How Corporate Bankruptcies Affect Your Investment
What Happens to Bondholders, In the Event of a Company Filing for Bankruptcy?
A public company filing for bankruptcy affects everyone that has a stake in it, right from its employees to its creditors to its bondholders. The following general information will serve to assist bondholders in understanding what could happen to their investments, in such an eventuality were to occur.
Ques. What exactly is bankruptcy?
Ans. Generally, bankruptcy is the inability of a company to pay off its debts, as and when they become due. Public companies file for protection under the federal bankruptcy laws, whenever their liabilities or debts exceed the value of their assets, or they are unable to pay their bills. A bankruptcy filing allows the company to reorganize its business, in the hope of returning to profitability, or completely shutting down operations and selling off assets, using the sale proceeds to pay off debts, in a process called liquidation.
Ques. What happens when a company files for bankruptcy?
Ans. Public companies are allowed to file for bankruptcy protection under either Chapter 7 or Chapter 11 of federal bankruptcy laws.
In order of priority…
In a bankruptcy, assets and proceeds are distributed to satisfy claims in order of claim priority. Investors who took the least amount of risk receive payment first. This means, after legal and administrative costs have been covered, creditors and bondholders who lent company money will be paid, and then stockholders, who bought an ownership stake in it.
Under Chapter 7, a corporation is liquidated after federal courts have determined a company re-organization is not worthwhile. Court-appointed trustees liquidate all company assets and distribute the proceeds to satisfy claims. Claims considered in order of their priority are as follows:
1. Secured creditors with claims protected by specific assets or collateral, such as real estate, get paid first.
2. Next in line, unsecured creditors, such as, bank lenders, bondholders and suppliers get paid.
3. Stockholders, who purchased a portion of the company, are paid last, if any money is available after secured and unsecured creditor claims have been paid.
Under Chapter 11, a company attempts to re-organise and operate as before, with management continuing to run day-to-day operations, but only a bankruptcy court can approve all major business decisions.
The US Trustee Programme, a part of Department of Justice oversees the administration of bankruptcy cases, and establishes and oversees several committees to represent the interest of parties, including creditors, such as banks and bondholders, and stockholders. The committees work together with the company to develop a re-organization plan, which must be approved by creditors, and stockholders, including receiving confirmation from the bankruptcy court. However, even if some of the groups vote to reject the plan, the court can approve it, if it believes the plan treats creditors and stockholders fairly.
Ques. What will happen to my bonds?
Ans. Bonds represent debt, a company has agreed to repay with interest. As such, when a company files for federal bankruptcy protection, bondholders have a better chance of getting repaid than stockholders. While, bankruptcy laws determine the order of repayment, stockholders, considered owners of the company, have the last claim on assets.
In a Chapter 7 bankruptcy, bondholders may receive a portion of the value of their bonds. After receiving notification of the bankruptcy filing, bondholders should file a claim, in order to receive a payment, if any cash is still available after paying off other expenses.
When a company fails to pay principal and interest when due, a default occurs. In a corporate bankruptcy or liquidation, although secured creditors, bondholders and holders of other senior debt issues may receive some distribution of corporate assets, it is rarely enough to make whole their total investment. In default company bonds trade at very low prices, if they trade at all resulting in liquidity disappearance.
Even after a company has filed for bankruptcy under Chapter 11, its bonds are allowed to continue to trade. However, bondholders stop receiving principal and interest payments, causing a default to occur. As well, the value of the securities could decline sharply and trading could be extremely limited.
In addition, as a part of court-approved re-organization, bondholders may receive new stock, new bonds, or a combination of new stock and bonds in exchange for their bonds. It is well to bear in mind that new securities may be worth less than the old ones.
Ques. How do I know if a company has filed for bankruptcy?
Ans. Investors often learn of bankruptcy filings from various news reports. However, if you hold bonds through a broker, your broker will contact you and forward information from the company. If the bonds are held in your name, then you will receive information directly from the company. Contact your brokers or investment advisors, if you do not receive any information from the company.
As well, investors may be asked to vote on a company’s re-organization plan. Before doing so, a copy of the plan and a ballot, as well as, a court-approved disclosure statement and information on any court hearings on the plan’s confirmation and deadlines for filing objections to the plan should have been received by you.
If securities lose their value due to bankruptcy filings, investors may be able to take an income tax deduction for worthless securities. An accountant, tax or bankruptcy attorney or investment advisor can provide additional information, or the Internal Revenue Service can be contacted for information and publications to find out if your securities meet the IRS criteria.
Visit www.irs.gov for information and forms on worthless securities.
Ques. How can I find out more information?
Ans. The U.S. Bankruptcy Courts provides a listing of the bankruptcy courts in each region, as well as links to their Web sites. The Administrative Office of the U.S. Courts website also provides information on bankruptcy procedures, as well as, official bankruptcy forms, including a creditor’s proof of claim form.
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