Bankruptcy
Bankruptcy is the legal process for a company or person that cannot pay its debts. In the US, Chapter 11 lets a business reorganise while it keeps operating, and Chapter 7 liquidates it. Shareholders are paid last and usually lose most or all of their money.
When a company runs out of cash to pay its lenders, a court steps in to decide who gets what. For shareholders this is usually the worst outcome: they stand at the very back of the line. Knowing how bankruptcy works helps you read warning signs, understand why a bankrupt stock can still trade, and avoid buying shares that are likely to be cancelled. This entry covers the basics, with a US focus; rules differ by country.
- Category
- Fundamentals and Macroeconomics
- Reading time
- 4 min
- Also called
- Chapter 11, Chapter 7, Insolvency
- Updated
Bankruptcy in plain words
Bankruptcy is the legal status of a person, company or government agency that cannot repay its outstanding debts to creditors.1
For US companies, the usual paths are Chapter 7, a liquidating bankruptcy, or Chapter 11.2
Chapter 11 deals with reorganisation, and the court usually lets the debtor keep some or all of its assets to pay creditors over time.3
How a Chapter 11 case typically unfolds
Cash runs short
Debts can't be paid. See Default Risk.
Company files a petition
Creditors' collection is paused.
Business keeps operating
Under court supervision.
Reorganisation plan
Debts are cut or swapped for new equity.
Creditors vote
Senior lenders get priority.
Exit or liquidate
Old shares are often cancelled.
Worked examples
Example 1 — The payout waterfall
Equity wiped outA bankrupt firm has $600m of value; secured debt $400m, unsecured bonds $500m, shareholders after that.
| Secured lenders | $400m (paid in full) |
| Unsecured bondholders | $200m of $500m = 40 cents per dollar |
| Shareholders | $0 |
Shareholders sit at the back of the line, which is why bankruptcy usually wipes out equity. See Distressed Debt.
Example 2 — Buying a bankrupt stock
−$4,000A stock in Chapter 11 trades at $0.40; a trader buys 10,000 shares, and the plan cancels the old shares.
| Cost | $4,000 |
| Value after plan | $0 |
Bankrupt shares can keep trading for months, but in many Chapter 11 plans they are cancelled with nothing paid.
Example 3 — Chapter 7 liquidation
LiquidatedA small retailer files Chapter 7; a trustee sells its stores and stock.
| Business | Ceases operating |
In a liquidation the business generally stops operating unless the trustee decides to continue it while assets are sold.3
Chapter 7 vs Chapter 11
| Aspect | Chapter 7 | Chapter 11 |
|---|---|---|
| Purpose | Liquidation | Reorganisation |
| Business keeps running? | Usually not | Yes |
| Who runs it | Trustee | Usually existing management |
| Shareholders | Rarely recover anything | Often wiped out or diluted |
Why bankruptcy matters to investors
Stock risk
Equity is last in line.
Bond recovery
Seniority sets payouts. See Corporate Bonds.
Credit signals
Ratings and spreads warn early. See Credit Rating.
Distressed investing
Specialists buy debt cheaply. See Distressed Debt.
Advantages and disadvantages
Advantages
- Gives viable businesses a chance to restructure.
- Orderly, court-supervised process.
- Creditors are treated by clear priority rules.
Disadvantages
- Shareholders usually lose most or everything.
- Long and costly legal process.
- Jobs and suppliers suffer.
Going deeper
Read as far as you need. Each level builds on the one before it.
Why companies file
Beginner
Companies may file after a big decline in business that hits revenue and cash flow, or after taking on more debt than they can repay.2 See Debt-to-Equity Ratio.
Other chapters
Intermediate
The US code has other chapters too: Chapter 9 covers municipalities, and Chapters 12 and 13 cover farmers and individuals.3 See Municipal Bonds.
Debt-for-equity swaps
Advanced
Many reorganisations hand ownership to creditors by converting their debt into new shares, which is why old shareholders are often wiped out.
Common mistakes
Buying because it's 'cheap'
Old shares are often cancelled.
Ignoring the ticker suffix
Bankrupt stocks may trade with a 'Q' added.
Assuming bonds are safe
Unsecured bonds can recover little.
Missing warning signs
Watch cash burn and maturities.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Bankruptcy is the legal process for unpaid debts.
- Chapter 7 liquidates; Chapter 11 reorganises.
- Secured creditors are paid first.
- Shareholders are last and often get nothing.
- Rules differ by country.
Frequently asked questions
What happens to my shares if a company goes bankrupt?
Can a company come back from Chapter 11?
Is bankruptcy the same everywhere?
Further learning
- Default Risk
The road to bankruptcy.
- Distressed Debt
Investing in troubled firms.
- Credit Rating
Early warning signs.
- High-Yield Bonds
Bonds with higher default risk.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Bankruptcy (opens in a new tab) Checked .
- Corporate Finance Institute. Chapter 7 vs. Chapter 11 Bankruptcy (opens in a new tab) Checked .
- Corporate Finance Institute. US Bankruptcy Code (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.