The Motley Fool Previous Page

When Companies Go Bankrupt

Bill Mann
September 16, 2008

In the first half-hour of trading today, Lehman Brothers (NYSE: LEH  ) , which filed for Chapter 11 this morning, saw its shares drop 94% to somewhere in the neighborhood of $0.20. A year ago, shares traded for around $58.

And there are investors who are wondering right now if it would be worth throwing a few dollars at Lehman "just to see." After all, it's not to zero yet.

Stop right there
We've been here before: Enron, Kmart (which later merged with Sears Holdings (Nasdaq: SHLD  ) ), Delta Air Lines (NYSE: DAL) -- all massive companies that filed for bankruptcy protection against creditors.

When they filed, their shares sold for only pennies apiece. And while Kmart and Delta were ultimately able to rise again in different forms, that didn't mean the original shareholders got anything. In fact, shares in both companies were canceled in the resulting deals.

Sure, Lehman's shares are exceedingly cheap right now, but you'd have to buy a bunch of shares for it to make a difference, and the chance of loss is still nearly 100%.

Look at it this way: Would you rather have more than 20,000 shares of Lehman for $4,000 or one share of Berkshire Hathaway (NYSE: BRK-B  ) for the same amount? The chance of Berkshire going to zero is next to nil; the chance of Lehman being anything but zero is just as remote. In the end, $4,000 is $4,000.

Buying shares of companies in bankruptcy is a bad idea, a monumentally bad idea. You're probably going to lose it all -- and here's why.

A rough bankruptcy primer
When companies file bankruptcy, what they're saying is that their assets are insufficient to cover their debt obligations -- and they'll go through every financial strategy possible before filing for Chapter 11. What can be 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 can't generate enough capital to pay off its creditors, then it will slide down the scale to Chapter 7, complete liquidation.

Complicating matters slightly in this discussion as it pertains to Lehman Brothers is the fact that brokers are treated slightly differently from other operating companies. To protect their clients' assets, brokers are not allowed to declare Chapter 11 -- they go straight to Chapter 7. That's why the Lehman situation is still pretty fluid: It's trying to reorganize at its parent-company level while keeping its brokerage operations out of bankruptcy. Keep watching.

Mortgage company New Century ended up in Chapter 7; so did IndyMac Bank. In some cases the company may emerge, but it's 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. They're behind the debt holders, behind the merchant creditors, behind the trustees, behind the employees, behind the tax man, and behind even the preferred shareholders.

Here's how Chapter 11 works: 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 have the right to vote on that plan. 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 a haircut for certain creditors, the company has little chance of getting it approved 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 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 have 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