What Happens to Stock If a Company Goes Bankrupt?

When a company faces financial distress and cannot meet its obligations, it may file for bankruptcy. This reshapes the company’s financial structure and impacts all stakeholders, particularly shareholders. The bankruptcy process is designed to address the company’s inability to pay its debts, often by reorganizing its operations or liquidating its assets. Understanding this process is essential for investors, as it directly impacts their equity holdings.

Corporate Bankruptcy Processes

In the United States, corporate bankruptcies primarily occur under two chapters of the U.S. Bankruptcy Code: Chapter 7 and Chapter 11. Each chapter outlines a distinct path for distressed companies, with different outcomes for the business and its creditors, influencing the fate of equity.

Chapter 7 bankruptcy involves the liquidation of a company’s assets. Under this process, a court-appointed trustee takes control of the company, sells its non-exempt assets, and distributes the proceeds to creditors according to a legally defined priority. The company ceases all operations and is dissolved. For shareholders, a Chapter 7 filing almost always results in their stock becoming worthless, as there is typically no value remaining after creditors are paid.

Chapter 11 bankruptcy is a reorganization process, allowing a company to restructure debts and operations while continuing to operate. The company, often referred to as the “debtor in possession,” typically retains control of its assets under court supervision. The goal of Chapter 11 is to develop a reorganization plan enabling the company to return to profitability and satisfy obligations. While reorganization is the intent, a Chapter 11 case can convert to Chapter 7 liquidation if a viable plan cannot be achieved or is not approved by the court and creditors.

The Priority of Claims in Bankruptcy

The distribution of a bankrupt company’s assets is governed by the “absolute priority rule” or “liquidation waterfall.” This rule dictates the order in which creditors and shareholders receive payments from remaining assets. Compliance with this hierarchy is mandatory in both Chapter 7 and Chapter 11.

Higher-priority claimants must be paid in full before lower-priority claimants receive any distribution. The typical order of priority for claims is:

• Secured creditors, such as lenders holding collateral, paid from the proceeds of their collateral.
• Administrative expenses, which include costs incurred during the bankruptcy process, such as legal fees, trustee fees, and other necessary operational expenses.
• Unsecured creditors, which typically include bondholders, suppliers, and general trade creditors.
• Within this category, certain claims, like employee wages and specific tax obligations, may receive priority over other unsecured claims up to certain limits.
• After all creditors have been satisfied, preferred stockholders have a claim to any remaining assets.
• Common stockholders are at the very bottom of this payment hierarchy, meaning they only receive a distribution if all higher-priority claims have been paid in full and assets still remain.

Because most of a bankrupt company’s assets are consumed by higher-priority claims, common stockholders frequently receive nothing.

Impact on Stockholders

When a company files for bankruptcy, the impact on stockholders is often severe, due to their position at the bottom of the liquidation waterfall. For common stock, the outcome is typically bleak: shares are usually rendered worthless and cancelled. This occurs because company assets are almost always insufficient to satisfy creditor claims, leaving no residual value for common shareholders. Even if the company successfully reorganizes under Chapter 11, the original shares are commonly extinguished, and new shares may be issued, often to creditors who become the new owners.

Preferred stock, while having a higher claim than common stock, is subordinate to all creditors. Consequently, preferred stockholders frequently receive little to nothing in bankruptcy. In some Chapter 11 reorganizations, preferred stockholders might receive a small recovery, possibly as new equity in the reorganized entity or a cash payment. This is not guaranteed and depends on the reorganization plan and asset availability after higher-priority claims are addressed.

A consequence for a bankrupt company’s stock is delisting from major stock exchanges like the NYSE or Nasdaq. Companies often fail to meet listing requirements, such as minimum share price or financial reporting standards, once they enter bankruptcy. After delisting, the stock may trade on over-the-counter (OTC) markets, sometimes called “pink sheets,” and often carries a “Q” at the end of its ticker symbol to indicate its bankrupt status. Trading on OTC markets means less liquidity and transparency.

The possibility of common shareholders receiving new equity in a Chapter 11 reorganization is rare. This typically occurs only if all higher claims are fully satisfied, or as part of a specific reorganization plan where creditors agree to provide a nominal recovery to common shareholders. Such instances are uncommon because the absolute priority rule generally prevents lower-priority claimants from receiving any value if higher-priority claims are not paid in full. Therefore, for most investors, a company’s bankruptcy filing signals the loss of their equity investment.