meetings and allow creditors to gather more information about the debtor's finances as necessary.

As part of the Chapter 11 process, the debtor will develop a reorganization plan that dictates how it will continue to operate, but also pay its creditors what they're owed. Often, the creditors' committee will have a say as to what the reorganization plan's terms look like. Once that plan is filed with the bankruptcy court, creditors get an opportunity to vote on that plan, and if it's approved, the debtor will then need to fulfill its financial obligations. Keep in mind that these plans don't always get approved during their first go-round, and that the creditors' committee will sometimes advise creditors to reject a plan if it isn't in their best interest.

How do companies decide between Chapter 7 and Chapter 11?

The decision to file for Chapter 7 versus Chapter 11 boils down to the financial state of the company, and whether staying operational is feasible in light of it. The benefit of filing Chapter 11 is that a company can continue to operate, and it gets more of a say in the bankruptcy process.

Often, companies that go through Chapter 11 recover and stay in business. Take GM, for example, which is alive and well 10 years after filing for bankruptcy. In fact, many companies that wind up liquidating don't start out that way, but rather are forced into going that route when they're unable to reorganize their debts. For example, Lehman Brothers filed Chapter 11 but ultimately wound up liquidating.

What happens to creditors during a bankruptcy?

As an investor, owning stocks or bonds from a company that goes bankrupt can be nerve-racking. And in some cases, losses are unavoidable. But that doesn't mean that your investments are totally worthless, either. The amount you'll receive in a bankruptcy will depend heavily on the class of claim you fall into and the type of bankruptcy at hand. The following is a hierarchy of who gets paid first in a corporate bankruptcy:

Secured creditors (typically banks or mortgage lenders).
Bondholders.
Preferred stockholders.
Stockholders.

Secured creditors, like banks or mortgage lenders, own debt backed by collateral. It's common for secured creditors to fully be made whole in a Chapter 7 or Chapter 11 bankruptcy, since they have the option to reclaim the assets they helped finance.

Bondholders are usually next in line to get paid. As a bondholder, you'll stop receiving interest and principal payments during a company's bankruptcy proceedings. Then, depending on the plan of reorganization or liquidation, you'll get paid out to the extent that the company's finances allow. In a Chapter 11, you might also receive new bonds in exchange for your old ones, the terms of which might be more or less favorable depending on how the bankruptcy plays out.

In the case of a Chapter 7 filing, however, you won't receive new bonds because the company is going out of business. In that case, you might receive just pennies on the dollar for your bonds' face value. It will all depend on how much assets the debtor has available for debt payoff purposes.

Following bondholders, preferred stockholders generally get paid next in a bankruptcy. Preferred stock is essentially a hybrid investment between a stock and a bond. Investors are guaranteed a certain rate of return on preferred stock, whereas dividends for common stock are not guaranteed.

As you might imagine, owning common stock in a bankruptcy isn't a great spot to be in, because it means you're last in line to be paid. Furthermore, just as bondholders don't received interest payments during a bankruptcy, dividends are also put on hold for stockholders.

The extent to which your shares of stock will be worth something following a bankruptcy will depend on the financial picture of the debtor. In a Chapter 7 liquidation, common stock often becomes completely worthless, though in some cases, stockholders do get paid a little something. In the case of a Chapter 11, you might get some value out of your stock, or you might be asked to give up your existing shares and instead accept new shares as the company in question emerges from bankruptcy. The value of those new shares, however, will once again depend on what the company's finances look like.

Can you invest in bankrupt companies?

When a company files for Chapter 11, its securities may continue to trade. However, companies operating under Chapter 11 often fail to meet the listing requirements for the Nasdaq or the New York Stock Exchange. As such, bankrupt companies often find themselves delisted. Once that happens, you can still buy their stock, but you'll need to do so over-the-counter, which means through a broker or dealer as opposed to a public exchange. As such, as an investor, you may not be privy to the same level of details or disclosures about your investment as you would when buying a security that trades publicly.

For example, when a stock is sold on a public exchange, you can see exactly what price it's trading at. When it's sold privately, you don't get such information, and so you might end up overpaying for it.

Why might you buy a bankrupt company's stocks or bonds? In the case of stocks, you might snag a really low share price, and in the case of bonds, you might manage to purchase them far below face value. If you've been researching a bankrupt company and think that at some point, those stocks or bonds will be worth more than what you pay for them, then you could make money by investing. But know that doing so is an extremely dangerous move in most cases, especially if you're not already a seasoned investor.

Trade claims: an unconventional way to invest in bankrupt companies

Trade claims are debts due to a company's vendors, suppliers, and service providers. For example, if a bankrupt company orders stationery from a small paper vendor, that vendor might have an outstanding claim for unpaid invoices during a bankruptcy filing. As such, that vendor might be desperate to get its money, especially if those outstanding invoices represent a large chunk of its incoming receivables.

Now, if that vendor waits out the bankruptcy proceedings, it might get paid some or all of its money. But that could take months, or even years. Therefore, if you have cash on hand to invest, you might contact that vendor and offer to buy its claim for a certain percentage of its total value. Once that claim is assigned to you, you can then hold on to it in the hope that you'll get paid more from the debtor than what you paid for the claim.

Here's how that might play out. Imagine John's Paper Shop is owed $10,000 by Company X, which is in the midst of a Chapter 11 bankruptcy. Since debtors are required to file a schedule of liabilities, you, as an investor, have access to its open trade claims. You might then contact John's Paper Shop and offer to buy that claim for $0.20 on the dollar, or $2,000. If John's Paper Shop needs money, and isn't sure what that claim will be worth at the end of the bankruptcy proceeding, it might agree. You would then sign a contract assigning that claim to you, and hope that it's worth more than $2,000 at the end of the day.

Depending on how a bankruptcy plays out, claims can be worth 100%, or pretty close to their full value. In other cases, you might have a bankruptcy where general trade claims are worth 50% of their original value. Either way, know that while buying trade claims is technically something you can do as an individual, it's a practice generally best left to larger investment firms or hedge funds -- powerhouses with the capital to buy those claims at scale, and with the knowledge to price those offers just right to come out profitable.

Corporate bankruptcy and your taxes

The IRS allows you to claim capital losses on your tax returns, which means that if you buy stocks or bonds, and then sell them at a price that's lower than what you initially paid, you get a tax break out of the deal. Therefore, if you're sitting on a bankrupt company's stocks or bonds, selling them at a loss can help lower your taxes as a consolation prize of sorts.

Keep in mind that if you sell your stocks or bonds at a certain price, rather than hold them and see how the bankruptcy plays out, there's a chance you'll end up losing out -- meaning, those securities could be worth more under a company's reorganization plan than what you can sell them for. But if you're looking at capital gains in your portfolio, selling a bankrupt company's stocks or bonds at a loss might allow you to offset those gains, thereby avoiding taxes on them.

Even if you don't have gains to show, you can use up to $3,000 in capital losses to offset that much money in ordinary income. This means that if you take a $5,000 loss and have no capital gains, you can use $3,000 of that $5,000 to cancel out earnings from your job. You can then carry the rest of that loss forward to future tax years.

If you aren't able to sell your stocks or bonds at a loss (say, there's really no buyer because they're truly considered worthless), or if you hold on to those securities through a bankruptcy only to find that they're worthless at the end of those proceedings, you also have options. Essentially, what you'd do then is treat those assets as if they were sold for $0 for tax purposes. If you go this route, you'll need to be prepared to show the IRS that those securities are truly worth nothing. You'll also need to determine the date on which they lost their value.

How to avoid bankruptcy-related investment losses

Buying stocks and bonds is a good way to generate income and build wealth -- provided the companies that issue them don't crumble to pieces. What can you do, as an investor, to avoid losses related to corporate bankruptcies? For one thing, research the companies you're investing in. Most businesses don't go from healthy to bankrupt overnight, so read those financial statements and keep up on company news. A series of dreadful earnings reports or product updates could be a sign that a company is headed toward an unfavorable financial fate, in which case it might pay to get out before things truly get ugly.

Signs of financial mismanagement should also be a red flag. Enron, for example, employed a complex (and ultimately fraudulent) accounting system prior to its bankruptcy that was confusing to company shareholders and analysts alike, to the point where it just wasn't clear how the company was actually earning its money. A few months before its filing, the company also amended financial statements from previous years that painted a less rosy financial picture.

Company credit ratings

If you're in the market for corporate bonds, researching companies' credit ratings can help you prevent losses. There are three notable ratings agencies that rate bond issuers:

Standard & Poor's
Moody's
Fitch

S&P and Fitch use a similar system that rates bond issuers from least risky to most risky:

AAA
AA
A
BBB
BB
B
CCC
CC
C
D (refers to bonds that are already in default)

The Moody's rating system differs slightly:

From there, numbers or symbols are used to further explore companies' creditworthiness. S&P and Fitch use pluses and minuses for this purpose, while Moody's uses numbers.

For example, a B+ rating from S&P is better than a B or B-, while a Ba1 from Moody's is a more favorable rating than Ba2 or Ba3. The lower a company's credit rating, the greater its chances of filing for bankruptcy or encountering some other scenario where it's unable to make good on its financial obligations. Furthermore, bonds from companies with a rating below BBB- by S&P and Fitch, and Baa3 by Moody's, are considered "junk bonds," or below investment grade.

Keep in mind that a company might start out with a favorable credit rating but get downgraded over time. For example, Enron's credit rating was downgraded to just a couple of notches above junk two months before it filed for bankruptcy. It was then downgraded all the way into junk status right before its filing.

Pay attention to your investments, and if you own bonds issued by a company that starts out with an A rating but starts creeping toward junk territory, consider getting out before those bonds are truly worthless.

The bottom line on corporate bankruptcy

When a company you've invested in files for bankruptcy, you might regard that as the worst news possible. But remember: Not all bankruptcies have an unhappy ending. Many companies that go through bankruptcy emerge stronger and go on to thrive, and it's often the case that creditors come out fairly -- or even wholly -- unscathed following a Chapter 11 filing.

Furthermore, if you're a savvy enough investor, there is the possibility of capitalizing on a corporate bankruptcy by buying up cheap stocks, bonds, or even trade claims.

And if you'd rather not experience corporate bankruptcy from the investor side, do your research and keep tabs on your investments -- you might manage to get out before a bankruptcy filing even comes into the picture.

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Maurie Backman owns shares of General Motors. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.