6

What drives the stock of bankrupt companies?

For example:

Energy Company SunEdison (SUNE) filed for bankruptcy in early 2016, with debt exceeding assets by at least $1 Billion USD.

Throughout the bankruptcy proceedings, the stock continues to be volatile, occasionally swinging nearly 40% over a few days. (Feb 7: 8cents, Feb 10: 11cents).

This is not the only clearly bankrupt company to continue to have large stock swings even after all value seems gone.

Who is buying stocks like this, and why?

6

What drives the stock of bankrupt companies?

The company's potential residual assets. When a company goes bankrupt it is required to sell its assets to pay off its debts. The funds raised from selling assets go to the following entities:

The usual order of debt repayment, in terms of the lender, will be the government, financial institutions, other creditors (i.e. suppliers and utility companies), bondholders, preferred shareholders and, finally, common shareholders.

Depending on the amount of debt and the value of a company's assets, the common shareholders may receive some left over from liquidated assets. This would drive the stock price of a bankrupt company.

  • 1
    If there is any money left over for the shareholders, then the company wasn't bankrupt in the first place. – Simon B Feb 24 '17 at 18:17
  • 15
    A company doesn't have to have a negative net worth to go bankrupt. – JoeTaxpayer Feb 24 '17 at 18:22
  • 2
    @JoeTaxpayer Yes, cash-flow problems are often the proximate cause of chaper 11s. – Nathan L Feb 24 '17 at 18:40
  • 1
    This is wrong. Whoever wrote the investopedia article didn't know what they were talking about. Financial institutions don't come first in the order; only preferred lenders of loans of specific type (who of course usually happen to be financial institutions) do. E.g. if you simply hold a regular debt to BoA, that has no precedence over other creditors. Additionally, pretty much everything is actually deteremined by bankruptcy court as long as main order isn't violated. – user2932 Feb 25 '17 at 2:43
  • 2
    @DVK Even preferred lenders can have their claim nullified by a judge as happened in the Chrysler case where union pension benefits were elevated above preferred lenders. This answer concludes that liquidation (chapter 7) is the only option. Restructuring is certainly also possible (chapter 11) but usually results in a total loss for equity holders as well. It's astonishing that this answer got as many upvotes as it did. – Nathan L Feb 25 '17 at 15:05
5

With debts exceeding assets by a billion dollars, this activity likely comes from penny stock speculators and "pump and dump" schemers. There is no rational expectation that the stock is even worth multiple pennies when the company is that far upside-down on its debts.

Even if the debts could be restructured in a chapter 11, the equity shares would likely lose all of their value in the bankruptcy proceedings. Shareholders are at the bottom of the totem-pole when debts are being adjusted by the courts.

2

What drives the stock of bankrupt companies?

Such stock is typically considered "distressed assets".

Technically, what drives it is what drives every stock - supply and demand.

A more interesting question is of course, why would there be demand?


First, who exerts the buying pressure on the stock? Typically, three types of entities:

  • The largest ones are financial institutions specializing in distressed assets (frequently, alternatives specialists - hedge funds, private equity firms etc...). Usually, they invest in distressed debt or distressed preferred equity; but sometimes distressed equity as well.

    Why? We will discuss their motivations separately in this answer.

  • Second one are existing equity holders.

    Why? Short answer, behavioral psychology and behavioral economics.

    Many investors - especially non-professionals - insist on holding distressed stocks due to variety of investment fallacies (sunk cost etc...); usually constructing elaborate theories of why and how the company and the stock will recover

  • Sometimes, people who buy into penny stock scams, pump and dump schemes etc...

    Why? "There's a sucker born every minute." - P.T. Barnum


Let's find out why an investment professional would invest in distressed equity?

  • First, the general process is always the same. Company's assets are used to pay off its liabilities; in accordance with applicable law. There are two ways this can be done - either through selling the company; OR through bankruptcy process.

    The liabilities are paid according to seniority. The seniority priorities rules are covered by 11 U.S. Code § 507 - Priorities

    1. DIP (Debtor in Possession) debt as well as other super priority debt obtained under 11 U.S. Code § 364; and some administrative expenses
    2. Secured creditors (mostly paid out of collateral)
    3. Domestic support obligations (DSO) like alimony, maintenance, and child support)
    4. Administrative expenses by trustee as well as taxes incurred during bankruptcy
    5. Other administrative expenses and unsecured claims of any Federal reserve bank under 12 U.S.C. 343
    6. Other priority claims by unsecured creditors
    7. Other claims by unsecured creditors as listed in § 507
    8. If any assets are left over, they go into the estate, which may then compensate prior equity holders.
  • A company in bankruptcy can have one of 2 outcomes:

    • Buyout. Some buyer might decide that the company's assets are worth something to them as a whole; and buy the whole enterprise; rather than risk it being destroyed piecemeal in bankruptcy proceedings.

      In that case, the proceeds from the sale will be used to fund the liabilities as discussed above.

      This option is one of the possible reasons people might consider investing in distressed equity.

      For example, if the company is in bankruptcy because it can't get enough financing right now, but is likely to have good profits in the future. The chances are, some buyer will buy it for a premium that includes those future profits; and that sale amount might possibly exceed the liabilities.

    • Bankruptcy. The assets are sold and liabilities are covered according to priorities.

      In that case, the investors in distressed equity might be hoping that there are un-obvious assets whose value would also put the total assets above claimed liabilities.

      Additional possible beneficial factor is that unsecured debtors must file with the court in order to be paid; and the claim must be validated. Some might fail on either count; so total amount of liabilities might lessen once the bankruptcy process goes through.

  • Assets

    Now, here's where things get interesting.

    Of course, companies have usual assets. Real estate, inventory, plants, cash, etc... These are all able to be sold to cover liabilities, and at first glance are possibly not enough to cover liabilities, leaving equity holders with nothing (and even that's not a certainty - bankruptcy is simply inability to service debt payments; and while it correlates to assetsliquid assets, not full asset valuation).

    But some assets are less sure, and are thus rarely included in such calculations. These may include:

    • Chances of winning appeals if specific existing liabilities are results of litigation, e.g. tax appeals, court judgement appeals etc...

    • Clawbacks and lawsuits against former executives, especially in cases where the company's financial distress resulted from executive malfeasance.

      I was personally involved in one such case as an equity holder, where the company assets were valued at $X; had liabilities of $X*2; but had a real possibility of winning about $X*3 in a lawsuit against former CEO accused of various malfeasance including fraud and insider trading.

      As such, the best case scenario was literally 100% profit on holding that distressed equity.

  • To the downvoters: is there a way in which answer can/should be improved? – user2932 Feb 25 '17 at 4:49
  • I got a few downvotes too, you have to expect a few of those on hot network questions. I think the criticism I would give is concerning your declaration that there are two outcomes from bankruptcy. Even though chapter 7 and chapter 11 are the most common ways to file, there are lots of outcomes you didn't mention from that process. I agree that lawsuits are possible in general with a bankrupt company, I think it's unlikely in this particular case that there are an additional billion dollars worth of assets to be recovered. – Nathan L Feb 25 '17 at 14:56

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .