What Happens to Bondholders When a Company Files for Bankruptcy?
When a public company files for bankruptcy, everyone with a stake in the company, from employees to creditors to bondholders, is concerned about the future of the company and the outcome of the bankruptcy proceeding. For bondholders, here’s some general information to help understand what could happen to your investment.
What is Bankruptcy?
Generally, bankruptcy is the inability of a company to pay its debts as they become due. Public companies file for protection under the federal bankruptcy laws when their liabilities or debts exceed the value of their assets, or they are unable to pay their bills. A bankruptcy filing gives a company an opportunity to reorganize its business in hopes of returning to profitability or completely closing down operations and selling off assets, then using the money to pay off its debts in a process known as liquidation.
What happens when a company files for bankruptcy?
Public companies can file for bankruptcy protection under either Chapter 7 or Chapter 11 of the federal bankruptcy laws.
Under Chapter 7, the corporation is liquidated after the federal courts have determined that a reorganization is not worthwhile. A court-appointed trustee will liquidate all of the company’s assets and distribute the proceeds in order to satisfy claims. Claims are considered in order of their priority.
The U.S. Trustee Program, a component of the Department of Justice responsible for overseeing the administration of bankruptcy cases, will establish and oversee several committees to represent the interest of parties including creditors, such as banks and bondholders, and stockholders. The committees work with the company to develop a reorganization plan.
The reorganization plan must be approved by creditors, and stockholders and confirmed by the bankruptcy court. However, even if some of the groups vote to reject the plan, the court can approve it if it believes the plan treats creditors and stockholders fairly.
What will happen to my bonds?
Bonds represent debt which a company has agreed to repay with interest. As such, when a company files for federal bankruptcy protection, bondholders have a better chance of getting repaid than stockholders. While bankruptcy laws determine the order of repayment, stockholders, considered owners of the company, have the last claim on assets.
In a Chapter 7 bankruptcy, bondholders may receive a portion of the value of their bonds. After being notified of the bankruptcy filing, bondholders should file a claim so they can receive a payment if cash is available after other expenses have been paid. Proof of claim forms are available on the Administrative Office U.S. Courts Web site.
When a company fails to pay principal and interest when due, a default occurs. In a corporate bankruptcy or liquidation, although secured creditors, bondholders and holders of other senior debt issues may receive some distribution of corporate assets, it is rarely enough to “make whole” their total investment. Bonds of companies in default may trade at very low prices, if they trade at all, and liquidity may disappear.
Bonds may continue to trade once a company has filed for bankruptcy under Chapter 11. However, bondholders will stop receiving principal and interest payments, causing a default to occur. Also the value of the securities could decline sharply and trading could be extremely limited.
In addition, as a part of the court-approved reorganization plan, bondholders may receive new stock, new bonds, or a combination of new stock and bonds in exchange for their bonds. The new securities may also be worth less than the old ones.
How will I know if a company has filed for bankruptcy?
Often, news reports provide investors with their first information about a company’s bankruptcy filing. However, if you hold bonds through a broker, your broker should contact you, forwarding information from the company. If the bonds are held in your name, then you should receive information directly from the company. Investors should also contact their brokers or investment advisor if they do not receive any information from the company.
Investors may be asked to vote on a company’s reorganization plan. Before you do, you should receive a copy of the plan and a ballot, as well as a court-approved disclosure statement and information on any court hearings on the plan’s confirmation and deadlines for filing objections to the plan.
Important Tax Issues
If securities lose their value as the result of a bankruptcy filing, investors may be able to take an income tax deduction for worthless securities.
An accountant, tax or bankruptcy attorney or investment advisor can provide additional information, or contact the Internal Revenue Service for information and publications to find out if your securities meet the IRS criteria.
Visit www.irs.gov for information and forms on worthless securities, frequently asked questions regarding worthless securities, and the Gain/Loss Publication.