You’ve probably heard of bankruptcy, but wondered what it actually means.

That’s especially true now, with numerous companies in the retail and energy industries filing for bankruptcy protection. 

So what is it?

Bankruptcy is a legal process that allows businesses that are unable to pay their debts to come up with a plan to pay back creditors, or people to whom they may owe money as a result of their normal business operations. The proceeding is typically handled in court and overseen by a judge.

Businesses may file for bankruptcy for a variety of reasons. Market forces may be unfavorable, the economy may be doing poorly, the business may have mismanaged its finances, or someone key to the company’s operations may have left, making it difficult for the business to continue. Whatever the case, the business needs to either stop functioning, or reorganize to meet its obligations and become profitable again.

It’s all about chapters

Bankruptcy is organized into chapters, which refer to subsections of the actual bankruptcy law. For example, businesses most often file for bankruptcy under chapters 7 and 11.  

Chapter 7 bankruptcy results in the complete liquidation of a business. That means the business stops all operations, and its assets, or what it owns, are sold off. Those proceeds from the sale of those assets are then distributed to creditors. Any money left after paying back creditors is returned to shareholders. 

Chapter 11 bankruptcy allows a business to reorganize, and potentially to round up new sources of financing, while discharging, or getting rid of, some of its debt. It hopes to become profitable again as a result of the reorganization. 

Good to know: Consumers can also file for bankruptcy under other sections of the law. They do so usually under Chapter 7 or Chapter 13, which are also court-mediated processes that allow them to get rid of debts. With Chapter 13, debts are not liquidated completely, and a repayment plan for some of the debt is drafted.

What happens to stocks and bonds of bankrupt companies? 

When a company files for bankruptcy, it pays its secured creditors first. That means entities like banks that have loaned money for things like a mortgage for the company’s property or equipment, are first in line. Bondholders are also likely to get paid because the company has agreed to pay them back by issuing bonds; equity shareholders, on the other hand, are usually paid last and often end up losing money. 

When public companies file for bankruptcy, the stock may also be delisted from its main stock exchange. Delisting is a process whereby a company is removed from the exchange where it trades for failing to meet the minimum value for its shares, typically $1 a share. If the company is delisted, it may continue to trade “over the counter,” on either the Over the Counter Bulletin Board (OTCBB), or the Pink Sheets. (Read more about delisting here.)

While there is no federal law that prohibits investing in the shares of companies in bankruptcy, it is extremely risky and can lead to substantial financial losses. It is possible for existing shareholders to lose all (or nearly all) of their investments. This is because creditors get paid first and shareholders only receive what’s left over, if there’s anything left over at all.

Remember, all investing involves risk and you can lose money on your investments. Stash does not recommend investing in the shares of companies in bankruptcy.