What Happens With Preferred Stocks Under Chapter 11 Bankruptcy?

Chapter 11 bankruptcy is designed to aid businesses with fractured finances.
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Few things are more frightening than receiving notification that a company you've invested your future in is filing for Chapter 11 bankruptcy protection. "That's okay," you assure your partner, "We've got preferred stock." Unfortunately, your benefits in holding preferred stock over common stock will not amount to much if the company cannot effectively reorganize its debt under Chapter 11 and become a profitable entity again.

Bankruptcy Options

Businesses have two bankruptcy options: Chapter 7 and Chapter 11. A company is closing its doors if it files for Chapter 7 bankruptcy. Businesses filing for Chapter 11 are attempting to stay in business by reorganizing their debt under the protection of the bankruptcy court -- much like a personal Chapter 13 filing. There is small glimmer of hope for shareholders when the company files for Chapter 11 bankruptcy, because it is -- at the very least -- trying to stay in business and meet its financial obligations.

Benefits of Chapter 11 Bankruptcy

Preferred shareholders cannot breathe a sigh of relief just because a company has filed for Chapter 11 instead of Chapter 7, but they can be assured that the company's operations will be under the bankruptcy court's scrutiny. While the company's management might stay intact, it will not have final say on major operating and financial decisions. The SEC confirms, "All significant business decisions must be approved by the bankruptcy court." This does, in some small measure, assure investors that the company might not repeat the mistakes that got it into financial trouble in the first place.

Company Stock

Filing for any type of bankruptcy is a kiss of death for companies trading on the New York Stock Exchange and NASDAQ. Most likely, the company will be delisted and unable to continue trading on major floors. In some cases, however, the stock continues to trade on secondary exchanges, but don't say "whew" quite yet. Investors rarely take chances on company stock under bankruptcy protection, so there will be no meaningful market for your shares; it's a bad investment decision because most existing stock is liquidated, even if the company survives the economic crisis.

Order of Relief

If the company survives the bankruptcy, it might begin to offer new stock under the reorganized business. Initially, investors purchase the "offer" of new stock, not actual shares, and both the old and new stock trade on secondary markets. When the reorganized company is solvent, it can then afford to issue the new stock shares. Once the new shares are issued, the old shares become obsolete. Investors might be left holding the bag on the old stock, unless they are given the option to trade in their old shares for new ones. Should the company be forced to liquidate despite the initial Chapter 11 filing, the chance of receiving money for preferred stock shares is slim to none. This is because secured creditors, such as banks that issued collateral-based loans, have first dibs on the liquidated proceeds. Unsecured creditors, suppliers and bondholders have second dibs. This leaves stockholders last in line for financial recovery. Why? Because stockholders -- regardless of preferred or common -- own the company, and if the company goes down, so do they, losing their entire investment.

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