Think Bankrupt Stocks Are a Bargain? Think Again

By Markets Fool.com

Buying stock in a bankrupt company is not much better than buying a lottery ticket. Image source: Flickr user Mark Ou.

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Who gets paid in bankruptcy?

When a company files for Chapter 11 bankruptcy protection, two things generally happen right away to its stock -- a letter "q" is added to the end of the ticker symbol, and the price collapses. For example, Aeropostale(NASDAQOTH: AROPQ)recently filed for bankruptcy and shares now trade for just $0.04 -- well below their $15 price tag of just three years ago. While it may seem tempting to pick up shares of a company like this in bankruptcy for a few cents each with the intention of profiting when the company emerges from bankruptcy, it's usually not a good idea. Here's why.

One of the main purposes of Chapter 11 bankruptcy is to pay off or restructure a company's debts in a way that allows it to continue to operate in a sustainable manner. So who gets paid depends on what types of debt and how much debt the company has, as well as the amount of assets it has on its balance sheet. Once these are established, creditors get paid back in order of priority of their claims to the company's assets.

Secured creditors get paid first -- this typically means banks. If a company has an outstanding bank loan, or, say, a mortgage secured by a building it owns, these claims are dealt with first. Next up are unsecured creditors such as bondholders. If there are any preferred stockholders, they're next. Common stockholders are last to get paid, and unless the other creditors get paid in full, or negotiate lower debt settlements they're happy with, common stockholdersusually end up with nothing.

Do shareholders ever get paid?

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Note that in the last sentence, I said common stockholders usually get nothing. There are some instances when companies emerge from bankruptcy, and common shareholders receive some form of compensation. Generally, this means a small portion of the company's newly created stock, or maybe even a small cash payment.

However, this isn't a good reason to buy stock in bankrupt companies. It's quite rare for common shareholders to receive anything at all. In fact, of the 41 publicly traded companies that filed for bankruptcy protection in 2009 and 2010, a study found that common shareholders got a return in just four cases.

Even when it does happen, any compensation is likely to be minimal. Companies emerging from bankruptcy typically issue completely new stock, which can be issued to creditors in exchange for a more favorable debt settlement. Once new shares are issued, the old stock is canceled and these shares become worthless. So, in the rare cases where shareholders get some type of compensation, it may be an arrangement such as one share of the new stock for every 50 shares of the old stock.

The bottom line on bankrupt stocks

Sure, shareholders of bankrupt companies do get paid some of the time. Then again, so do some people who buy lottery tickets.

In the vast majority of cases, the odds are stacked against common shareholders receiving anything at all when the smoke clears and the company emerges from bankruptcy, so it's best to avoid these stocks altogether. I'd even go so far as to say that if a stock you already own enters bankruptcy, your best bet is probably to unload your shares for pennies on the dollar -- this way you'll at least walk away with something, and have the realized loss to claim on your taxes.

The article Think Bankrupt Stocks Are a Bargain? Think Again originally appeared on Fool.com.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.