BusinessWeek Online

The Empty Truth about Bankruptcy Stocks

Daily Briefing: NEWS ANALYSIS

By David Shook in New York

Funny thing about the shares of bankrupt companies: Many continue to trade long after the issuer has declared bankruptcy. In many cases, the companies fall below capital requirements necessary to continue trading on the New York Stock Exchange or on Nasdaq, so their stocks are relegated to the over-the-counter market. Even there, however, trading volume often remains brisk.

That's the story for Enron, the largest bankruptcy in U.S. history, which is still trading in the area of 15 cents to 20 cents a share. And it remains true for Global Crossing (OTC BB:GBLXE.OB - news) and Williams Communications (OTC BB:WCGRQ.OB - news), two telecom giants that filed for bankruptcy this year. Now it's happening with Kmart (NYSE:KM - news), the beleaguered discount retailer, which filed for Chapter 11 protection in January. Its stock trades at around $1.15, up from 99 cents a few weeks ago. From 1.2 million to 1.5 million Kmart shares are trading daily.

Why? Perhaps it's the allure of risk. Buying stocks of bankrupt outfits is certainly risky, and some investors do search out risk as a matter of course. "There's a mystique about stocks of bankrupt companies," says Bill Brandt, CEO of Development Specialists, which specializes in corporate turnaround strategies. "They always seem to trade, though nobody can give any reason why they should. There's usually no meaningful value left."

"BRAINLESS" TRADING. The temptation may seem compelling. And yes, short-term stock jumps can create potential gains. But wise investors will be careful. The best bankruptcy strategy for all but the most daring is usually to sell, which creates a tax benefit, say analysts.

Better yet, advise most, don't buy the shares if you don't own them already -- no matter how cheap they become. Shareholders rarely do well in large bankruptcies of publicly traded companies, says Brandt. Trading these stocks is downright futile, "even brainless," he says.

Consider Kmart's plight as an example of why such stocks can be dangerous. It's hard to know how solvent the mass merchandiser is because it has delayed its annual report and says it may have to restate some of its numbers from last year. If Kmart's debts turn out to be greater than its assets [and nobody will know until the restatement is issued], equity holders will probably be left with little, if anything, after the bankruptcy is resolved.

Moreover, Kmart execs may have more incentive to keep creditors [who can scuttle a reorganization plan] happy than to salve the wounds of shareholders. Kmart says it's making no promises to investors. Even if it emerges from bankruptcy and becomes profitable, it could issue new equity without compensating current shareholders -- something that's fairly common in bankruptcy workouts. Kmart declined any additional comment for this story.

WAIT YOUR TURN. Managers of bankrupt companies often speak sincerely of their plans for a speedy turnaround, but these comments are aimed primarily at the company's creditors, suppliers, and customers -- not the shareholders. Regardless of how loyal or hesitant management may be in supporting shareholders, bankruptcy law is clear: Shareholders wait their turn, with little, if any, claim to assets until creditors are fully compensated.

Of course, the risks for shareholders aren't always the same from one bankruptcy to the next. In a Chapter 7 liquidation [in which the company disbands], the shares usually become worthless. But in the more common Chapter 11 filings, shareholders sometimes receive at least a token percentage of any new equity that's issued, says Bettina Whyte, a turnaround specialist for Jay Alix & Associates in New York.

In other situations, a company may file for Chapter 11 to protect itself from litigation -- such as those involving asbestos claims. It may have no intention of abandoning shareholders, and investors might even see their shares rise as the company's prospects improve. That appears to be the case with USG Corp. (NYSE:USG - news), a building-products maker in bankruptcy that faces crushing asbestos claims. Its stock plummeted 60% last summer to $5. Over the past 10 months, however, it has crept back up to $7, despite the bankruptcy.

LONG AND RISKY ROAD. If the Chicago Federal Court judge handling the Kmart case grants shareholders a seat at the table in the bankruptcy, they might get lucky. Even at $1.15, Kmart's shares are trading at only a tiny fraction of their one-year peak of $13 last August. Yet the company still has a sizeable market capitalization of more than $600 million, so a fair amount of value may remain.

Shareholders would remain at great risk, however. The case could drag on for more than a year and still end up a washout for equity holders. Another case in point: the ex-retailer Bradlees, which had a customer base similar to Kmart's. It slogged through two bankruptcies in the late 1990s, yet shareholders wound up with nothing, and the company has been liquidated. Or take Ames Department Stores, which has yet to emerge from a Chapter 11 filing last August. Since then, its stock (OTC BB:AMESQ.OB - news) has fallen from about 25 cents to 15 cents.

So, why is there still such interest in Kmart? Some investors may have a sentimental attachment to a once-dynamic company, and others may be taking a flier because the price has fallen so far. "There's always some hope in people's minds that because of the low price, perhaps the stock is a good deal," says Whyte, whose firm is serving as treasurer of Kmart during its bankruptcy. "But that's a dicey situation."

SCAM ALERT. Troubled companies also often are the subject of rumors -- or downright fraud by swindlers -- in Internet chat rooms. The rumormongers hope to profit from a short-term rise in the stock price. "This is very common. I see it all the time," says Brandt.

In Kmart's cases, a recent study commissioned by Cap Gemini Ernst & Young also may be fanning investors' optimism. The study concludes that Kmart may yet survive, largely because it retains a base of customers as loyal as those of rival Wal-Mart.

Sounds tempting, doesn't it? But given the great risks, smart investors may want to ignore this Blue Light special.

Go to www.businessweek.com to see all of our latest stories.