How Does Chapter 11 Bankruptcy Affect Stock Equity?
Corporate bankruptcies not only cause financial losses for business partners, such as customers, lenders and suppliers, but also have adverse effects on shareholders and securities markets' investors. A chapter 11 bankruptcy is a legal mechanism that helps a business entity reorganize and stop reimbursing debt while the reorganization process is in progress.
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Chapter 11 Bankruptcy Defined
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Under the United States Bankruptcy Code, a Chapter 11 bankruptcy allows a corporation to stop reimbursing lenders and use the company's remaining assets, such as cash, machines and equipments, to reorganize. Reorganization means the firm gets a "fresh start" without the heavy burden of debt. While a Chapter 7 bankruptcy relates to a firm's complete liquidation, a Chapter 11 insolvency process helps individuals stop paying loans and reorganize. A Chapter 11 bankruptcy does not result in the stoppage of all debts because debtors remain in control of corporate operations as "debtors in possession." A company that completes a successful Chapter 11 process, or becomes profitable after such process, reimburses the debtors in possession before acquiring new lenders.
Stock Equity Defined
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Stock equity consists of ownership rights that a firm sells to investors on a securities exchange or in private transactions. Equity products may include common (regular) shares, preferred shares, equity futures and equity-linked financial derivatives. An investor who buys shares of equity, or shareholder, receives periodic dividend payments and makes profits when the company's share prices rise on the financial market. He also can vote on corporate decisions, appoint senior executives and participate in a company's annual shareholders' meeting.
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Bankruptcy and Stock Equity
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A company that files for bankruptcy generally has worthless shares of equity. Investors on securities exchanges usually sell such shares, and this process causes shares to decrease significantly. However, a firm's shares of equity may continue to be traded during a Chapter 11 reorganization process, provided that the company meets minimum listing requirements that a securities exchange, such as the New York Stock Exchange (NYSE) or the Johannesburg Stock Exchange (JSE), generally requires. Alternatively, these shares may be traded in over-the-counter (OTC), or electronic, markets.
Significance
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A Chapter 11 restructuring process has significant effects on shareholders' equity. Besides the financial losses that investors incur, a corporate insolvency case has an adverse "domino effect" (chain reaction) on other business partners, or trade counter-parties. A company that is unable to reimburse loans or meet other monetary commitments when they are due causes other business partners to suffer losses, which may lead to further bankruptcies.
Bankruptcy and Equity Accounting
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Financial accounting and reporting rules, such as generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS), require a shareholder to record bankruptcy-related equity losses on the date of bankruptcy. For example, if an investment bank holds $1.5 million worth of equity in a large chemicals company, and the chemical firm files for a Chapter 11 bankruptcy, the bank's accountant will debit the investment loss (expense) account for $1.5 million, and credit the equity investments (asset) account for the same amount. (An accountant credits an asset account to reduce its balance, and she debits an expense account to increase its amount.)
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References
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