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By Newsweek Editors
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Alexander Pope, the great 18th-century poet, was a writer, not a financial speculator. But when he wrote that "hope springs eternal in the human breast," he could have been talking about those intrepid souls who buy the stock of bankrupt companies. Then again, another of Pope's lines is even more appropriate: "Fools rush in where angels fear to tread."
With so many high-profile bankruptcies like Kmart, USAir, WorldCom, Enron and Global Crossing the past few years, the spectacle of naive investors' getting fleeced by buying the common stock of bankrupt companies has become distressingly commonplace.
On the surface, buying the stock of a company in Chapter 11 seems so logical. Take Enron, for example. The stock used to trade at 80 bucks a share. How can you go wrong buying it at its recent price of six cents? Easy. The stock of a bankrupt company can get cheaper. And it generally does, down to zero when the bankruptcy case ends, a new company emerges from the rubble and the old stock is canceled. "About 99 percent of the stocks of companies in Chapter 11 end up being worthless," says George Putnam III, editor of The Turnaround Letter, and buying such stocks is "a snare and a delusion."
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Susan Wyderko, director of the SEC's office of investor education, said that losing money in bankruptcy stocks ranked No. 8 on the commission's complaint list last year, the first time it had cracked the top 10. The SEC has a lengthy (and excellent) warning about bankruptcy stocks on its Web site www.sec.gov/investor/pubs/bankrupt.htm)."In most instances, the company's plan of re-organization will cancel the existing equity shares," the SEC says.
To understand why, it helps to have a brief refresher in bankruptcy law. When a company goes Chapter 11, various creditors have claims on the company's assets. Stockholders come last in line, after everyone else--including lenders and preferred stockholders--has been paid. Because the company's assets are worth less than its obligations--that's why it went into bankruptcy, remember?--there's generally nothing left for the common stockholders.
The only significant exceptions are companies like A.H. Robins or Texaco, which went Chapter 11 to protect themselves from lawsuits, not because they were in financial distress. A handful of asbestos firms currently in Chapter 11 because of their legal liabilities might--repeat, might--emerge with significant value for their stock, especially if Congress passes legislation limiting asbestos liability.
But, you say, I've read about bankruptcy investors' making fortunes. Yes, you have--but they do so by buying the company's debt, not its common stock. The bankruptcy investors--known in the trade as vultures--make out when they exchange their debt for stock in the postbankruptcy company at what turns out to be a cheap price.
What's confusing is that the new company generally has the same name as the company that went under. Global Crossing and Kmart, for instance, are now trading nicely. But they're not the same companies that went Chapter 11. Those companies are defunct, and their stock was canceled.
You've got to pay attention to what corporations tell you. Take a situation with which I'm painfully familiar, RCN Corp., an up-start telecom company that announced last month that it would file for Chapter 11 with "extremely significant, if not complete, dilution" of its common stock. Translated into English, this means the stock will become worthless, or virtually worthless. RCN bonds trade well below face value. Its $2 billion of preferred stock, which, like the bonds, ranks ahead of the common stock, is underwater, too. One holder, Microsoft cofounder Paul Allen, recently sold about $650 million of it for a mere $2 million. Yet the common stock not only trades, but rallies. I invested in RCN's predecessor company 10 years ago, and waited until the bankruptcy announcement to sell. I couldn't believe someone paid me 41 cents a share, roughly 41 cents more than the stock is worth. (Don't cry for me. I'm way ahead on my total investment because the other parts of RCN's predecessor have done well.)
The only reason to buy stock of a company in Chapter 11 is a cynical one: you think you can dump fundamentally worthless shares onto someone else for more than you paid for them. We started with Pope; let's end with Shakespeare: when it comes to buying stock of companies in Chapter 11, what fools these mortals be.
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