FOOL'S SCHOOL DAILY Q&A

When Good Stocks Go Bankrupt

Options for investors

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By Ann Coleman (TMF AnnC)
October 24, 2001

Q. What happens to a company's stock after it declares bankruptcy? If I own stock in a bankrupt company, what are my options? --A.M.

A. Options? You may have options, but then again, you may not. It depends on what type of bankruptcy the company has filed. Some companies continue to trade right through a bankruptcy and emerge later with stock that is actually worth something. That's a Chapter 11 "reorganization" type of bankruptcy where the company is still a going concern.

In a Chapter 11, the company continues to operate while it attempts to work out a solution to its debt problems. (This is similar to Chapter 13 bankruptcy, which applies to individuals.) The company files a reorganization plan that must be approved by the bankruptcy court, and is protected from its creditors while the reorganization is taking place. With luck the company will return to profitability under the reorganization plan.

That doesn't always happen, of course, but as long as a resurrection is considered possible, a bankrupt company may continue to trade. The Nasdaq and the New York Stock Exchange may "delist" a company that is in serious financial trouble and/or no longer meets their minimum listing requirements, but if the company is still doing business it can trade "over the counter." Bankrupt companies trading on the Nasdaq exchange have the letter Q added to their stock symbols.

So in a Chapter 11 bankruptcy, you do have options. You can sell your shares in the bankrupt company and take your tax loss (more about that later), or, if you think that the bankrupt company has a good chance of getting back on its feet, you can hold your shares in hopes that the return to profitability will be swift. (There isn't much point in holding if you expect that the return will be slow -- i.e., that your investment will return less than the market as a whole.) I don't recommend holding unless you have sound reasons for believing that the company will bounce back from bankruptcy quickly.

While a Chapter 11 bankruptcy offers little hope for the investor, a Chapter 7 bankruptcy offers none. Chapter 11 cases that cannot be resolved can be converted to Chapter 7, or a company can file for Chapter 7 bankruptcy directly when reorganization is not a viable option. In Chapter 7 a trustee is appointed to oversee the liquidation (sale) of all of the company's assets and the distribution of the proceeds to the company's creditors.

There are strict rules about how the money is distributed. As a shareholder you are the owner of the company and entitled to any value left over after all other debts have been discharged. That's usually not much. In fact, it's usually not anything. Secured creditors get paid first (banks, mortgages, etc.). Unsecured creditors, including bondholders, are next. Shareholders are last on the list. They stood to make the most if the company were successful, so they lose the most when it is not.

While all this is happening, either the company or your broker will inform you of the company's moves, so you won't be in the dark.

If a company you own stock in declares a Chapter 7 bankruptcy, you don't have much in the way of options.  The only good news is that you get a tax deduction -- and that really isn't such terrific news. The procedure for claiming the loss is the same as if you'd sold the stock, except that you use the last day of the year in which the stock became worthless as the sale date, and you write "worthless" for your sale price. Your capital loss will be equal to the cost of the stock including commissions. This loss will be used to offset any capital gains you may have had that year.

If you end up with a net capital loss on all stock transactions for the year, up to $3,000 of that loss can be used as a tax deduction against your regular income. If the total capital loss is greater than $3,000, it can be carried forward year after year as a $3,000 deduction against each year's taxes until it is used up. The end result is that you can get back from 10-38% (depending on your tax bracket and the year you claim the loss) of the price you paid for the stock.

Tax deductions are always nice, but really, there are better ways to get them. And if you are holding the bankrupt stock in an IRA, you can't deduct your loss at all. (No capital gains, thus no capital losses.) All that boring financial stuff we Fools keep prattling on about -- debt ratios and profit margins and burn rate -- it's there to help you spot the warning signs before a company gets into deep trouble.

Ann Coleman learned about corporate bankruptcy following the adventures of Lernout & Hauspie Speech Products, a company she bought 10 shares of because she liked the idea of owning a speech recognition company with the stock symbol LHSP. It's now LHSPQ, Other stocks she owns can be viewed in her personal profile. The Motley Fool is investors writing for investors.