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Buying Bankruptcy Stock
Unless you are a very daring short-term trader, The Turnaround Letter rarely recommends that you buy the stock of a company operating under protection of the U.S. Bankruptcy Court. Under bankruptcy law, any blood that can be squeezed out of a distressed corporation’s stone is first allocated to senior creditors, like bank lenders and bondholders.
Stockholders are the lowest priority when it comes to payback; and—even if a company can successfully emerge from Chapter 11 protection—there is rarely enough value in that reorganized entity to give the old stock any value. To the contrary, often the old stock is cancelled altogether, rendering it completely worthless.
Other money-losing scenarios include the old stock remaining intact—but hugely diluted by newly-issued stock; or the issuance (to old stockholders) of out-of-the money warrants in the reorganized entity. It is important to recognize the difference between the old stock in a company in Chapter 11 and the new stock issued by the company upon its emergence from bankruptcy (post-reorganization stock). The new, post-reorganization stock often has significant value, particularly if the company has used bankruptcy as an effective turnaround tool. These post-bankruptcy stocks are often over-looked and under-valued and present significant investment opportunities.
Remember, not every post-bankruptcy stock does well. Over the years we’ve learned about Chapter 22 and Chapter 33, colloquial designations for habitual bankruptcy filers. Sometimes, a company doesn’t reduce its debt enough while in Chapter 11, or perhaps its business just wasn’t viable for some other reason.