Why People Buy Stock in Bankrupt Companies

Blockbuster's stock must be worth something, says Ron Krenn, a 48-year-old day trader in Daytona Beach, Fla., 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 of Blockbuster's bankruptcy, the stock price has ranged from 4 cents to 23 cents, with volume averaging 5.46 million shares a day.

Krenn and others who buy stock in bankrupt companies such as Lehman Brothers, Washington Mutual, and Borders hope there will be money left over for equity holders after all the debt is repaid. It's an increasingly risky gamble. 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.

Of 41 bankrupt public 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 the UCLA School of Law who works with Lynn LoPucki, a UCLA bankruptcy law professor. 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.

Some speculators beat the odds. LoPucki cites the case of Tronox, a producer of titanium dioxide pigment, which gave shareholders 5 percent of the new stock when it reorganized. The shares trade near $130, up from $123 when the company emerged from bankruptcy on Feb. 15.

Stock investors don't get a final accounting until a bankrupt company files a disclosure statement, which details the terms of recovery for each class of creditor and announces whether existing shareholders get anything. Until then, the stock continues to trade as secured creditors and unsecured creditors fight over the company's worth and investigate potential lawsuits that could bring money into the bankrupt estate. Some investors bet on the stock, while those who sold it short—borrowing shares and selling them, hoping to buy them back later at a lower price—unwind their positions. Purchases by short sellers can sometimes lead to a temporary runup in price.

Blockbuster, which has yet to file a disclosure statement, said in a May 9 regulatory filing that it "anticipates" its A and B shares will be worth nothing. Krenn, who bought Blockbuster shares for 6 cents each in February, says he saw the company's regulatory filing, but dismissed it. "I still believe there is more to this shell," Krenn wrote in an e-mail on May 12, saying he was buying stock on the dips and awaiting news on the value of the company's Italian assets.

Some investors may trade on news about a bankrupt company without fully understanding it. Paul Rachmuth, a bankruptcy lawyer with Gersten Savage, represents Blockbuster shareholders. He says the sale of the company's assets to Dish Network (DISH) for $320 million on Apr. 7 effectively ended the chance that shareholders would get any money. Nonetheless, from Apr. 6 to Apr. 8, the stock rose 17 percent, to almost 7 cents a share. As of May 16, it was trading at just above 5 cents a share, giving the presumably worthless stock a market value of $9.7 million.

Jon Becker, 53, who owns a grocery store in Miami Beach, bought a few thousand dollars' worth of Blockbuster at 10 cents a share in February. He was still holding the shares when Dish Network bought the company's assets. Becker says he did not realize that the stock could end up worthless. He can't believe there was nothing on his screen to differentiate Blockbuster from other stocks he buys on E*Trade Financial (EFTC): "It's a different category than normal risk," he says. "If it's foreseeable shares would go to zero, I would think the powers that be would flash something—some kind of warning." Why did he buy a bankrupt stock in the first place? "My thought was, this is Blockbuster, it will come back," Becker says. It didn't. He finally sold at 7 cents a share.

The bottom line: Only 4 of 41 public companies that went through bankruptcy in 2009 and 2010 produced returns for shareholders.

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