For those who want to lnow more about Bankruptcy
Bankruptcy and The Risk of Common Stock
27-Nov-01 09:37 ET
[BRIEFING.COM - Robert V. Green] For those investors holding stocks of companies headed into or already in bankruptcy, an understanding of how bankruptcy works is essential. For all holders of common stock, it is important to know that you are the "last in line" when it comes to bankruptcy proceedings. Here's how it works.
Declaring Bankruptcy
Bankruptcy becomes an option when a company realizes that it cannot pay all of its obligations from a combination of cash flow and cash reserves. The bankruptcy option allows a company to suspend and restructure existing obligations to allow the company to either continue operations or dissolve.
Bankruptcy proceedings are defined by federal law for publicly traded companies. Management of the company declares bankruptcy by filing a petition in Federal court.
Generally, the time sequence to enter bankruptcy follows these basic steps:
Company realizes it has financial problems that cannot be addressed through normal business operations.
Company files Chapter 11 or Chapter 7 bankruptcy petition
Chapter 7 is giving up: The company ceases operations, sometimes immediately, liquidates (sells) everything and distribute proceeds to the claimants.
Chapter 11 is reorganization: The company continues operations, but stops paying all debt interest and dividends, and restructures the debt and equity of the company to an "equitable" new level.
The court approves the bankruptcy petition and the company officially is in bankruptcy.
During the entire time of bankruptcy, between the approval of the filing of the initial petition and the approval of reorganization or liquidation plan, every step of operation of the company, and payment of company funds, must be approved by the court. In essence, the court has complete control of the company during the bankruptcy period, although plans for management and operational decision making are submitted to the court, and generally do not originate there.
Purpose of Bankruptcy
Chapter 11 bankruptcy exists to allow a company to reorganize claims against it, in order to allow the company to continue operations. Bankruptcy is not designed to fully relieve a company from its obligations, but instead allows restructuring in order to permit the company to make good on its obligations under new payment schedules.
The common perception that debts are simply "forgiven" in bankruptcy stems from personal bankruptcy concepts, not corporate bankruptcy proceedings.
What are the company's obligations? Claimants file petitions to the court to make their claims. Generally, all claimants in a single class are organized together.
The Priority of Claims
Federal law establishes the hierarchy of claims against the company. Claims of a higher priority must be paid or settled before claims of the lower priority.
The basic principle behind all bankruptcy claim payments is simple:
The higher the level of risk assumed in a transaction with the company, the lower the level of claim in bankruptcy
This principle makes the assumption that the claimant, when he/she first made their deal with the company, negotiated a price which accounted for the level of risk they were assuming in the transaction.
The following table lists the priority of claims, by class of claimant.
Claim Priority Level Group Claim Comment
1. IRS 100% of unpaid taxes of all kinds. No surprise; the government wrote the laws.
2. Employees Any outstanding claims related to payroll, accrued vacation, pension contributions. 100% is generally paid. Affects only payments for existing work already performed. In Chapter 11, payroll and benefits continue to be paid unaffected. Jobs are not guaranteed, however. Employees are rarely paid less than 100% of outstanding balance. Also, while the cash value of contributions to a 401(k) plan are secured, the value of the investment after purchase, for example, in company stock, is not. Management bonuses are frequently excluded. Option value is not included nor considered. Options are on common stock, (see which).
4. Debtors-in-Possession Creditors 100% regardless of whether secured or not. Includes persons lending money to a company during bankruptcy. They get first priority over all other claimants other than employees, since risk is highest.
5. Secured lenders Full outstanding balance, up to day of filing. Leases for real estate and equipment. Often current amounts continue to be paid through bankruptcy, and full amount owed is carried over, with security, into post-chapter 11 operation. (This means secured lenders effectively lose nothing if company exist Chapter 11 successfully.)
6. Vendors Outstanding balance up to day of filing. Frequently settled for less than the full amount, in exchange for a cash payment at time of approval, any excess amount owed is wiped off the books of the company.
7. Bondholders Principal, plus unpaid interest Frequently bondholders will accept partial cash payment with equity in the company issued in exchange for the unpaid principal amount.
6. Preferred Stock Liquidation preference, as stated in stock agreement, plus accrued dividends, if any. In many cases where debt payment is the cause of bankruptcy, there is little left after the above claimants have been settled, so the preferred stock has little bargaining position. Often restructured into common stock, with dividends wiped out upon exit on bankruptcy. For these reasons, preferred stockholder in public companies often have veto rights over debt issuance.
8. Common Stock Level of claim is on whatever is left over, after all of the above classes of claims have been settled. Each share Rarely is anything left. In Chapter 11, if bondholders accept equity in exchange for debt, any amount left over can be assigned to common stock. Often, there is no value remaining.
Priority of Claim
In the table above, it is important to realize, each level of claimant is entitled by law to 100% of their claim, before anyone below them gets anything. It may be in their interest to accept less than 100% of their outstanding claim, but the starting point for all claims is 100% of any outstanding balance.
It is also important to note:
Common stock is at the very bottom of the list.
Most claimants settle for less than the full amount of their claim, at the time of bankruptcy. The reason is that few companies can pay off 100% of any claim below the vendor level. Any claimant who insists on 100% of their claim risks throwing the company into liquidation.
Therefore most bondholders and claimants subordinate to bondholders settle for something less than the full amount owed to them, with some mechanism designed for them to possibly recover the unpaid balance over time, either through equity, or restructured debt or dividends.
The Process - Chapter 11
When a company enters bankruptcy, the future ownership structure is eventually determined by a court.
A "Plan of Reorganization" is submitted by management of the company to the court. Management generally tries to come up with a plan which will be acceptable to vendors and bondholders, prior to submission. A plan which is submitted to the court with the support of the major claim holders will generally be accepted by the judge.
The timeline for the court's process follows this basic outline:
Plan of reorganization submitted
Claimant parties either file statements of agreement to the plan or objections, and submit an alternate plan.
Judge reviews and either accepts, requests new plan, or writes own plan (rare).
The judge's decision is generally final, although an appeals process exists.
The approved reorganization plan is put in place, the company is recapitalized, new securities are issued, old securities are cancelled.
Company emerges from bankruptcy and continues operations.
Chapter 7, the alternative, is simply to sell everything and divide up the proceeds according to claimant's claim levels. In some cases, if the parties cannot agree on a Chapter 11 plan of reorganization, the bankruptcy court will order a Chapter 7 liquidation and the company is dissolved.
Common Stock Comes Last
As a common stock holder, you must realize that Chapter 11 bankruptcy law places your claim on the company assets after all other claims.
This is a fundamental principle of bankruptcy law. Your ownership of the company can be drastically reduced and even removed entirely.
In many cases, existing common stock holders do not lose their entire value, but are simply diluted to such an extent as to render the shares worthless. For example, common stock holders may hold 100% of equity in a company prior to bankruptcy, but only 1% afterwards, as equity is transferred to bondholders. The smallest shareholders don't even show up in the eighth decimal point of percentage ownerships. Those shares can be unilaterally cancelled by the bankruptcy court in exchange for a modest payment or even nothing at all. If this happens, you have no recourse as a common shareholder.
However, in some cases, common stock ownership is wiped out entirely. If the total valuation of the company is far less than the total debt owed, the equity value of the company may be transferred to the bondholders. With no existing value left for common holders, their ownership can be cancelled entirely.
Exodus Communications As Example
Exodus Communications filed bankruptcy on September 26, 2001. At that point, all bond payments and bill payments stopped, and the company filed a bankruptcy petition with the court. The company will now submit requests to make payments on bills and other expenses while in bankruptcy, and every payment must be approved by the court. Eventually a plan of reorganization will be submitted to the court.
The total debt owed by Exodus exceeds $3 billion. The total value of the company is probably in the $1 to $1.5 billion range, given a price/sales ratio of about 1.0. If the company were liquidated, bondholders would receive, at best, one-third of the amount owed to them. It is likely that bondholders, as a class, will approve a plan that gives them continuing debt of approximately $1 to $1.5 billion outstanding. This leaves them with another $1 to $1.5 billion still owed to them. In exchange for that amount, the bondholders may accept equity in the company instead.
Since the entire company is only worth about $1 to $1.5 billion, the bondholders will likely wind up owning the entire company. Common stockholders will be able to make a claim on whatever is left over, which is likely to be nothing. The company issued a statement to this effect on November 12, possibly concerned that the stock was still trading at a price that assumes there will be at least $100 million in value left over for existing common stockholders. The only possible explanation for this statement is that the company is perplexed that the stock still trades at $0.10 per share, and wants to avoid future liability by making it clear to holders of EXDSQ that their equity is almost certain to be wiped out, as bondholders claims are settled.
Is It Fair?
The investing world is a risk/reward proposition.
Common stock always gets the reward of all the upside. When a company grows in value, the newly created wealth is reflected only in the value of the common stock (and in preferred stock). None of the new value is reflected in the bonds. Although the credit rating may go up, the interest payments do not.
The flip side of this is that the common stock has no downside protection. When the company fails, common stock has no risk protection.
From the email we have received it is clear that many common shareholders holding stock in bankrupt companies do not feel it is fair to pay bondholders in equity and recapitalizing a company.
Is it fair? Definitely. When you capture all of the upside, it is only fair that you also capture all of the downside.
Investors often ask, "How low can the price go?" The answer, for common stock holders of bankrupt companies, is "Zero."
Comments may be emailed to the author, Robert V. Green, at rvgreen@briefing.com |
