The Impact of Bankruptcy on Shareholders

Companies that file for bankruptcy also have a capital structure just like normal companies. This means that their capital structure is comprised of debt as well as equity. In the past few articles, we have been continuously talking about the interests of the debt holders i.e., how they will get paid in the event of liquidation or reorganization.

However, up until now, we have completely ignored the issue of shareholders. This is because shareholders are not considered to be beneficiaries of a bankrupt company. Their needs and preferences take a back seat during the entire process. In this article, we will explain exactly how shareholders’ interests are affected as a result of the bankruptcy process.

Dividends are Stopped Completely

The interests of shareholders are negatively impacted during the bankruptcy process. This is because when a company files for bankruptcy, they usually have more liabilities than they have assets. Also, their cash flow is inadequate at that point in time. Hence, any cash flow that a company has is used to pay back the debt holders first. As per the companies law, the company does not have any obligation to make payments to the shareholders. The company is supposed to pay the shareholders only when they are making profits and have excess money. Hence, in the event of a bankruptcy, any dividend payments are stopped. This pause on dividend payments is likely to continue for a long time i.e., till the company comes out of reorganization. This has a massive negative impact on the shareholders who are dependent upon the dividends for their monthly income.

Equity Gets Wiped Out

It is important to realize that a company only files for bankruptcy when they have zero or very little equity left. In most cases, the value of the shareholder’s investments gets completely wiped out. There are many investors who purposely buy stocks in companies facing bankruptcy. This is done since these stocks are selling for a few pennies on the dollar. Hence, if the company survives, there might be a tremendous upside. However, this kind of investing needs a lot of skill and patience. In 90% of companies facing bankruptcy, shareholders stand to lose all or most of their money! The skill lies in identifying the balance 10%.

Equity May Get Diluted

Even if the value of the equity is not completely wiped out, it stands to get severely diluted during the process. This is because when a company undergoes reorganization, it often ends, converting a large amount of its debt to equity. This newly created equity may or may not have voting rights. However, it does dilute the value of the current equity. It is not uncommon for promoters to lose its majority interest in a company after undergoing the reorganization process.

Issuance of New Shares

In many cases, the old shares of the company facing bankruptcy simply cease to exist. Hence, they become worthless. In their place, a new class of equity shares issues. These shares are generally issued to the creditors who have accepted equity in lieu of their debt. Sometimes, this new equity is also issued to existing shareholders. The number of shares or the value of shares issued may be reduced. From a shareholder’s point of view, this is a grave loss. Ideally, the value of the shares that they hold is being transferred to the debt holder. However, this can be considered to be fair because the shareholders were in command of the company when it was making losses and hence can be considered to be responsible for the downturn.

Loss of Management Rights

Finally, the most important fact is that the shareholders of the company lose management rights as well. Until a company files for bankruptcy, the management appointed by the shareholders is in complete control of the company. However, after the bankruptcy has been filed, the responsibility of the management is given to a trust. This trust is responsible for the well-being and interest of the creditors. They are not concerned with the well-being of equity shareholders. Also, this committee does not have complete control of the company. In case any important decision has to be made, it needs to be approved by the bankruptcy court. Therefore, if shareholders feel that they can implement a reorganization plan which will benefit them, then they cannot implement it till the approval of all other shareholders is also received.

Hence, the fact of the matter is that a bankruptcy filing can be considered to be a death sentence for the shareholders of a company. In very rare cases, that is not the case. However, 90% of the time, equity shareholders stand to lose all their money. This is the reason why equity values plummet as soon as bankruptcy is announced. This happens unless the shareholders are aware that the bankruptcy filing is only strategic in nature and that the value of their investment will be protected.