Understanding the Impact Bankruptcy Has on Shareholders

With the current bankruptcy of Pareteum Corporation (OTC:TEUM), a company plagued by accounting fraud accusations, it seems apropos to address what happens to shareholders' investments when a publicly traded company files for bankruptcy.

Pareteum, a communications technology company, filed for voluntary protection under Chapter 11 of the U.S. Bankruptcy Code in May 2022. The Company cited increased legal expenses and lower revenues caused by the economic impact of the COVID pandemic as reasons for filing bankruptcy.

Pareteum was $80 million in debt. At the time it declared bankruptcy, it was facing eight shareholder lawsuits following an investigation by the SEC that resulted in a fine after finding the Company had inflated revenue reports as the result of improper accounting practices that former employees attempted to hide from the Company's auditor.

Chapter 7 vs. Chapter 11 Bankruptcy Protection

When a company files for Chapter 7 of the U.S. Bankruptcy Code, the company stops operations and sells all its assets for cash. The company uses the cash to pay the expenses incurred in the bankruptcy process. The company then pays its creditors in the following order: (i) secured creditors; (ii) unsecured creditors; and (iii) shareholders. Usually, there is nothing left for shareholders after paying senior creditors.

A company that files for Chapter 11 protection is hoping to get a second chance at success. Under Chapter 11, a company that has more debt than it can pay off in the course of normal business operations can seek court protection from its creditors until it files a financial recovery plan. If accepted, the company can renegotiate debts, cut costs, and keep doing business. The goal is to emerge from bankruptcy stronger and eventually recover financially.

What Happens to the Company's Stock in Bankruptcy?

What happens to stock when a company goes bankrupt? While a company is in Chapter 11, its stock may retain some value. However, the stock will likely have plummeted from the fact that the company is in Chapter 11. If the stock continues to trade during the bankruptcy proceedings, it may fail to meet the listing requirements for the major exchanges such as the NYSE and NASDAQ, but may still trade over-the-counter or on the pink sheets. When this happens, a "Q" will appear at the end of the ticker symbol to indicate that the company is undergoing bankruptcy proceedings.

If the company emerges from bankruptcy, all may not be lost. For example, when Hertz Global Holdings, Inc. (HTZ) filed for bankruptcy protection in 2020, its shares continued to trade over-the-counter. Hertz emerged from bankruptcy in June 2021 with shareholders receiving a combination of cash, shares, and warrants in the reorganized company.

Warning Signs

Companies in distress exhibit certain similarities, which should act as red flags of potential trouble. According to Fidelity, these include "[s]ignificant and persistent declines in reported earnings and revenues, failure to raise needed investment capital, credit rating downgrades, and other company-specific events." Even if the company is not headed for bankruptcy, these symptoms are still worth further evaluation, as they do not bode well for stockholders, who expect their investments to be well managed and income generating.

If you see the warning signs, one option is to sell your shares before the company declares bankruptcy. If you are caught off guard or choose to retain your shares, you may choose to hold them through bankruptcy. However, holding shares of a company in bankruptcy is risky. As the SEC explains:

"Although a company may emerge from bankruptcy as a viable entity, generally, the creditors and the bondholders become the new owners of the shares. In most instances, the company's plan of reorganization will cancel the existing equity shares. This happens in bankruptcy cases because secured and unsecured creditors are paid from the company's assets before common stockholders. And in situations where shareholders do participate in the plan, their shares are usually subject to substantial dilution."

In a best-case scenario, shareholders receive new shares in the reorganized company in exchange for their old shares. Though fewer in number or valued lower than the old shares, newly distributed stock has a chance to increase in value over time.

It's Not Just Stock That is Lost

Shareholders litigating class actions and other cases against a company with bankruptcy protection have little hope of seeing their case to fruition, let alone recovering any assets. This is because shareholders are last in line for recovery. While shareholders accept the upside potential increases in their shares' value, they also assume the risk of a decline in value, including due to fraud. As explained by John M. M. Wunderlich in the Fordham Journal of Corporate & Financial Law, since it is unlikely that securities fraud plaintiffs will receive any distribution, bankruptcy rules have "the practical effect of prohibiting [shareholder] actions against the debtor-company by reducing the economic incentive for litigation."  Further, bankruptcy courts are not necessarily kind to shareholders as they have great leeway in implementing procedures that subvert the aims of securities laws.  

Protect Yourself

All investments should be made thoughtfully. Only invest in companies that fall within your level of risk tolerance. Be sure to monitor your investments and the actions of the company fiduciaries to ensure the company is complying with accounting standards and applicable laws and acting in the best interests of shareholders. If you ever have questions about the legality of certain actions taken by a company you are invested in, you can contact the shareholder rights attorneys at Robbins LLP