Corporate bankruptcy is the process that companies or individuals opt for when they are unable to pay their debts to their creditors on time. It is a difficult time for companies or individuals and creditors, but for investors, it is an opportunity. Potential investors should do their due diligence and thorough research on whether the reorganised company is a good investment plan or not. Hence, it is important to be informed of the relevant laws and their applicability and other factors that an investor should look for. The Insolvency and Bankruptcy Code, 2016 can rely on the U.S. Insolvency Code because of its innovative mechanism for bankruptcy.
Types of Corporate Bankruptcy
There are two types of Corporate Bankruptcy under the U.S. Bankruptcy Code:
Under Chapter 7:
Under this Chapter the company is liquidated, hence business operations are stopped completely and its assets are put up for sale by the trustee that has been appointed by the court. The proceeds from the sale are distributed among its creditors as the seniority of the debt. Priority debts are paid first, followed by secured debts. Any non-priority debts or unsecured debts are paid from the remaining debts. Therefore, the stockholders get little to nothing according to the priority basis, while bondholders and secured creditors may receive a fraction of their investments.
Under Chapter 11:
Chapter 11 deals with ‘reorganisation’ of the company, and the business operations of the company may continue, aiming to meet its financial obligations and get out of its financial distress. The company’s assets may still be sold under section 363 with the approval of the court. However, this is not beneficial to the shareholders as there may be insufficient funds to repay the debts of the creditors. The shareholders may exchange old shares for new shares that would be worth less than the old shares and bondholders may receive new bonds or stocks
Priority of Claims in Corporate Bankruptcy
Here mention about priority rule that dictates who gets paid first
- Secured Creditors: Secured creditors are usually banks or financial institutions that have lent the company funds with assets as collateral. This is the reason they are paid first. Secured creditors have lesser risk than bondholders and accept low interest rates in exchange for the added safety of assets being pledged against corporate obligations.
- Bondholders: Bondholders are included in unsecured creditors, and have relatively lower risk due to fixed interest payment they are the next on the list. They do provide the company with loans or goods, but without any collateral, therefore they have a lower priority in comparison to secured creditors.
- Preference Stockholders: Preference shareholders have priority over the company’s incomes, which means they are paid before common shareholders but after bondholders. Preference shareholders are unsecured creditors who fall within the category of non-priority claims.
- Common Stakeholders: Common shareholders’ stocks do not have much weight in corporate bankruptcy and are paid last. Whether it be Corporate Bankruptcy under Chapter 7 or Chapter 11, common shareholders will unlikely receive any returns on their investments. The liquidation assets that remain usually go to secured creditors, bondholders, and preferred shareholders.
Differences in Payment Between Chapter 7 and Chapter 11
Chapters 7 and 11 are two common methods for a company to declare corporate bankruptcy.
Companies or individuals can opt for bankruptcy under Chapter 7 when they are past the state of recovery and have an option but sell off their assets to pay their creditors. The business operations of a company come to an end and its assets are sold to its creditors. The Corporate Bankruptcycourt appoints a trustee to ensure that the creditors are paid as per the repayment plan. The company will continue to operate under Chapter 11 as it deals with reorganisation and the inclusion to create a play to repay its creditors under the supervision of the court. This type of bankruptcy is chosen by companies rather than individuals because it is a more costly and complex form of bankruptcy. Companies here have a chance to reemerge as a healthy business. If the process fails, the assets are liquidated and the stakeholders are paid off as per their priority basis.
Chapter 7 Bankruptcy: What Happens to Investors?
Chapter 7 deals with the liquidation of the company. A bankrupt trustee is appointed by the court to liquidate the company’s assets and distribute the proceeds on a priority basis. The shareholders are last on the list after secured creditors, and unsecured creditors, such as bondholders. Preference stockholders and common shareholders are considered as ‘non-priority’ and may receive nothing from the proceeds of the sale of the liquidation assets.
Chapter 11 Bankruptcy: How It Impacts Investors
Investments under this Chapter may fluctuate as it depends on the reorganisation plan. This could mean that the value of the assets may drop or the issuance of new securities, warrants, or shares with a reduced equity value. Therefore, investors should monitor the reorganisation, directly contact the company representatives and attend meetings, receive quarterly reports, etc. or if they are unable to contact the company’s representatives, an investor can review court filings.
Real-World Examples of Bankruptcy
Cryptocurrency exchange FTX filed for Chapter 11 bankruptcy in November 2022. When they filed for bankruptcy, the employees were informed through Twitter, having no indication of whether their unpaid salaries, holiday pay, etc would be recovered. Referencing the priority list, shareholders have a lower priority in comparison to secured creditors. This is represented in the collapse of the Silicon Valley Bank in Santa Clara, California, and Signature Bank in New York City. In March 2023, the U.S. Government announced that it was stepping in to protect its depositors, but not protecting their shareholders and certain unsecured debtholders.
How Bankruptcy Affects Stock and Bond Prices
If the company and the court retain the shareholder’s rights to equity, the shares may diluted. This means that there are either fewer shares, the existing shares have less value or both. Stocks under Chapter 7 usually indicate that your money may not be recovered, Bonds may receive a fraction of their face value, but it is not something to be expected. If there are funds remaining from selling the liquidation assets, the stockholders will be notified and they can file a claim. Hence it is recommended that investors avoid investing in bankrupt stocks.
Read more : Liquidator: Powers and Functions under IBC
What Happens to Your Investment
Investments are dependent on whether filing for bankruptcy is under Chapter 7 or Chapter 11. The chance of recouping your investment under Chapter 7 is low there may be a chance that you may not see your money at all. Shareholders may receive nothing from the proceeds of the liquidation assets sale as they are paid after secured creditors, bondholders, and unsecured creditors. As per reorganisation under Chapter 11, the company may be able to recuperate, which means that your investments may be successful. Hence, the ‘old company’ after its reorganisation is a ‘new company’ with the help of the investors. However, the likelihood of a successful comeback is low, and it is important to keep in mind that if your investments go to a bankrupt company, there are tax considerations, such as capital loss, the stock that may be ‘useless’, and other tax implications.
What Should Investors Do During Bankruptcy?
Investors should evaluate their options and take the appropriate steps when the company is going through bankruptcy. If it is a Chapter 7 bankruptcy, shareholders are the last to receive the proceeds from the sale of its liquidation assets. Here, investors should sell any shares they may have before they become ‘worthless’. Chapter 11 bankruptcy attempts to restructure or reorganise the company. Hence, there is a small chance that the funds may be recovered, but old shareholders may lose equity in this process. if the company’s prospects are too bleak, it might be better to abandon your investment entirely than be dependent on the chance that your funds will be recovered. In the majority of cases, the best option for investors is to cut their losses.
Conclusion
Corporate bankruptcy is not a good sign for any investor. To understand the bankruptcy process and the restructuring plan, investors should understand Chapter 7 and Chapter 11. Companies that file for Chapter 11 bankruptcy often mean that investments may be at risk and can lead to financial loss rather than profit. However, Chapter 11 is better for investors than Chapter 7, but not ideal. Investors can make more informed decisions regarding their investments if they monitor the bankruptcy process and the assessment of the restructuring plan.