When most business owners or investors hear about bankruptcy, they think of the worst-case scenario – total financial ruin. But what if you could buy stock in a bankrupt company? Is it possible to make a profit from such a daring move?
The reality is, it is indeed possible to buy stock in a bankrupt company. The process of buying stock in a company that is already bankrupt is often referred to as “bottom feeding.” What this means is that the investor is willing to take a chance on the company; one that may never recover from its financial problems. Generally, when a company is declared bankrupt, its stock value plummets, and the prices of the stocks become significantly cheaper, providing an opportunity for investors to purchase stock at lower prices.
Although it may seem like a smart move, there are several risks associated with bottom feeding. First and foremost, as a stockholder you have no assurance that the company will ever become solvent again. Furthermore, depending on the type of bankruptcy the company has filed, the stockholder’s ownership may be substantially limited. There is a chance that all shares will be canceled and replaced with debt payments, or that the debts of the company will be paid out before the stocks become available for buying.
The bankruptcy process can also be extremely lengthy, as the company’s creditors and shareholders will often debate over its liquidation and reorganization. During this time, the stock value may remain relatively stable or may even increase slightly. However, this does not guarantee that the stock will be profitable once the bankruptcy proceedings are complete. As a result, investors should always be aware that their investments in bankrupt companies may not be profitable.
Given the potential risks, it is important to consider seeking professional advice before buying stock in a bankrupt company. It is wise to hire a financial advisor who is knowledgeable in bankruptcy law and can help evaluate the risks of purchasing such stock. Additionally, investors should look into the company’s books and records and examine the liability and debt structures that may be involved. Doing these steps can give investors a better understanding of the likelihood of recouping their investments and help weigh the risk of purchasing the stock.
Tax Consequences of Buying Stock in Bankrupt Companies
Understandably, most investors are primarily concerned with the financial risks associated with bottom feeding. However, they should also be aware of the potential impact their decision could have on their taxes. It is important to note that the IRS treats capital losses from bankrupt companies differently than other types of losses. For example, if an investor were to purchase stock in a bankrupt company, any capital losses incurred would be treated as a short-term capital loss which can offset short-term capital gains that were otherwise taxed in the same year. In some cases, those losses can even be used to offset up to $3,000 of the investor’s taxable income. Investopedia notes that “This treatment can be extremely valuable for individual investors looking to minimize their tax liability.“
Rewards vs. Risks of Buying Stock in Bankrupt Companies
In theory, investors can make a profit by bottom feeding. However, there is no guarantee that the strategy will be successful. If it is, the investor could earn a sizable return on their initial investment. However, if it is not, there is a real chance that their entire investment could be lost. This is why it is important to understand the risks and rewards of buying stock in a bankrupt business before making any decisions.
When a bankruptcy filing is complete, it must be approved by a court. Once approved, the bankruptcy trustee will then begin to divide the company’s assets and resources among the creditors and shareholders. The priority of creditors is determined by the type of bankruptcy filed. In general, secured creditors may have priority over unsecured creditors. And in most cases, the shareholders of a bankrupt company will generally be last in line to receive compensation. This all serves to highlight the risks of investing in a company, as the shareholder’s ownership may be cancelled out and replaced with debt payments.
Legality of Purchasing Stock in Bankrupt Companies
It is not illegal to buy stock in a bankrupt company. However, some countries, such as the United Kingdom, have specific regulations governing the purchase of such stocks. These include declaring the holdings and interests to tax authorities, reporting financial accounts, and adhering to international laws governing the transfer of funds. As a result, investors should always consult a financial advisor before taking any risks and understand the potential liabilities involved.
Stock Exchange Regulations
It is also important to be aware of the regulations set forth by stock exchanges. For example, the NYSE does not allow companies that are in bankruptcy, or have recently filed for bankruptcy, to remain listed on the exchange. Instead, it requires that the company be delisted and any remaining stock be deregistered. On the other hand, the Nasdaq allows companies that have recently filed for bankruptcy to remain on the exchange, but they must provide updates to the exchange to ensure compliance.
Conclusion
Buying stock in a bankrupt company carries a substantial risk. However, there may also be a potential reward. Before investing, it is important to understand the legal and financial implications of the process and seek professional advice when necessary. In addition to evaluating the risks of bottom feeding, investors should also be aware of stock exchange regulations and tax implications and make sure to follow any applicable laws.
