Blockbuster Stockholders Hang on to Test Steep Bankruptcy Odds

Blockbuster Inc. (BLOAQ)’s stock must be worth something, according to Ron Krenn, a 48-year-old day trader in Daytona Beach, Florida, who hopes to profit on the equity of what was once the world’s largest movie rental chain, seven months after it filed for Chapter 11.

He’s not alone. Since Sept. 23, the date that Dallas-based Blockbuster declared bankruptcy, the stock price has ranged from 4 cents to 23 cents a share, with volume averaging 5.46 million shares a day.

Krenn and others who buy stock in bankrupt companies such as Lehman Brothers Holdings Inc. (LEHMQ), Washington Mutual Inc., and Borders Group Inc. hope there will be money left over for equity holders after all the debt is repaid. It’s an increasingly risky gamble, Bloomberg Businessweek reports in its May 23 issue.

Bankruptcies are less likely than ever to return anything back to stockholders, according to a new study. Once a company files for Chapter 11, creditors are paid first in order of their seniority, with shareholders coming last after senior lenders, unsecured creditors, and holders of preferred stock. Unless creditors are paid in full, shareholders get nothing. If the company reorganizes, any stock in the new company usually goes to creditors.

“Research shows shares are overpriced in bankruptcy, even though it’s often already been decided that equity will get nothing,” said Lynn LoPucki, a bankruptcy law professor at the University of California, Los Angeles. The most common reason is a misunderstanding of the way the law works, he added.

Declining Recovery

Of 41 bankrupt companies that announced reorganization plans in 2009 and 2010, only four delivered returns to shareholders, according to a study by Andrew Wood, a student at UCLA’s law school who works with LoPucki.

Of the companies that went through bankruptcy from 1991 through 1996, 44 percent had returns for shareholders. The figure was 78 percent for those that went bankrupt from 1982 to 1987.

“The number of cases in which equity makes more than a nominal recovery has steadily declined since approximately 1987,” wrote Wood. The study cites an increase in the amount of secured debt carried by companies as one reason for the decline in shareholder recoveries. Wood also found a decline in recoveries for unsecured creditors.

Beat the Odds

Still, penny-stock investors such as Krenn sometimes do manage to beat the odds, LoPucki said.

“There are lots of bankruptcies where shareholders have had recoveries,” LoPucki said, citing Tronox Inc., Tronox Inc., a producer of titanium dioxide pigment, which gave shareholders 5 percent of the new stock when it reorganized. Tronox trades at about $133 a share, up from $123 a share when the company emerged from bankruptcy on Feb. 15.

The study also showed that 90 percent of cases had “nominal” recoveries, or those that gave old shareholders warrants, or rights, to buy new stock.

Krenn said he made money by buying shares of Pilgrim’s Pride Corp. in bankruptcy. Pilgrim’s Pride gave 36 percent of its new equity to “stockholders existing immediately prior” to the reorganization, the company said in 2009, the year it emerged from Chapter 11.

Krenn, who bought Blockbuster for 6 cents a share in February, objected in April to a report that said Dish Network Corp.’s winning bid for Dallas-based Blockbuster left nothing for shareholders. He cited the company’s foreign assets, the fees being paid by franchisees and the value of its net operating losses to support his view that the company must be worth more than the $320 million that Dish bid.

Shareholder Group

Paul Rachmuth, a bankruptcy lawyer with Gersten Savage LLP representing Blockbuster shareholders who tried to argue for a recovery in the case, said the stock’s value has little correlation with news in the case. “Shares are still trading at a positive value, and on the day all of Blockbuster’s assets sold, effectively removing the ability for them to have a recovery, the stock went up by 10 percent,” Rachmuth said.

A group of seven shareholders represented by Rachmuth hasn’t officially disbanded. Since Dish announced its offer would leave no value for equity, there’s been no litigation that would challenge that, however, Rachmuth said.

Yet stock-trading message boards such as Yahoo Inc.’s are filled with posts about the promise of the stock, touting business reasons such as the way the company compares with online rival Netflix Inc. and news that executive Michael Kelly would head Blockbuster. On May 6, about 15 messages debated the idea that the stock was a “strong buy” based on such issues.

Finality for Shareholders

Finality for shareholders doesn’t come until a company files its disclosure statement, which details the terms of recovery for each class of creditor. Until then, secured creditors and unsecured creditors will fight over the company’s worth, investigating potential lawsuits that could bring money into the bankrupt estate.

“I’ve never seen a company say independently from its disclosure statement that they will cancel shares,” said Matthew Morris, a bankruptcy lawyer at Wilmington, Delaware- based Grant & Eisenhofer PA. He noted that they’re under no obligation to do so, and haven’t breached any duty to shareholders as long as they haven’t issued false information.

Short Positions

Meanwhile, short positions need to be worked out, causing some confusion; Krenn said May 5 that Blockbuster’s rise indicated to him that news is on the way. Short interest for the most recent month isn’t yet available.

When investors who shorted shares -- or borrowed them to sell them with the expectation that they can buy them back at a lower price to turn a profit -- need to cover their positions, it could result in a “short squeeze” or run-up in price related to a lack of supply.

Opaque court proceedings can also mislead shareholders. While bankruptcy proceedings are theoretically open to the public, creditors haggle over a company’s worth behind closed doors, and reports that value the company’s assets aren’t made public.

“I kept Googling ‘Blockbuster bankruptcy,’ and couldn’t find information,” said Jon Becker, 53, who owns a grocery store in Miami Beach, Florida. After buying shares for 10 cents each in February, five months into the company’s Chapter 11 bankruptcy, he was still holding them in April, when Dish bought the company’s assets. Even Rebecca Bauman, his 41-year-old girlfriend with a brokers’ license, who had already lost thousands on the stock, couldn’t persuade him to sell.

Some Warning

Becker said he doesn’t blame anyone, but can’t believe there was no flashing on his screen to differentiate Blockbuster from other stocks that he buys on E*Trade Financial: “It’s a different category than normal risk,” he said. “If it’s foreseeable shares would go to zero, I would think the powers that be would flash something -- some kind of warning, maybe in more than one language.”

Companies don’t have to offer such warnings, said Nell Minow, editor for GovernanceMetrics International, a corporate governance research company in New York. In fact, companies often deny the possibility of a bankruptcy right up the day they file, as they’re also bound to protect their own interests, and those of creditors, she said.

“This is why people shouldn’t be retail shareholders,” Minow said. “They don’t do their homework and sometimes they pay the price.”

Icahn

Even sophisticated shareholders can lose money. One of Blockbuster’s biggest shareholders, billionaire Carl Icahn, also a lender to Blockbuster and former director at the company, still held 4.15 million shares, or 3 percent of the stock outstanding, as of April 2010, the most recent filing according to Bloomberg data. Icahn didn’t return a call for comment.

Icahn had supported a deal from the outset of the bankruptcy under which there would be no recovery for stock. Though that plan wasn’t followed, the company warned shareholders online: “As you may know, when a company files for Chapter 11, its primary obligation shifts to maximizing the value of the company for its creditors. Shareholders of a company in Chapter 11 generally recover value only if the claims of the secured and unsecured creditors are fully satisfied.”

Blockbuster’s Chapter 11 bankruptcy petition in September listed assets of $1.02 billion and debt of $1.47 billion. When it filed, it had 5,600 stores, including 3,300 in the U.S. Dish hasn’t decided how many stores to keep.

“My thought was, this is Blockbuster, it will come back,” Becker said. It didn’t. He finally sold at 7 cents a share.

To contact the reporter on this story: Tiffany Kary in New York at tkary@bloomberg.net.

To contact the editor responsible for this story: John Pickering at jpickering@bloomberg.net.

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