What Happens When a Stock Goes Bankrupt?

When a company can no longer meet its financial obligations, it may seek bankruptcy. This legal process allows businesses to either reorganize debts and operations or liquidate assets to repay creditors. Understanding its implications for individual stock shareholders is important. The outcome for investors depends heavily on the type of bankruptcy filed and the company’s financial structure.

Shareholder Outcomes in Different Bankruptcy Filings

Corporate bankruptcy in the United States typically falls under two main categories: Chapter 7 and Chapter 11, each carrying distinct consequences for shareholders. Chapter 7 bankruptcy involves the complete liquidation of a company’s assets, leading to the cessation of its business operations. A trustee sells assets, and proceeds are distributed to creditors by priority. Shareholders are at the bottom of the payment hierarchy, almost invariably receiving no compensation after creditors are paid.

Chapter 11 bankruptcy allows a company to continue operating while it develops a plan to restructure its debts and reorganize its business. This process aims to give the company a chance to become profitable again. For shareholders, outcomes in Chapter 11 are varied, though often unfavorable. While the company restructures, its stock may continue to trade, usually at a significantly reduced price and without dividends.

In many Chapter 11 reorganizations, existing shares are canceled entirely, especially if the company is insolvent. This means shareholders lose their entire investment. Alternatively, a reorganization plan might propose converting existing shares into new, often heavily diluted, shares in the reorganized entity. Even if old shares are exchanged for new ones, the valuation of these new shares is typically much lower, reflecting the company’s distressed financial state. In rare instances, shareholders might receive some compensation, but this is uncommon.

Hierarchy of Creditor Payments

The “absolute priority rule” dictates the strict order in which claims are paid during bankruptcy proceedings, explaining why shareholders often receive nothing. Creditors are classified into various tiers, and each tier must be paid in full before the next lower tier receives any distribution.

Secured creditors stand at the top of this hierarchy. These are lenders with a lien on specific company assets, such as real estate or equipment, as collateral. If the company defaults, secured creditors can seize and sell the collateral to satisfy their claims before other creditors.

Following secured creditors are administrative expenses, which include costs incurred during the bankruptcy process. These are priority claims. Examples include legal and accounting fees, court costs, and wages for services rendered after the bankruptcy filing. These expenses are considered essential for preserving and managing the bankruptcy estate.

Unsecured creditors come next, including bondholders, suppliers, and general lenders who do not have collateral backing their debts. Within the unsecured category, some claims may have priority status, such as certain tax obligations or employee wages, before general unsecured creditors are paid. Shareholders are considered residual claimants, meaning they are last in line. They only receive a distribution if any assets remain after all other creditors have been paid in full, which is rare.

Tax Consequences for Shareholders

When a stock becomes worthless due to a company’s bankruptcy, investors may claim a “worthless stock deduction” on their federal income taxes. The IRS treats a security that becomes completely worthless during the tax year as though it was sold on the last day of that tax year, allowing shareholders to recognize a capital loss.

To claim this deduction, the shareholder must establish the stock became worthless in the tax year claimed. This can be evidenced by events like the company ceasing operations, a liquidation, or the shares having no market or liquidation value. A deduction is not allowed for partially worthless stock or a decline in value due to market fluctuations.

The capital loss from worthless stock can first be used to offset any capital gains the investor has in the same tax year. If capital losses exceed capital gains, taxpayers can deduct up to $3,000 of the remaining loss against their ordinary income each year, or $1,500 if married filing separately. Any unused capital loss can be carried forward indefinitely to offset capital gains or up to $3,000 of ordinary income in future tax years. Shareholders report worthless securities on IRS Form 8949, transferring the summarized loss to Schedule D. IRS Publication 550 provides guidance.

Market Status of Bankrupt Stock

When a company files for bankruptcy, its stock’s market status changes, affecting where and how its shares can be traded. Companies facing bankruptcy often fail to meet listing requirements of major exchanges like the NYSE or Nasdaq. Their stock is typically delisted.

Despite being delisted, the stock may continue to trade on over-the-counter (OTC) markets, such as the Pink Sheets or OTCQB. Trading on these markets involves less stringent financial reporting or minimum price requirements. To alert investors, shares of bankrupt companies trading OTC often have a “Q” appended to their ticker symbol.

Trading in bankrupt company stock is speculative and carries substantial risk, as the value is usually very low and volatile. Shares stop paying dividends once bankruptcy proceedings begin. In some cases, trading may cease entirely if the shares are canceled as part of a reorganization plan or if they are deemed to have no value during liquidation. Investors considering these shares are betting on a successful reorganization or an improbable recovery, often understanding their investment could become worthless.