Stocks are one of the most popular types of investment. Trillions of dollars are invested annually in the stock market as people chase the fortunes of individual companies and ride the rise of entire industries. Now more than ever, the tools for investing in stocks are available to everyone via online stock brokers and trading apps, bringing us all just a few taps away from investing in stocks.
When you buy shares in an individual company, that means you’re on board with that company’s future, through both ups and downs, until you sell that share. If the company does well, you do well — your shares rise in value and likely pay out more dividends, too. If the company doesn’t do well, neither do you — your investment declines in value.
What happens if the company begins to seriously struggle, however, and you hold the stocks? What if that company declares bankruptcy? Is your stock investment in that company now worthless?
What happens to a stock when a company goes bankrupt?
First of all, let’s look at what exactly bankruptcy means in the United States. Bankruptcy is a legal process to help organize a financially troubled individual or business. According to the United States Courts, bankruptcy laws “protect financially troubled businesses.” More specifically, “[b]usinesses may file bankruptcy under Chapter 7 to liquidate or Chapter 11 to reorganize.”
What that means is that there are two distinct types of bankruptcy that a business can file to protect itself when it’s in serious financial trouble. Chapter 7 bankruptcy occurs when the company is unable to continue operating and must sell off assets to pay its creditors as much as it can. Chapter 11 bankruptcy occurs when the company believes it can continue to operate and simply needs legal help in reorganizing its business.
How do those two different plans affect your stock? Let’s look at each case.
What happens to stock when a company files Chapter 11 bankruptcy
When a company files for Chapter 11 bankruptcy, it’s an indication that the company still believes that it can be a viable business, but it needs legal help to fix the financial situation it finds itself in. Often, this is due to a company accumulating more debt than it can easily pay with current revenues.
In this situation, the shares of the company still retain a small amount of value, but they tend to drop below $1 a share, even as low as $0.10 per share, and become very speculative investments. Few people want to buy shares in companies that are in such deep financial trouble, after all, and lots of investors want to sell, so the price falls dramatically.
There are three reasons for this dramatic drop. One, obviously, is that the company is at serious risk of going completely out of business, rendering the stock worthless. Another risk is that, as part of Chapter 11 bankruptcy, a company may restructure itself in such a way that the old shares of stock are canceled and become worthless, even if the company remains alive. In addition, the company may also choose to issue many new shares as a way to partially pay creditors, which also drives the value of shares downward.
So, if you hold a share in a company that is filing Chapter 11 bankruptcy, the price will drop dramatically, often down to as low as $0.10 per share. These shares may end up being canceled — becoming valueless — depending on how the bankruptcy proceedings go.
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Sometimes, companies emerge from Chapter 11 bankruptcy without canceling the original shares. In those situations, the value of the shares rebound rapidly.
Should you sell your shares if you hold shares in a company that is in Chapter 11 bankruptcy? The returns will be very small, as the price of a share will have declined to a fraction of a dollar in most cases. However, you would be able to claim the money you lost as a tax deduction, which would reduce your tax bill.
Sometimes, however, the company is not able to fix itself and then files for Chapter 7 bankruptcy.
What happens to stock when a company files Chapter 7 bankruptcy
In Chapter 7 bankruptcy, a company recognizes that it is no longer a viable business. A bankruptcy filing at that point is simply a legal process by which its creditors — the individuals and businesses that the company in question owes money to — are paid.
Aren’t shareholders also creditors? After all, they own shares in that company, which were bought at some point during their initial offering.
Chapter 7 bankruptcy does consider shareholders to be creditors, but they are the lowest priority creditors. Other creditors — the ones that loaned the company money, such as banks and individuals who own corporate bonds — get their money first, and they often don’t get everything that they’re owed.
If a company pays off all of its creditors and still has a pool of money left over after selling all of its assets, that remaining money may be split as a final payment among all shareholders, after which the stock is canceled and becomes valueless.
There is usually no option to sell shares of a company in Chapter 7 bankruptcy, as the shares are essentially worthless outside of a chance of a single small payment. However, you will be able to claim the full amount that you invested as a tax deduction, which will help with your income tax bill, so you will get some value out of the situation.
How to reduce your risk of being affected by company bankruptcy
The specter of bankruptcy may make many individual investors wary of stock market investments. What can an individual investor do to minimize their risk of investing in companies that may go into bankruptcy? Here are three strategies to consider.
Know the basics of investing before you jump in
The first tool is always knowledge. Before you invest in anything, you should know the basics of investing, including simply knowing what you need to know about a company before investing in its stock. Knowledge is always king.
Don’t invest in the shares of individual companies
Another strategy is to simply avoid investing in individual companies and instead spread out your investment risk by using mutual funds or index funds. That way, an individual bankruptcy won’t hurt much at all, plus you’ll own a little bit of companies that are doing very well to counterbalance it.
Owning index funds is a particularly smart move for investing for retirement, as it provides a very easy way to spread out your risk without requiring you to study investments each day. It’s a good “set it and forget it” strategy.
Don’t follow pop culture trends or even business headline news
A final strategy is to ignore pop culture trends when investing, including even the business news and headlines. Those headlines are not only sometimes misleading as to the actual health of the company, you usually hear them far after professional investors have already acted on the news.
Instead, if you really want to invest in individual companies, study the business side of the companies themselves, not what’s popping up in the news. Look at their financial numbers and SEC filings and annual reports. This circles right back to the opening strategy: knowledge is always king.