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What Happens When a Company Goes Bankrupt?

The realm of financial markets is complex and dynamic, with numerous possible scenarios based on the health of the company, the nature of investments, and the state of the economy. One such situation is bankruptcy, where a company declares itself incapable of paying back its debts. The repercussions of this can ripple across various stakeholders, including creditors, shareholders, and investors with a short position on the company's stocks.

When a company goes bankrupt, it is effectively acknowledging its inability to service its financial obligations. This usually happens when the company's liabilities, or what it owes, significantly outweigh its assets, or what it owns. In such circumstances, the company is obligated to distribute its residual assets, if any, to its creditors and shareholders, following a distinct hierarchy.

Bondholders, or creditors, are placed higher in this hierarchy compared to common shareholders. Bonds, as an investment instrument, inherently carry the risk of issuer bankruptcy. The higher the bond's rating, the less likely the issuer will face bankruptcy, conversely, bonds with higher coupons, implying higher returns, are generally riskier. This principle underpins the fundamental investment mantra: higher risks, higher returns. Nevertheless, in the event of bankruptcy, bondholders have what is known as a 'senior claim' on the company's residual assets. This means they are prioritized during the distribution of these assets, often receiving a percentage of their investment back, depending on the value of the assets. In contrast, common shareholders, who are lower in this hierarchy, may not receive anything.

Now, let's delve into a rather sophisticated investment strategy: short selling. This strategy entails borrowing shares, selling them at a higher market price, then repurchasing the shares at a lower price to make a profit. However, the risk associated with short selling is substantial and is typically avoided by individual investors.

What happens when an investor has an open short position on a company that goes bankrupt and gets delisted? Essentially, the investor does not have to repay anyone as the shares become worthless. Although this might seem like a best-case scenario for a short seller, the journey to this point can be cumbersome. They may have to wait until the company is fully liquidated to realize their profits. However, once the brokerage declares a total loss on the loaned stock, the short seller's debt is canceled, and all collateral is returned.

It's crucial to remember that it is the brokerages that allow short selling and not the companies themselves. Short selling, while potentially profitable, represents a sophisticated, risky strategy, and it is crucial for investors to thoroughly understand the ins and outs before venturing into it.

Bankruptcy can have different implications for different stakeholders, with bondholders, shareholders, and short sellers each experiencing unique outcomes. Investors must be fully aware of the inherent risks associated with their investment strategy, especially in light of potential company bankruptcy.

There is a hierarchy of which creditors and investors will be serviced first in the event that a company goes bankrupt. When a company goes bankrupt, it is unable to pay back the money that it borrowed. The higher the bond's rating, the less likely that the issuer will go bankrupt.

To learn more about bond ratings, see “What are Bond Ratings?

The possibility of bankruptcy is the risk associated with investing in bonds - you can never know for sure if you will get your money back. Typically, bonds with higher coupons are riskier investments (again, the recurring theme of higher returns = higher risks!). For example, if you see a bond with a 30% coupon, there is (obviously) a greatly increased chance that the company will not be able to pay back your loan.

However, as a bond holder, you will have what’s called a “senior claim” on the residual assets of the bankrupt company. Senior securities receive service first in such situations. When the bankruptcy judge distributes these assets, they first go to the bondholders, and only then, to the common shareholders.

Therefore, in most cases, bond holders might get a percentage of their money back (of course, not everything), but a common shareholder may never get any money back.

What is Bankruptcy Court?
How Can I Check if My Portfolio is Diversified?

Disclaimers and Limitations

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