Lesson 6 of 7
Equity after bankruptcy
A Chapter 11 plan of reorganization decides who owns the company that emerges, and fresh-start accounting resets its books to reflect that decision.
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 plan of reorganization decides who owns the company that emerges from Chapter 11, and the old common stock is often cancelled or reduced to almost nothing.
- Fresh-start accounting resets the balance sheet to the plan's own estimate of value, so the numbers after emergence do not carry the company's history with them.
- The new shares are often handed to lenders who never wanted equity, so a forced seller can turn up again right after the company re-emerges.
A company leaving Chapter 11 is not the same claim it was going in. A plan of reorganization sets a new capital structure and decides who owns each piece of it, usually the creditors who were owed money, not the shareholders who owned the stock before the filing.
Capital structure before the filing
Paid first
- Debt$1,00083%
- Old common equity$20017%
Paid last
Total$1,200
What a plan of reorganization decides
The plan states what the reorganized company is worth and who receives that value, following the same order of claims that applies to any company: debt before equity, senior debt before junior debt. When that estimated value is less than the total debt owed, as it usually is by the time a company files, the old common stock gets nothing. The absolute priority rule pays debt before equity, and the new equity in the reorganized company is instead handed to the creditors whose claims absorbed the loss.
Capital structure after the plan takes effect
Paid first
- New debt$30038%
- New equity, owned by the old lenders$50063%
Paid last
Total$800
Fresh-start accounting resets the books
Under ASC 852, a company adopting fresh-start reporting restates its assets and liabilities to their fair value as of the emergence date and resets retained earnings to zero. It applies only when the company was insolvent and the old shareholders receive less than half of the new voting shares. The value it records is a negotiated number, and senior creditors have reason to argue it low. The balance sheet you see afterward reflects the plan's own estimate of value on that date, not the history that led into the filing. Comparing a pre-petition year against a post-emergence year on the same line item is comparing two different accounting bases.
Why the new shares often find a forced seller too
The lenders who receive new equity are often bond funds and bank loan desks whose mandates hold debt, not stock. Distressed-debt funds are the exception: many bought the debt to end up with the shares. Handed shares instead of cash, a mandate-bound lender often sells them promptly once trading opens, for the same reason a bond fund sells a downgraded bond: the mandate, not a view on the business, decides. A newly reorganized company can therefore carry the same kind of forced early seller a spin-off does.
Check yourself
When a Chapter 11 plan estimates the reorganized company is worth less than the total debt owed, what usually happens to the old common stock?
- It is repaid in full before any debt
- It is cancelled or reduced to nearly nothing, under the absolute priority rule
- It automatically converts into the new debt
Show the answer
Answer: B.
The absolute priority rule pays debt ahead of equity. When the estimated value does not cover the debt, the old equity is left with nothing.What does fresh-start reporting under ASC 852 do to a company's balance sheet on emergence?
- It leaves the pre-petition book values unchanged
- It restates assets and liabilities to fair value and resets retained earnings to zero
- It applies only to companies that never filed for Chapter 11
Show the answer
Answer: B.
Fresh-start accounting rebuilds the balance sheet around the plan's own estimate of value on the emergence date, breaking the link to prior book values.Why can new shares issued at emergence meet heavy early selling?
- The plan requires the new owners to sell within a year
- Many recipients were lenders whose mandates hold debt, not stock
- Fresh-start accounting forces a new share price
Show the answer
Answer: B.
Bond funds and loan desks handed equity often sell because of their mandate, not a view on the business.Sources
- ASC 852, Reorganizations, on fresh-start reporting.
- Moyer, Distressed Debt Analysis, 2005, on valuing the claims that pass through a reorganization.
What this leaves out
- The $1,000, $200, $300 and $500 figures are round invented numbers, chosen so the split of value can be checked by hand.
- Plans of reorganization vary widely: some leave old equity a small stake, and secured creditors do not always take equity at all.
- Nothing here is advice about any security, and nothing here says any particular reorganization will follow this pattern.