Bankruptcy, insolvency and how they affect investor wealth

In the previous chapter, we very briefly touched upon the concepts of insolvency and bankruptcy. What are these two terms and what does it mean for a company that’s been adjudged as insolvent or bankrupt? These are some of the questions that we’ll be answering in this chapter, starting with insolvency. 

What is insolvency?

Insolvency is the term that’s used to refer to a situation where an entity (both individuals as well as companies) is unable to satisfactorily meet its financial obligations when they are due. For instance, when a company takes a loan from a bank for its operations and subsequently fails to make periodic repayments because of low revenue generation, the company is said to be facing insolvency.  

Speaking of insolvency, there are two primary forms that you need to know about - cash-flow insolvency and balance sheet insolvency. Let’s get into the specifics.  

• Cash-flow insolvency: When an entity does not possess or generate enough liquid assets such as cash to pay off its debtors, it is said to be cash-flow insolvent. For instance, a company may have a huge piece of land and expensive manufacturing equipment, but may still not be able to pay off its debts due to lack of cash and other liquid assets. In such a case, the entity is said to be facing cash-flow insolvency. 
• Balance sheet insolvency: When an entity does not possess enough fixed or liquid assets to settle all its debts and financial obligations, it is said to be balance sheet insolvent. For instance, a company whose total combined liabilities exceed its total combined assets is said to be facing balance-sheet insolvency. This is a far more serious situation to be in because it can lead to bankruptcy. What is bankruptcy, you ask? We’ll tell you.

What is bankruptcy?

Most people confuse the terms insolvency and bankruptcy and tend to use them interchangeably. However, they’re two different concepts. While insolvency is more of a temporary phase that entities go through, bankruptcy is permanent. When an entity still remains insolvent even after taking all the possible steps for recovery, it files for bankruptcy with the courts. 

So, bankruptcy is a legal process that cements an entity’s insolvency and is aimed at helping the insolvent entity pay off its debts, thereby giving its creditors some much-needed relief. When a company files for bankruptcy, it is essentially seeking the help of the government to help settle its dues. Filing for bankruptcy is usually done by the insolvent entity itself. However, the filing can also be initiated by the entity’s creditors. 

As with insolvency, there are two primary forms of bankruptcy - reorganisation bankruptcy and liquidation bankruptcy.

• Reorganisation bankruptcy: When an entity prefers to reorganise its debt and other financial obligations to make it easier to discharge its commitments, it files for reorganisation bankruptcy. 
• Liquidation bankruptcy: When an entity prefers to close down its entire business and liquidate its assets to pay off its financial obligations, it files for liquidation bankruptcy. 

Okay, so now you’re clear about the answers to these two questions: What is insolvency? And what is bankruptcy? Let’s take a look at what a company would do when it is adjudged as insolvent and when it files for bankruptcy. 

What does a company do when it goes insolvent?

As we’ve already seen before, most of the time, insolvency is just a temporary phase and is far from the end of the world. Therefore, insolvent companies generally adopt either one of two approaches.

• Request for more time: Companies that are cash-flow insolvent generally adopt this approach. Since they’re only short of liquid assets and not long-term assets, companies typically approach the creditors directly and request for more time to settle their dues. This approach, if successful, gives the company enough time to sell off some of its assets to make payments. 
• Restructure its debt: Sometimes, companies may reach out to their creditors directly and make a formal request for restructuring of debt. This plan of action involves breaking down the debt into smaller and more manageable installments over a longer period of time. This approach requires the company to prepare a detailed plan of action to convince its creditors.  

If all else fails, and a company is unsuccessful at resolving its insolvency, it can then move to the court to formally file for bankruptcy. 

What does a company do when it goes bankrupt?

In India, bankruptcy rules are governed by the Insolvency and Bankruptcy Code (IBC) 2016. Once a company has filed for bankruptcy, it either goes for reorganisation or liquidation. In the event of reorganisation, the creditors of the company may be asked to take a ‘haircut’ with respect to their debt. This may include foregoing a portion of the interest on their loans or in some cases of severe bankruptcy, even foregoing a portion of their principal loan amount as well. 

In the event of liquidation of the company, all the assets are sold off and the proceeds are used to pay off all of its debts or financial obligations. This is where things get exciting. How do you determine who gets paid first? And, how is the order of the payout determined? 

The Insolvency and Bankruptcy Code, 2016 has the answer to this question. It specifies an order of priority with respect to settlement of dues that a company under liquidation should follow. Here’s a quick look at the order of preference ranked from 1 to 7, with 1 denoting the highest preference and 7 denoting the lowest preference.  

1. Workmen’s wages and unpaid dues and all the debts and loans owed to secured creditors. 
2. Wages and unpaid dues owed to the employees of the company.
3. All the debts and loans owed to unsecured creditors.
4. All the amounts owed to the central and the state governments of India.
5. All the other remaining dues, debts, and loans owed by the company. 
6. All the payments owed to preference shareholders. 
7. Distribution of the remaining assets, if any, to the equity shareholders.

As an investor, what happens to you when the company you’ve invested in becomes insolvent?

As an investor, if the company that you’ve invested in becomes temporarily insolvent, the first thing that would happen to your investment would be a decline in its value. 

This is because the stock markets do not take insolvency kindly, as it brings the entire going concern assumption into question. When a company becomes insolvent, the shares of the company would experience a deep sell-off, bringing the share value down. 

In such a case, you have two options. 

1. You can either sell off your investments to prevent any further decline in their value. 
2. Or, you can keep holding onto your investments with the hope that the company would sail through this temporary insolvency phase and get back on track. 

As an investor, what happens to you when the company you’ve invested in goes bankrupt? 

If the company you’ve invested in goes bankrupt, as an investor, it is essential for you to know exactly where you stand. Now, here’s where it gets a little interesting. The shares of a company that’s filed for bankruptcy take a huge hit and are almost always delisted from the stock exchanges. In such a scenario, you’re effectively stuck with the investment since there’s no way for you to sell your holdings. And, in quite a few cases, the shares become totally worthless. 

However, as an investor, you might have a chance to get back at least a part of your investment in the company through the liquidation process. Depending on the type of investment you have in the company, your order of priority changes. Here’s a look at what’s likely to happen.  

When you’re a bond or debenture holder

Generally, the debentures or bonds of a company are secured by an asset or assets. If you’ve invested in secured debentures, you’ll be classified as a secured creditor. And according to the order of preference as specified in the IBC, 2016, you would get first preference to the proceeds of the sale of that asset. In the event of an investment in unsecured debentures, you would be classified as an unsecured creditor and consequently get to enjoy the third position in the preference order. Since bond and debenture holders are placed higher in the preference list, there’s a very high chance for you to recover your investment capital with little to no losses.   

When you’re a preference shareholder

If you’re a preference shareholder, you only get to receive the proceeds from the sale of assets after the company has paid off all its debts and financial obligations. Being a preference shareholder is quite risky. And, since you’re lower down the order in the preference list, there’s a slim chance that you may not be able to recover all of your investment. 

When you’re an equity shareholder

As an equity shareholder in a company, you’re in the last position on the priority list. This effectively means that you’re not entitled to get anything from the company. Your claim is limited to only the residual proceeds from the asset sale after clearing out all the liabilities of the company. Even then, the residual proceeds, if any, are divided by the number of total outstanding shares and then paid out according to the proportion of shares that you own. Due to this, the likelihood of you getting your investment back either in full or in part is slim, at best.    

Wrapping up

That said, do not let this deter you from investing in a company. In fact, this piece of information should only serve to prompt you towards conducting a full and thorough fundamental analysis on the company that you wish to invest in. In the next chapter, we’ll take a look at what happens to your equity investment when a company delists, merges, or splits.

A quick recap

• Insolvency is the term that’s used to refer to a situation where an entity (both individuals as well as companies) is unable to satisfactorily meet its financial obligations when they are due.
• There are two primary forms of insolvency - cash-flow insolvency and balance sheet insolvency.
• When an entity does not possess or generate enough liquid assets such as cash to pay off its debtors, it is said to be cash-flow insolvent.
• When an entity does not possess enough fixed or liquid assets to settle all its debts and financial obligations, it is said to be balance sheet insolvent.
• Insolvency is more of a temporary phase that entities go through while bankruptcy is permanent. 
• When an entity still remains insolvent even after taking all the possible steps for recovery, it files for bankruptcy with the courts.
• Bankruptcy is a legal process that cements an entity’s insolvency and is aimed at helping the insolvent entity pay off its debts, thereby giving its creditors some much-needed relief.
• When a company files for bankruptcy, is essentially seeks the help of the government to help settle its dues.
• There are two primary forms of bankruptcy - reorganisation bankruptcy and liquidation bankruptcy.
• When an entity prefers to reorganise its debt and other financial obligations to make it easier to discharge its commitments, it files for reorganisation bankruptcy.
• When an entity prefers to close down its entire business and liquidate its assets to pay off its financial obligations, it files for liquidation bankruptcy.
• Insolvent companies generally adopt either one of two approaches – request for more time or restructure its debt. 
• There’s an order of priority with respect to settlement of dues that a company under liquidation should follow.

1. 1. Workmen’s wages and unpaid dues and all the debts and loans owed to secured creditors. 
   2. Wages and unpaid dues owed to the employees of the company.
   3. All the debts and loans owed to unsecured creditors.
   4. All the amounts owed to the central and the state governments of India.
   5. All the other remaining dues, debts, and loans owed by the company. 
   6. All the payments owed to preference shareholders. 
   7. Distribution of the remaining assets, if any, to the equity shareholders.

• If the company that you’ve invested in becomes temporarily insolvent, the first thing that would happen to your investment would be a decline in its value.
• The shares of a company that’s filed for bankruptcy take a huge hit and are almost always delisted from the stock exchanges.
• If you’re a secured bond or debenture holder, you would get first preference to the proceeds of the sale of assets.
• If you’re an unsecured debenture holder, you would be classified as an unsecured creditor and consequently get to enjoy the third position in the preference order.
• If you’re a preference shareholder, you only get to receive the proceeds from the sale of assets after the company has paid off all its debts and financial obligations.
• As an equity shareholder in a company, you’re not entitled to get anything from the company.
• Equity shareholders’ claim is limited to only the residual proceeds from the asset sale after clearing out all the liabilities of the company.