Lesson 7 of 7
Distress, bankruptcy and recovery
From a covenant breach to a missed payment to Chapter 11, the priority of claims that ranks a healthy company decides who is repaid and who is wiped out.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A company often drifts toward distress over months, through a covenant breach and a forbearance agreement, before any single event forces a bankruptcy filing.
- Chapter 11 reorganizes a company under bankruptcy court protection; Chapter 7 liquidates it. Most large public companies file Chapter 11.
- The same order of claims that ranks a healthy company's debt and equity governs who is repaid in bankruptcy, which is why common shareholders usually recover little or nothing.
Bankruptcy does not skip the order of claims from who gets paid first, it enforces it. A court oversees the same priority a healthy company's debt already carries, applied to a company that can no longer pay every claim in full.
One company's path into and out of Chapter 11
- Month 1Covenant breachNet debt to EBITDA crosses the limit set in the credit agreement.
- Month 2ForbearanceLenders agree not to act yet, for a fee, while the company tries to fix the business or refinance.
- Month 4Missed couponA scheduled bond payment is not made in full.
- Month 5Chapter 11 filingThe company files for reorganization under bankruptcy court protection.
- Month 14Plan confirmedThe bankruptcy court approves a plan of reorganization.
- Month 15EmergenceThe company exits Chapter 11. New equity is issued under the plan, usually to former creditors.
Reorganize or liquidate
Chapter 11 lets a company keep operating while it reorganizes its debts under a bankruptcy court's supervision. A plan of reorganization restates who is owed what and how each claim is treated. Chapter 7 instead liquidates the company, selling its assets and distributing the proceeds. Most large public companies that file choose Chapter 11. An operating business sold or reorganized as a whole is usually worth more than its assets sold off piece by piece.
The path is usually gradual, then sudden
A single missed payment is rarely the first sign of trouble. It is more often preceded by a covenant breach, described in the earlier lesson on covenants. A forbearance agreement usually follows, in which lenders agree to hold off enforcing their rights while the company works through its options. The bankruptcy filing itself, when it comes, is often the point at which negotiation stops and a court starts overseeing the process.
Absolute priority, applied again
Inside Chapter 11, the plan of reorganization must respect the absolute priority rule, the same order the contracts already set. A class is not paid until every class ahead of it is paid in full, unless that class agrees otherwise. A company's remaining value is distributed down the same order, from secured lenders to unsecured lenders to equity. That is why the priority of claims matters as much in bankruptcy as it does the rest of the time.
What is left for the old shareholders
Filing for Chapter 11 stops creditors from collecting on their own, an automatic stay imposed the moment the case begins. The shares usually leave their exchange once the filing is disclosed, and can keep trading over the counter, sometimes above zero, even under a plan that later cancels them.
Under ASC 852, fresh-start reporting is required when two things are both true: the reorganized business is worth less than its claims, and old shareholders end up holding under half of the new voting shares. A company that meets both must restate its assets and liabilities at fair value. Its history then splits into a predecessor period and a successor period that do not compare directly.
Old common stock is typically cancelled or heavily diluted. New shares are issued under the plan, usually to the lenders and bondholders whose claims were not paid in full in cash. A shareholder who held the stock into the filing is very often left with a small stake in what remains, or with nothing at all.
Check yourself
A company's business is valued at 550 in bankruptcy, against secured debt of 400 and senior bonds of 300. What do the senior bondholders recover?
- 300, paid in full
- 150, half of what is owed
- 0
Show the answer
Answer: B.
Secured debt takes 400 of the 550 first. The 150 that remains covers half of the 300 owed to senior bondholders.What is the main difference between Chapter 11 and Chapter 7?
- Chapter 11 only applies to small companies
- Chapter 11 reorganizes a company that keeps operating; Chapter 7 liquidates it and distributes the proceeds
- Chapter 7 lets shareholders keep their shares
Show the answer
Answer: B.
Chapter 11 restructures debts under court supervision while the business keeps running. Chapter 7 sells the assets and winds the company down.A company emerges from Chapter 11 under a confirmed plan of reorganization. What usually happens to the old common stock?
- It is unaffected and keeps its full value
- It is typically cancelled or heavily diluted, with new shares issued mostly to former creditors
- It converts into the new shares one for one
Show the answer
Answer: B.
The absolute priority rule pays creditors before old equity. New shares issued under the plan usually go to lenders and bondholders whose claims were not paid in full in cash.Sources
- US Bankruptcy Code, Chapters 7 and 11, and the absolute priority rule.
- ASC 852, Reorganizations: fresh-start reporting for a company emerging from Chapter 11.
What this leaves out
- The timeline and the 600-against-700 example are illustrative shapes, not one company's filed history, and a real case can run for months or years longer.
- A plan of reorganization can be negotiated with exceptions to strict priority, so a class can end up with more or less than this lesson's simple waterfall implies.
- Nothing here says any company is in distress or predicts what any bankruptcy court would approve. It is not advice about any security.