When the economy turns south, sometimes it exposes cracks in certain companies or industries. There are a few lifelines built into the system—bailouts and bankruptcies for instance—but they're not all alike. Here what investors should know.
As COVID-19 tore through the U.S. economy—grinding several large sections of it to a halt—questions arose about whether certain companies and industries might get thrown a lifeline by the government. Transportation, travel, leisure, entertainment—and really the entire Consumer Discretionary sector—are among the segments hit hardest by the virus.
Depending on the length of the crisis, certain industries like airlines might be in line for bailouts. And if bankruptcy is in the future for some companies, authorities are looking at ways to minimize disruption to the economy.
Whether such assistance is right or wrong philosophically is well beyond the scope of this article. But bankruptcy is baked into the capitalist system, and economic stability is part of the Fed’s mandate.
The question, though, is what assistance and transition programs might mean for an investor. And that depends on a couple things:
If you’re an investor in a company or sector that might be affected, understanding the basics can help you position yourself. Here are a few definitions, rules of the road, and lessons learned from past bankruptcies and bailouts.
In general, a company bankruptcy falls into two categories: Chapter 7 (a "liquidation") and Chapter 11 (a "reorganization"). A full explanation by the Securities and Exchange Commission (SEC) is available on its website, but here's the gist:
Chapter 7 Liquidation. Company operations stop, a trustee is appointed to liquidate the assets and settle all claims in order of so-called "seniority."
Chapter 11 Reorganization. Most publicly-held companies would choose reorganization if given the choice, as it allows the company to continue day-to-day operations while it rejiggers its assets, operational practices, and credit arrangements—and perhaps its management structure. In the case of large companies with thousands of employees, or so-called "systemically important" industries such as banks and financial institutions, this type of bankruptcy can help keep the workforce intact and the existing infrastructure in place.
Chapter 11 is meant to give the company a bit of "breathing room" from creditors. During the bankruptcy, bondholders and other creditors stop receiving interest and principal payments. That money is tied up until the end of the process.
In most cases, the reorganization will cancel all existing common shares, even if the company re-emerges as a public company. Why? It's that "residual claim" again. Typically, since the creditors (including bondholders) didn't get their claims fulfilled—and had their payments suspended during the bankruptcy—they become the new owners, and are often granted common shares in the reorganized company. General Motors (GM) is a recent example.
Sometimes the government will step in and offer assistance in conjunction with a bankruptcy, if they deem it to be in the best interest of the nation. General Motors (GM), for example, went through a Chapter 11 bankruptcy during the financial crisis of 2008-09, wiping out all the equity in common shares. A $65 billion bailout orchestrated by the Obama administration made the government the controlling shareholder of the restructured company and, in the process, saved many jobs. Still, there was plenty of pain along the way for workers, creditors, executives, and the company’s network of dealers.
Ultimately, new GM shares were issued and began trading again, though they never gained much traction over the roughly 10 years between bankruptcy and the COVID-19 epidemic. GM shares traded at $33.99 on Jan. 31, the last month before the virus sent everything spinning down. That was down from $36.86 a share at the end of 2010.
That slight loss over nearly a decade doesn’t tell the entire story, however, because it doesn’t include dividends. GM suspended its dividend program in late April as it dealt with the pandemic.
Before that, it had a quarterly payout of $0.38 for every share (or $1.52 per year). Someone who owned 1,000 shares over that period would have been down around $2,900 on the original investment, but would have received more than $1,500 per year in dividends. Not too shabby when you consider that more conservative fixed income investments paid far less in recent years, often below 1%. By the time GM suspended the dividend, its yield had risen to more than 6%.
During the financial crisis, banks and other financial firms experienced bailout, bankruptcy, government facilitation, and everything in between. Entire books have been written about the many forms of assistance, but here’s a sampling.
Do you hold—or are you considering taking a stake in—companies that are in the crosshairs of bailout and/or bankruptcy? Proceed with caution, said George Tsilis, Senior Contributor to our media affiliate the TD Ameritrade Network.*
“Even if a company comes out of bankruptcy and new shares are issued, those shares are completely different from a legal standpoint than the previous shares,” Tsilis said.
Companies not going bankrupt but getting government help also require a very close look before going in (or staying in, as the case might be).
Referring to bailouts during the coronavirus crisis, Tsilis said, “A bailout provides liquidity to businesses that have become cash starved as a result of their businesses being shut down. But just because a company is bailed out or is on a list of companies getting bailed out doesn’t mean the common shareholders are going to benefit.
“That’s a misnomer that folks have to be wary about,” he continued. “For instance, airlines are getting bailouts both in the form of grants and loans. But since the announcement of these vehicles to finance their continuing operations, the shares of these companies have not participated” in any rallies. (For more from Tsilis, scroll down and watch the video below).
And remember the lessons from the financial crisis.
Some might look at GM’s experience and say the company got off relatively easily, considering what many economists now see as mismanagement heading into the 2008 financial crisis.
“The understandable objection to bailouts is that they foster moral hazard, the willingness to act recklessly without fear of consequences,” wrote the late Paul Ingrassia of The Wall Street Journal in an 2010 article examining the bailouts of GM and Chrysler. “Yet the bailouts of these two companies had painful consequences aplenty for the major actors.”
Ingrassia, who won a Pulitzer Prize for his coverage of the auto industry, suggested that those considering investment in bailed out companies look for two things before jumping in: Spending discipline and good corporate governance.
Naturally, no one can know right away how these things might shape up. That means anyone itching to take a flyer on a bailed out company might want to wait a few quarters and closely watch how the company makes its spending decision, what it decides to invest in, and who it appoints to its board of directors. Share buybacks, increased executive compensation, and higher dividends might be signs of profligacy in a company still emerging from a bailout, and might not even be allowed under many circumstances. Instead, you arguably want to see the company invest in improving its plants and supply chains, as well as in hiring an executive team that’s respected in the industry and by Wall Street.
*TD Ameritrade Network is brought to you by TD Ameritrade Media Productions Company. TD Ameritrade Media Productions Company and TD Ameritrade, Inc. are separate but affiliated subsidiaries of TD Ameritrade Holding Corporation. TD Ameritrade Media Productions Company is not a financial adviser, registered investment advisor, or broker-dealer.
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