Finding Opportunity in Bankruptcy

With swine flu panic the occasional guest star, bankruptcy stories seem to be dominating the financial headlines. A few months ago, Lehman Brothers filed for bankruptcy, and just last week automaker Chrysler filed. According to some, General Motors(GM Quote) is sure to follow. Technology firm Epiq Systems(EPIQ Quote) was upgraded by KeyBanc based on a rise in bankruptcy filings.

"Bankruptcy" is a scary word. In this installment of The Finance Professor, I thought we would try to explain bankruptcy from the investor's perspective.

Most bankruptcies are filed by the debtor company on a voluntary basis. An involuntary bankruptcy can be filed by the creditors who file a petition with the bankruptcy court. Corporate bankruptcy is usually referred to by the section, or chapter, of the U.S. Bankruptcy Code under which the filing becomes effective.

Typically in a bankruptcy, the shareholders' stock is deemed worthless, and that class of investor is "wiped out," although there are exceptions under which certain shareholders may retain a future share of ownership under reorganization.

Chapter 7 bankruptcy, or liquidation, is the most common form of bankruptcy. Under Chapter 7, liquidation a trustee is appointed to sell the remaining assets of the company and distribute the proceeds or remainder assets to the creditors. Once the liquidation and distribution is wrapped up, the company no longer ceases to operate.

During the current recession, there have been two Charter 7 liquidations worth noting: Circuit City and Linens 'n Things. Both of these companies completed their liquidations in fast order. Linens n' Things was privately held at the time, but investors in Circuit City stock were wiped out, and the creditors received some return of their claims on the companies.