======Bankruptcy Protection======
Bankruptcy Protection is a legal shield a company can raise by filing for bankruptcy with a court. In the United States, this process is governed by the federal Bankruptcy Code, with [[Chapter 11]] (for reorganization) and [[Chapter 7]] (for liquidation) being the most relevant for investors. Similar frameworks exist in Europe, such as 'administration' in the United Kingdom. When a company files, it gets an '[[automatic stay]]', which is like hitting a legal pause button. This immediately stops creditors from suing the company, seizing its [[asset]]s, or trying to collect debts. This breathing room is crucial, allowing the company, under court supervision, to either formulate a plan to restructure its finances and operations to become profitable again (Chapter 11) or to conduct an orderly sale of its assets to pay back its creditors as much as possible (Chapter 7). For investors, a bankruptcy filing is a seismic event, dramatically changing the risks and potential outcomes of holding the company's securities.
===== How It Works: The Two Main Paths =====
A company entering bankruptcy protection isn't necessarily dead and buried. The path it takes determines whether it's getting a second chance or a funeral. The choice, typically between Chapter 11 and Chapter 7 in the US, dictates the fate of the company and its investors.
==== Chapter 11: A Second Chance ====
Think of Chapter 11 as corporate rehab. This is the route most large, publicly traded companies take. The goal isn't to shut down, but to reorganize and emerge as a healthier, viable business. Under this protection, the company's existing management often remains in charge (a status known as '[[debtor-in-possession]]') and is responsible for developing a reorganization plan.
This plan is a grand bargain with creditors. It might involve selling off non-essential assets, renegotiating labor contracts, or reducing debt. A key part of this debt reduction often involves swapping debt for equity, meaning creditors like [[bond]]holders might become the new owners of the company. The plan must be approved by a vote of the creditors and confirmed by the bankruptcy court. For existing shareholders, this process is usually brutal. Their ownership stake is almost always wiped out entirely or diluted to near-worthlessness to satisfy the claims of creditors.
==== Chapter 7: The Final Curtain ====
If Chapter 11 is rehab, Chapter 7 is the eulogy. This is outright liquidation. When a company files for Chapter 7, it has concluded that it cannot be saved and must be sold for parts. The court appoints a '[[trustee]]' whose job is to take control of the company, sell off all of its assets—from office furniture and patents to entire factories—and use the cash to pay off creditors. The company ceases to exist. For shareholders, this is the worst-case scenario. As you'll see below, they are the very last in line to get paid, and the line almost never reaches them.
===== A Value Investor's Playbook =====
For value investors, the word 'bankruptcy' should set off deafening alarm bells. While the idea of buying a famous company's stock for pennies on the dollar seems tempting, it's a classic investment trap known as 'catching a falling knife'.
==== The Peril of Common Stock ====
When a company is liquidated or restructured, there's a strict pecking order for who gets paid. This is often called the 'absolute priority rule'. Imagine a waterfall of money from the sold assets; each level must be filled completely before a single drop flows to the level below.
  - **1. Secured Creditors:** These are lenders who hold specific collateral (e.g., a bank that financed a building). They get first dibs on the money from selling that collateral.
  - **2. Unsecured Creditors:** This group includes employees owed wages, suppliers, and most bondholders. They get paid from whatever is left after the secured creditors are satisfied.
  - **3. Preferred Stockholders:** A special class of shareholders with a higher claim than common stockholders.
  - **4. Common Stockholders:** That’s you, the average investor.
By the time the money trickles all the way down to [[common stock]] holders, there is rarely, if ever, anything left. This is why [[Benjamin Graham]] taught that the primary goal of an intelligent investor is the 'preservation of capital'. Buying stock in a bankrupt company is one of the surest ways to lose 100% of your investment.
==== The Pros' Game: Distressed Debt ====
So, does anyone make money in bankruptcy? Yes, but typically not by buying the stock. A sophisticated and risky strategy called '[[distressed debt investing]]' involves buying a company's debt—its bonds—not its stock. These investors, often specialized [[hedge fund]]s, buy the bonds for a fraction of their face value.
Their bet is twofold:
  * That the company will successfully reorganize under Chapter 11, and their bonds will be worth more post-bankruptcy.
  * That they can acquire enough debt to influence the reorganization plan, sometimes converting their debt into a large equity stake in the newly emerged company.
This is a high-stakes game played by professionals with deep legal and financial expertise. For the average investor, the message is simple: //steer clear//. The potential for a total loss in a bankrupt company's stock far outweighs the infinitesimally small chance of a spectacular gain.