Understanding Bankruptcies As An Investor

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 |  Includes: AAL, KODK, LEHMQ, TRIDQ
by: Paulo Santos

Upon writing 2 other articles on an interesting pattern that happens to a stock when a well-known company goes bankrupt (“Surprised By AMR Going Up?”, “Prepare To Buy Kodak”), I’ve had tremendous feedback through the comments these articles generated.

Now, from these comments it has also come to my attention that bankruptcies are very badly understood, leading to ill-informed trades, some of which might well account for the pattern I described.

This article is thus to address some of the most often raised doubts. Things like “it’s still operating, so can’t the stock be worth something?”; “what will happen to the stock?”; “I own bonds, what will happen to them?”; “If the stock is still trading, can’t it recover with good news?”.

There are many bankrupt stocks still trading, from the recent bankruptcies of AMR Corporation (AMR, now AAMRQ.PK in the pink sheets) and Trident Microsystems (TRID) to stocks of companies that have already gone bankrupt years ago, like Lehman Brothers (OTC:LEHMQ). There are also quoted stocks of companies rumored to possibly file for bankruptcy in the short term, like Kodak (EK).

Now, the first thing to understand about corporate bankruptcies is that there are two modes to them: Chapter 11 and Chapter 7. Most bankruptcies you’ll see in the market will be Chapter 11.

The difference between Chapter 11 and Chapter 7

In a Chapter 7 bankruptcy, the company will be liquidated, its assets (which can be entire divisions, still operating – mind this) will be sold, and the proceeds divided between the stakeholders obeying to a scale of seniority, in which shareholders are the lowest rung – the last to get paid.

In a Chapter 11 bankruptcy, however, the company keeps operating. A Chapter 11 bankruptcy is a reorganization, which tries to restore economic viability to the company by reorganizing operations, shedding contracts and liabilities, and establishing a new financial structure for the company. Here, too, the stakeholders get compensated by order of their seniority. But since the company keeps operating, paying suppliers and employees, and most importantly, its stock keeps on trading, there can be a lot of confusion amongst trades as everything looks normal.

Bankruptcy process, Chapter 11

But everything is not normal. While the company keeps operating, a judge will be deciding on who gets what on the new financing structure with which the company will be emerging from chapter 11. A bankruptcy plan will be drafted, and in this plan an attempt will be made to make the pre-bankruptcy creditors (as well as debtor-in-possession financers) whole.

As said before, this plan will take into account the seniority these creditors had going into the bankruptcy process. First, the collateralized creditors will be made whole, then the senior creditors, then junior / unsecured creditors. Only after all these classes have been made whole will there be an attempt to leave some crumbs to shareholders, and even there, preferential shareholders are senior to common shareholders. Bear in mind that equity in the company is also used to make the creditors whole, which means that usually at the end of the process new shares are issued to the creditors, and the old – still trading – shares are canceled. This is where those shares that are still trading really become a zero.

What if there’s equity before the bankruptcy?

Many times traders are somewhat confused by the fact that there might still be (and this is usual) positive book value when the company files for bankruptcy. This can be illusory. Not only are there assets that really don’t have much value under bankruptcy, like goodwill and intangibles, but also many other assets on the balance sheet are usually realized at values that are lower than they had been valued for. This is easy to understand on inventory liquidation sales, where goods are deeply discounted, but can happen to many other assets as well.

Also, some liabilities can show up in the bankruptcy process that weren’t on the balance sheet when the company filed. Things like attorney fees, off balance sheet liabilities, or severance clauses when employees are let go.

So the equity can quickly vanish, and again, shareholders can be left with nothing even though there was equity on the balance sheet coming into the bankruptcy process.

So why don’t the stocks go to zero right away?

There are many reasons, from ill-informed traders, to short covering due to the margin requirements of keeping a position open in these equities, to the fact that in some rare cases, there can be some value left for old shareholders.

How often does it happen that old shareholders retain some value? Statistics on this are hard to come by, but according to a study done in 2001, “Penny Stocks of Bankrupt Firms: Are They Really a Bargain?” out of 154 cases, in 93 (60%) cases old shareholders were totally wiped out. And this was during the asbestos litigation period, where some viable firms, like USG Corporation (NYSE:USG) filed Chapter 11 just to limit their legal exposure, so the true ratio is probably more like 90%.

Anyway, in some rare cases after the bankruptcy process is done, there can be value left for shareholders, from keeping their shares though heavily diluted, to getting a small slice of the new shares, to getting warrants (options to buy calls) on the new shares, usually out of the money. This also means that every bankruptcy is a special case, and obviously either there’s a lot of equity left, making it possible for shareholders’ claims to still have some value, or there needs to be hidden assets, not fully accounted for in the balance sheet, able to provide that equity. This, for instance, could be the case in a Kodak bankruptcy, with the patents having value not yet recognized, although this is made problematic because Kodak already has a shareholder deficit even before the negative effects on equity described further back in this article.

What about the bonds?

As I said, the bankruptcy process tries to make creditors whole. The bonds represent credits, and, according to their seniority they can have different recoveries. The more senior and collateralized they are, the higher that recovery will be, and there can even be classes that get paid at par.

Distressed investing, however, is a complex field. There needs to be a very detailed knowledge of the assets in play, of all the debts and respective seniority in play, to have a decent estimate of how much each class of debt will recover. And that recovery rate varies wildly.

Still, it’s important to understand that debt does usually have value even if the company is bankrupt, contrary to equity (stock), which is most often wiped out entirely or gets just symbolic payouts.

And specific examples?

In the article I have already named several stocks that are presently undergoing chapter 11 or might file it soon. For instance:

AMR Corporation (AAMRQ.PK)

AMR entered chapter 11 with negative equity of close to $5 billion dollars, and no discernible hidden assets. It's thus very likely that it will have its entire equity canceled during the bankruptcy process.

Trident Microsystems (TRID)

TRID entered bankruptcy with a full $124 million in positive equity. However, it also carries $52 million in intangible assets, it's burning a lot of equity per quarter and some of the assets might be questionable (receivables from related parties - almost $48 million). This might be one of those examples where even though there's apparently significant equity before the company files, the shares will still be canceled and worthless.

Lehman Brothers (OTC:LEHMQ)

Lehman Brothers has already seen its CDS settle at 8.625% of par, with such a low recovery on debt it's a full certainty that all the equity will end up worthless and canceled.

Kodak (EK)

Kodak, which hasn't yet filed for chapter 11 but is rumored being close to it, already has a slight equity deficit of $1.65 billion, being made larger by continuous losses. It also carries $285 million in goodwill on its books, and predictably some of its $892 million in inventories would probably be written down. Yet, if EK does file chapter 11, there's some uncertainty as to whether all its old stock will eventually be canceled. This happens because Kodak has a large portfolio of patents whose value might vary wildly and be severely underrepresented in its balance sheet. Such value could be enough for some of the equity to survive, or maybe for the old stock to get some warrants on the new stock, during the reorganization.

Conclusion

In a bankruptcy (chapter 11), companies keep operating but that doesn’t necessarily mean their stocks – which also keep on trading – have value. The most likely outcome is for the old stock to be canceled, effectively being wiped out, at the end of the bankruptcy process. It is thus a losing preposition to buy bankrupt stocks on false hopes of good news.

Sometimes, however, there can be bankrupt stocks which will retain some value after the bankruptcy process. This usually happens with companies that have assets greatly in excess of their liabilities, as some assets will lose value under bankruptcy and some new liabilities will be created by it. This means that each bankruptcy is unique, and although speculating on bankrupt stocks will most often be a losing proposition very unlikely to pay off, sometimes it will actually work.

Finally, even though the bankrupt stocks will most often end up worthless, such is not the case with the debt of bankrupt companies. There is usually some recovery, which can even be high in the case of the most senior / collateralized debt. Again, however, the recovery rates vary wildly and it takes a lot of analysis to know, in each case, how much can be expected to be recovered.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.