What Happens When a Company Files for Bankruptcy?

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If you want to know what happens when a company files for bankruptcy and what that means for its business, shareholders, creditors, and investors—you’re at the right place.

Keep reading to learn about the types of bankruptcy, how they differ, and how they affect a company and its assets and stocks, as well as who gets paid first and in what order.

We also included a few tips to protect yourself when doing business and what to do if a company that owes you money files for bankruptcy protection.

What Does Bankruptcy Mean?

Bankruptcy is a legal proceeding handled by a federal court and filed by companies that have severe financial difficulties and can’t meet their immediate financial obligations.

When this happens, bankruptcy allows companies to reorganize debt so they can get back on track, or liquidate their assets and pay back debts.

However, not every situation is the same, and the possibility of creditors, shareholders, and bondholders regaining their investment depends on several factors.

DID YOU KNOW? The number of total commercial business bankruptcy filings nationwide during January and February 2022 was 2925. Most of these filings were Chapter 7, and the total number is in decline compared to the first two months of the previous years.

What Happens When a Company Files for Bankruptcy

When a company is facing financial trouble and insolvency, filing for bankruptcy protection can either make it go out of business or give it a chance to reorganize debt, cut its costs, and improve its financial situation.

Types of Bankruptcy

Depending on whether there is no way for the company to solve its cash flow issues or there is still hope for the business to rise from the ashes, one of the following types of company bankruptcy is in place.

Chapter 7 Bankruptcy

When a company files for a Chapter 7 bankruptcy, it means it completely stops its business and a court-appointed trustee is in charge to liquidate assets and distribute the funds to the company’s creditors.

When a company files for bankruptcy under Chapter 7, there is little chance for stockholders to get their investment back. The payment of the debt and obligations comes in a certain order, and which creditor will be paid off first depends on the type of its business loan and how it works.

The first to obtain what they’re owed are the secured creditors who loaned the money requiring some type of collateral, like a mortgage on the company’s property.

After all of them are settled, the unsecured creditors take their portion of the cookie if there’s anything left. Unsecured creditors are lenders that don’t have any guarantee in a company’s stake. This also includes bondholders, although bonds are seen as a debt that the company needs to repay with interest.

In the case of corporate bankruptcy, only after all of the above-mentioned creditors are settled, do stockholders come next.

Stockholders are not creditors, but owners of a certain share of the company. Although they have higher gains when things are going well, they also carry more risks, so keep this in mind when deciding whether investing or saving is a better option for you.

Chapter 11 Bankruptcy

This type of bankruptcy doesn’t mean the company is going out of business. It may be experiencing financial trouble and rising operating expenses, but it can still recover, although it has to reorganize debt, cut the losses, and increase income by selling a portion of the business, being acquired by some other business, or closing its least profitable part.

When bankrupting a company under Chapter 11, part of the reorganization can also include the debtor assuming or rejecting its contracts that haven’t been fully executed. However, there are special rules in place when this contract happens to be an intellectual property agreement where the debtor is the licensor.

Even if companies that file for Chapter 11 bankruptcy unexpectedly end up in liquidation, the company’s management can choose the liquidation company and to whom it will sell its assets, including intellectual property, brand name, and customer base. On the other hand, in the case of Chapter 7 bankruptcy, the court-appointed trustee handles all the liquidation.

Filing Corporate Bankruptcy

When in financial trouble and faced with insolvency, companies will often start renegotiating credit agreements to provide better conditions to emerge from debt. But this won’t always work. Depending on the situation, companies may decide to file for bankruptcy protection under Chapter 7 or Chapter 11.

Although the two types are different, what they have in common is that the federal court puts a stop to debt collection from the companies’ creditors. 

In the case of Chapter 7 bankruptcy, a court-appointed trustee will take care of the liquidation of the debtor’s property and the priority to pay back debts. On the other hand, when a company declares bankruptcy under Chapter 11, a US trustee forms a creditors committee that reviews the debtor’s decisions while considering the creditors’ interests. Sometimes, there can be two committees—one formed from secured creditors, and another from the unsecured creditors.

Other than the Official Committee of Unsecured creditors, there can also be a committee of stockholders, as well as an additional commission for a specific class of creditors. Although all committees must agree on the reorganization plan before the court confirms it, a federal court may confirm the plan even if the stockholders don’t agree with it if it finds to be fair to all parties involved.

Unfortunately, when a company goes bankrupt, that doesn’t mean that its debts are going to be paid in full. The amount of debt that can be resolved depends on the value of the company’s assets and the amount of money it owes. The U.S. Bankruptcy Code defines the priorities for paying company creditors, so the likelihood of creditors collecting their debt depends on where they stand compared to other creditors regarding this code.

DID YOU KNOW? Although undergoing a bankruptcy is stressful and undesirable from many aspects, some companies or even individuals perceive it as a “get out of jail free” card, so there are many types of bankruptcy fraud.

What Happens to Stock When a Company Goes Bankrupt

Here are the most common consequences:

  • Stock Delisting

Although no law states that companies filing for bankruptcy can’t be traded, they will most likely have trouble meeting the listing standards of the biggest stock markets. They can be delisted from NYSE and Nasdaq, but their shares may still be available on other stock exchanges.

  • Decreased Value of Stocks

Any company declaring bankruptcy will most likely experience a decreased value of its stocks. Also, the stockholders and bondholders won’t receive any payments during the bankruptcy procedure.

  • Cancellation of Stocks and Bonds

When a debtor goes into reorganization in the attempt to become profitable again within Chapter 11 bankruptcy, the stocks and bonds are usually canceled.

  • Stockholders May Lose Their Investment

Even if the company going bankrupt under Chapter 11 doesn’t go out of business—not right away at least—the value of its shares is predicted to decline. If the court declares the debtor insolvent, stockholders may lose their investment, in which case investors’ rights will be explained in the reorganization plan.

After the reorganization, new stocks are issued and investors can exchange the old ones for the new ones, which are usually fewer and have a lower value. Bonds can also be exchanged for new stocks, bonds, or a combination of both.

It’s important to differentiate between the canceled and new stocks of the same company that declares bankruptcy. Whereas the old ones will end with a “Q”, the new stocks that may not be issued just yet, but are authorized will have a ticker symbol ending with a “V” that stands for “when, as, and if issued.”

  • Stockholders May Not Be Notified of the Bankruptcy According to Chapter 7 Bankruptcy

In case of a business going bankrupt under Chapter 7 bankruptcy protection, the company has no obligation to inform the stockholders, as it’s not obligated to pay them if the stocks decline in value.

If this happens, the stocks are most likely worthless, so knowing where and how to get a tax consultation free of charge is great if you need advice on how to handle worthless securities in your income tax return.

How to Get Out of Bankruptcies

If you’ve invested in a company, the last thing you want to happen is for it to go into a corporate bankruptcy process, because this most likely means that you’re going to lose your investment. However, this depends on the type of investment you made, but also on the type of bankruptcy that’s at stake.

If you provide a company facing financial trouble with your goods or services, or you’re a creditor when they file for bankruptcy, you’ll get a notice from the court that you’re listed. You need to file your claim, together with the documentation proving the debt the company has to you.

In some cases, the company going bankrupt may not list you as a creditor. If this happens, and you learn about their bankruptcy, make sure to obtain their case number so you can file your claim as soon as possible.

Although this doesn’t guarantee that you’ll get paid, it gets you in line with other creditors. Depending on whether you’re a secured or an unsecured creditor, along with other factors, you may regain some or all of your funds.

We included a few tips that will allow you to protect yourself and get the most out of your investment in case of public company bankruptcy:

Trade Credit Insurance (TCI)

If you’re conducting extensive business with a company, you can opt for trade credit insurance that protects the creditor when the client fails to pay. There are different types of TCI policies, so make sure to choose the one that’s best for your situation.

Retention of Title Clause

You can include this as part of the contract in your business deals to make sure you stay in possession of your goods until they’re fully paid by the client. At the very least, this will keep you away from the unsecured creditors’ list if a company goes illiquid.

Key Takeaways

What does it mean when a company files for bankruptcy depends on the bankruptcy type. Chapter 7 means the company goes completely out of business, while under Chapter 11 the company is trying to reorganize and try to make its business profitable again.
When in financial trouble and unable to keep up with its rising operating expenses, companies may decide that the best thing to do is file for bankruptcy protection.
The bankruptcy process is handled by federal courts which put a stop to all debt collecting outside the process.
The U.S. Bankruptcy Code determines the priority among creditors, so not all of them are going to be paid in full, and some may not get paid at all.
The stocks of a company that files for bankruptcy usually go down in price, and some may lose their value altogether.

Wrap Up

When a company faces bankruptcy, it’s important to know what to expect if they owe you money or you invested in their stock, whether it’s just recently or you’re one of the long-time investors.

After this article, you’ll be able to understand the important aspects of both types of bankruptcy, how they differ, and who has the priority when a company has limited assets to pay off debts.

FAQ

If a company goes bankrupt, who gets paid first?

First in line are the secured creditors, followed by unsecured creditors that also include bondholders. After that, stakeholders may receive a portion of their investment, if there’s any money left after the liquidation of the debtor’s property and paying the prioritized categories.

What happens to 401k if a company goes bankrupt?

A 401k is held separately from your employer’s assets and it can’t be touched by its creditors in case of bankruptcy. However, a variety of situations describing what happens when a company files for bankruptcy can affect your 401k as well, like it containing your company’s stock, so make sure to double-check its status.

How does bankruptcy affect creditors?

After entering the bankruptcy process, a federal court stops all creditors from trying to retain their money outside the process. Lenders who have secured their loans with collateral are more likely to regain their money than the ones with unsecured loans, but it depends on the amount of money the company has to pay back debts.

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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