Bankruptcy 101

Many companies have filed for “Chapter 11” bankruptcy protection — including J.C. Penney, Chesapeake Energy, Hertz, Neiman Marcus and Brooks Brothers (and much longer ago, Polaroid and Texaco). These businesses often end up with super-depressed stock prices, which can tempt some investors. Here’s why you should steer clear.

Companies filing for bankruptcy protection are generally in trouble — often deep trouble — and may have issues paying their bills. Chapter 11 allows them to keep operating while reorganizing. Some of them will turn their businesses around and end up stronger than before, while others won’t. The latter may end up in “Chapter 7” — which means they’ll be liquidating assets in order to pay creditors.

Chapter 11 permits a company to hang on to its assets under the supervision of a court-appointed trustee. It must file a reorganization plan with the bankruptcy court. Any creditors in line to receive less than all they’re owed can vote on the matter. After the vote, the court can accept or reject the plan. So companies do have some flexibility, but if they offer creditors too little, their plan may not be approved.

Companies typically raise money to pay creditors by selling off assets. But they’re unlikely to be able to pay all debts in full, so creditors sometimes accept a partial repayment and/or some stock in the new, reorganized company.

That new, reorganized company usually emerges from bankruptcy protection with new shares of stock, leaving former holders of common stock with shares that are now worthless. Some or all holders of preferred stock may receive some payment, but even they rank lower in repayment order than debt holders, merchant creditors, trustees, employees and the IRS.

Avoid any companies in or near bankruptcy — and consider selling any shares you own, as they’re likely to end up worthless. Even if a company emerges and succeeds — as many, such as General Motors and Delta Air Lines, have done — it will be as a new entity. Stick with healthy and growing companies