Should I Sell My Stock if a Company Files Chapter 11?

When a company files for Chapter 11 bankruptcy, it often creates uncertainty and concern for its stockholders. Chapter 11 represents a form of reorganization bankruptcy, rather than a complete liquidation, where the company seeks to restructure its debts and operations to achieve long-term viability.

What Chapter 11 Means for a Company’s Stock

A Chapter 11 filing typically has an immediate and significant impact on a company’s common stock. While the company continues its operations as a “debtor in possession,” its stock usually experiences extreme volatility and a sharp decline in market value. Trading of the stock may continue on exchanges or over-the-counter markets, but the underlying value becomes highly speculative.

Existing common equity is generally considered junior to all forms of debt, meaning shareholders are at the bottom of the repayment hierarchy. Consequently, during the reorganization process, it is common for existing shares to be canceled entirely or significantly diluted. Shareholders face a high risk of their investment becoming worthless, even if the company successfully emerges from bankruptcy. Any recovery for common shareholders is typically contingent on the company having assets that exceed all creditor claims once a plan is confirmed.

Hierarchy of Claims in Chapter 11

Understanding the hierarchy of claims is fundamental to grasping why common stock often loses its value in Chapter 11 proceedings. When a company undergoes reorganization, its assets are distributed to various claimants in a specific order of priority.

Secured creditors hold the highest priority, meaning they have a legal claim against specific assets of the company, such as property or equipment, which serve as collateral for their loans. These creditors must be satisfied in full before any funds can be distributed to lower-priority claimants.

Following secured creditors are unsecured creditors, which include suppliers, employees for unpaid wages, and bondholders. For common stockholders to receive any value from their investment, all secured and unsecured creditors must be paid in full, or agree to a settlement that leaves some value for equity. This scenario is rare in most Chapter 11 cases, as companies often file for bankruptcy because their liabilities exceed their assets, leaving little or no residual value for common shareholders.

Assessing Your Stock’s Value and Future

Realistically assessing the current and potential future value of stock in a Chapter 11 company requires careful attention to the bankruptcy proceedings. Investors should monitor filings with the bankruptcy court, which often include detailed disclosure statements and proposed reorganization plans. These documents provide insight into the company’s financial state and and how different classes of creditors and equity holders are expected to be treated.

The future of your stock hinges significantly on the specific terms of the confirmed reorganization plan, which is a blueprint for the company’s recovery. This plan outlines how the company will restructure its debt, fund its operations going forward, and how existing equity will be handled. It might propose canceling existing shares, issuing new shares, or a combination of both, often resulting in severe dilution.

Evaluating the company’s assets, its overall debt burden, and the viability of its proposed restructured business plan is also important. Market sentiment regarding the company’s chances of successfully emerging from bankruptcy and operating profitably will also influence any remaining stock value. News releases from the company and official court announcements can provide valuable updates throughout this complex process.

Making a Decision About Your Stock

Deciding whether to sell or hold stock in a company undergoing Chapter 11 depends on individual financial circumstances and risk tolerance. Selling the stock, even at a significantly reduced price, offers certainty and allows investors to realize a definitive loss. This action can be beneficial for tax purposes, as capital losses can be used to offset capital gains and, to a limited extent, ordinary income.

For instance, individual taxpayers can deduct up to $3,000 of net capital losses against their ordinary income annually, carrying forward any excess losses to future years. However, selling also means forfeiting any potential, albeit remote, recovery if the company’s reorganization plan unexpectedly assigns value to existing equity.

Conversely, holding the stock is a highly speculative gamble, betting on a rare scenario where common equity retains or regains value post-reorganization. This choice might be made if an investor believes there is an extremely small chance of a favorable outcome or if they wish to defer the recognition of a loss for tax planning purposes. Ultimately, the decision involves balancing the desire to realize a tax benefit or avoid further monitoring against the slim prospect of a future recovery.