FOOL ON THE HILL
When Companies Go Bankrupt

The emails are rolling in. "Should I invest in Kmart? It's so cheap!" A few hundred bucks on a bankrupt company may not seem like a big risk, but the chance of positive return is near zero. When a company goes bankrupt, it has an order of priority for creditors to be repaid, if there is anything left, then common stock holders get a portion of that for the newly formed company. This, however, is extremely rare. Usually they get nothing.

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By Bill Mann (TMF Otter)
January 29, 2002

The emails are already coming in. There are certain high-profile companies that are so cheap that people can't help but wonder if they would be worth throwing a few dollars at "just to see."

You know which companies I'm talking about. Enron (OTCBB: ENRNQ), Kmart (NYSE: KM), and now Global Crossing (NYSE: GX), all of which are massive companies that have filed for bankruptcy protection against creditors. Sure, these companies are only a few pennies a share, but you've got to buy a bunch of shares in order for it to make a difference, and then, the chance of loss is still nearly 100%. Look at it this way: does it matter if you have 5000 shares of Global Crossing at $2500 or one share of Berkshire Hathaway (NYSE: BRK.A) for the same amount? The chance of Berkshire going to zero is next to nil, the chance of Global Crossing being anything but zero is just as remote. In the end, $2500 is $2500.

Putting some money in these companies is a bad idea, a monumentally bad idea. You are going to lose it all, so don't.

A rough bankruptcy primer
When companies file bankruptcy what they are saying is that their assets are insufficient to cover their debt obligations. Companies will go through every financial strategy possible before filing for Chapter 11. What is confusing is that Chapter 11 is the vehicle companies use when they hope to reorganize and continue operations, to "emerge from bankruptcy." If the company cannot generate enough capital to pay off its creditors, then it will slide down the scale to Chapter 7, complete liquidation.

eToys ended up here, so did Iridium (the new Iridium came from an asset sale from the liquidation, it has no relation to the earlier company that collapsed under $5 billion in debt). In some cases the company may emerge, but it is really quite rare for the shareholders to come along for the ride. That's because equity shareholders are quite literally the last people in line to receive something from the bankruptcy. Behind the debt holders, behind the merchant creditors, behind the trustees, behind the employees, behind the tax man, and even the preferred shareholders.

Chapter 11 works this way: The bankruptcy filing can either be voluntary, filed by the company, or involuntary, in which companies holding credit claims can petition the courts to force the distressed company into bankruptcy. In Chapter 11, unlike Chapter 7, the debtor company remains in possession of its own assets, under the administration of a court appointed trustee. The bankrupt company must then file a plan of reorganization with the bankruptcy court. If any of the creditors are to receive less than full value for their claims, they will have the right to vote on their acceptance. After the vote, the court can then elect either to accept or reject the plan. In other words, the company has some leeway in designing the plan, but if it requires too steep of a haircut by certain creditors, the company has little chance of getting an approval by a committee of creditors, much less the courts.

And this is why equity holders nearly always get reduced to zero. In most cases, the company will have to sell off assets in order to raise money to pay creditors. In almost all cases, these proceeds are going to be insufficient to pay off all prioritized creditors in full (after all, why else would the debtor had to file in the first place?), which means that they can take either a reduced amount of money, or they can agree to take some equity in the reorganized company.

In either case, the current equity shareholders would be counting on the priority creditors' sense of charity in order to be included in the recapitalized company.  I dare say that there are less sure things that one could count on, but I can't think of any off hand. There is nothing that says the creditors must include the existing shareholders -- even the insiders' stakes are reduced to zero value. That's how priority works: those higher in the food chain eat until they are satisfied, and then each subsequent group gets its turn until either the carcass is picked dry or all of the groups have been paid to their satisfaction. It goes without saying that it is rare for creditors to leave money on the table.

Book value doesn't help
This is, of course, a highly simplified look at bankruptcy. There are some great resources out there if you'd like to get more acquainted. But the point is: unless you are convinced that the company can generate enough cash through sale of assets to meet the requirements of ALL creditors, then there is no reason at all to invest. And please, for the love of God, DO NOT use the Book Value number. That is an accounting convention that includes things such as goodwill and other things that cannot easily be sold, such as in process R&D.

Book value is a useful proxy for an operating company, it is a miserable one to approximate liquidation value. Particularly as, in a distressed sale, the purchasers are not generally all hot and bothered to OVERPAY for assets. They buy off of liquidations to get the assets on the cheap. This, for example, is how I knew that PSINet was not going to survive. When PSINet began selling non-core assets to raise cash to cover its obligations, the bidding companies refused to pay more than 50 cents on the full value of the assets. But PSINet was forced to sell, so the purchasers had the upper hand. The same goes for companies that are in bankruptcy protection.

Occasionally a company emerges from bankruptcy with some pre-existing shareholders receiving something. This very thing happened with Covad (OTCBB: COVD), where the shareholders were significantly diluted, but did receive something. This is the exception, not the rule. It's sort of like betting on the slow and lame horse in a race: there is of course a CHANCE it could win, but that's not the way to bet.

So, potential speculators, bottom dwellers, and dumpster divers, the answer is that as a rule, investing in bankrupt companies (or even soon-to-be bankrupt companies) is a horrible idea. I'm in fact baffled that the SEC and the exchanges even allow companies in Chapter 11 to trade at all -- the implied return on the vast majority of these companies is exactly zero.

So don't do it. Please.

Bill Mann, TMFOtter on the Fool Discussion Boards

Moral bankruptcy? Bring it on! Bill Mann owns shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.