What Happens With Preferred Stocks Under Chapter 11 Bankruptcy?

Potential payout

Chapter 11 is the chapter of the Bankruptcy Code that provides for restructuring of a corporation in order for it to continue in business after the reorganization, whereas Chapter 7 of the code provides for liquidation of the corporation.

Chapter 11 Bankruptcy

Chapter 11 bankruptcy filings may be voluntary (filed by the debtor, also known as the company's management) or involuntary (filed by the creditors, namely the bondholders and/or others to whom the company owes money). Most Chapter 11 bankruptcies are voluntary, and the debtor-in-possession is placed in the position of a fiduciary and a trustee under Section 1107 of the Bankruptcy Code.

Debt

Most companies owe two types of debt: secured and nonsecured. Secured debt is backed by collateral (such as specific assets) to reduce the risk associated with lending. Unsecured debt (many corporate bonds and other types of credit extended to corporations) does not have any claim to specific assets, and the holders are general creditors of a firm. The U.S. bankruptcy trustee will appoint a creditors committee, which commonly consists of the unsecured creditors holding the seven largest claims against the corporation, to represent their interests.

Preferred Stock

Preferred stock is often referred to as a hybrid of debt and common stock because preferred stock pays contractually determined dividends, and these dividends must be paid before any dividends are paid to holders of common stock. Preferred stock does not have voting rights (it has no say in the management of the company), and preferred stock holders do not benefit from a company's good fortunes.

Common Stock

Holders of common stock are the owners of a corporation. Common stock carries voting rights---although these rights are often limited to the ability to vote for or against a block of directors. Common stock may or may not pay dividends, and there is no contractual obligation on the part of the company to do so. The bankruptcy trustee will often appoint an equity committee to represent the rights of holders of common stock in the reorganization process.

Priority in Bankruptcy

Because secured debt has claims on specific assets, it tends to have the highest priority in a bankruptcy reorganization. Unsecured creditors have the second-highest priority in bankruptcy. Preferred stock holders have lower priority than unsecured creditors but higher priority than holders of common stock. Holders of common stock have the lowest priority.

What Does Priority Mean?

Essentially, the seniority of creditors and equity holders determines who will own the reorganized company. Secured creditors and unsecured creditors have the highest priority and are most likely to own stock or bonds in the reorganized company. Whether holders of preferred stock are granted an ownership interest in the reorganized company will depend on whether the company's value exceeds the amount owed to holders of secured and unsecured debt. Common stock holders have the lowest priority and are most likely to lose out in a Chapter 11 bankruptcy.

References

• Investopedia: Primer on Preferred Stock
• U.S. Courts: Federal Courts - Reorganization Under the Bankruptcy Code
• U.S. Courts: Federal Courts - Liquidation Under the Bankruptcy Code
• Securities and Exchange Commission: What Every Investor Should Know - Corporate Bankruptcy