peer reviewed article

Penny Stocks of Bankrupt Firms: Are They Really a Bargain?

by Philip Russel and Ben Branch

Philip Russel  is an Assistant Professor of Finance at Philadelphia University.  Ben Branch is a Professor of Finance at the University of Massachusetts.

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The low priced stocks of bankrupt companies have attracted numerous (apparently) unsophisticated investors. The naive reasoning has been, if the stock that at one time was selling for $20, $30 or $50 a share is now selling for a few cents, how much lower can it sink? Perhaps lightening will strike and the stock will eventually get back to its earlier levels. Even if this stock does not recover, perhaps the next one will. The cold hard results of this study reveal the dangers of such irrational reasoning.

In the sample of 154 firms that this study is based on, the total investments of the common stockholders of 93 firms were totally wiped out. Overall, these shareholders suffered an average loss of around 70 percent. While a very few bankrupt stocks may produce stratospheric gains, the risk of loss inherent in most such situations is likely to be far greater than those potential gains. One is exposed to the uncertainty of the final resolution of the bankruptcy process, total time for completion of the process (averaging two years), the quality of the reorganization plan and successful implementation of the plan. A high percentage of reorganized firms fail a second time.

Based on the results of this study and the general nature of uncertainty surrounding the complex bankruptcy process, we recommend that unsophisticated individual investors not invest in the stocks of bankrupt firms. To make abnormal returns in this area, an investor would require superior financial analysis skills and a thorough understanding of the intricacies and legal wranglings of the bankruptcy process (and perhaps a bit of luck).


Casual empiricism suggests that stock market may overreact to bankruptcy announcements causing the prices of stocks to plummet during the bankruptcy period. For example, about seventy percent of the firms in our sample had stock prices under $2 at the time of filing. Such low priced stocks of bankrupt companies have attracted numerous (apparently) unsophisticated investors. The naive reasoning has been, if the stock that had once traded for perhaps $30 per share is now selling for a few cents, how much lower can it sink? The truth is the value of such stocks can (and usually does) drop to zero, generating a holding period return of -100% on the investment.

We examine a sample of 154 firms that filed for bankruptcy during the period 1984:1 - 1993:12. We find that the old stockholders, on average, lost about the seventy percent of their investment during the bankruptcy period. Indeed, the common stockholders of 93 firms received no consideration at the end of the bankruptcy.

The remainder of the paper is organized as follows: The next section reviews the relevant background literature. The third section describes the data and methodology. The fourth section discusses the results. The fifth section concludes this article.


A decline in the value of  a firm's stock while it is in bankruptcy generally reflects an erosion of its expected future cash flows. This decline in value could be due to a number of factors, including bankruptcy costs, the loss of reputation, drop in market share, resignation of key employees and impairment of regular operations.

Bankruptcy costs have typically been divided into two categories: direct costs consisting of legal fees and other administrative expenses and indirect costs consisting of opportunity costs such as lost sales, tarnished reputation, and lost investment opportunities. Studies by Warner (1977), Ang, Chua and McConnell (1982), Summers and Cutler (1988) and Weiss (1990) have explored the direct cost of bankruptcies. Relatively few researchers have attempted to measure the indirect cost empirically, as they are not easily observable. Altman (1984) used foregone profits as a proxy to estimate the magnitude of indirect cost. Several studies have investigated and found, in general, a positive relationship between firm size and bankruptcy costs (See Warner, 1977; Ang, Chua, and McConnell, 1982; Weiss, 1990; Guffey and Moore, 1991; and Deis, Guffey and Moore, 1995). Bankruptcy also has an adverse impact on the firm's pre-filing managers. (See Gilson (1989, 1990), Sutton and Callahan (1987) and LoPucki and Whitford (1991).)

The announcement of a bankruptcy filing (particularly if it is not fully anticipated) should be associated with market activity, as it provides material information about the reduction in the value of the firm. Several researchers have examined the impact of bankruptcy filings on the behavior of the firm's common stock on and around the announcement date. (See Aharony, Jones and Swary (1980), Clark and Weinstein (1983), Morse and Shaw (1988) Lang and Stulz (1992).) Hotchkiss (1995) investigates the post bankruptcy performance. Overall, these studies indicate that the stock prices tend to decline around the date of the  bankruptcy announcement. Further, the market is able to distinguish between firms that emerge successfully from the process and firms that do not. Moreover, bankruptcy announcements have important wealth implications for other firms in the same industry.

The academic literature largely suggests that distressed securities (such as bankrupt stocks) are efficiently priced. (See Fridson and Cherry (1990), Buell (1992), Eberhart and Sweeney (1992), Altman and Eberhart (1994), Ma and Weed (1986), Weinstein (1987) Blume, Keim and Patel (1991), and Cornell and Green (1991).) The popular press, however, has frequently conjectured that stock pricing may not reflect the true value during the bankruptcy period. Indeed, not infrequently, the proposed reorganization plan provided no consideration (or at best, only token consideration) for the pre-bankruptcy filing equity holders. Nonetheless, the shares continued to trade for non-trivial prices. For example, the shares of Continental Airlines continued to trade on the AMEX at or about $1.50 per share even after the company had negotiated a plan with its creditors that would provide no distribution to the pre-petition equity holders (WSJ, 1992). Note that Section 1125(b) of the Bankruptcy Act requires that adequate financial and related information be supplied to all impaired parties before soliciting approval of the reorganization plan. However, since the trading in the stocks of bankrupt companies precedes the actual confirmation (or publication) of the reorganization plan, a lack of complete and uniform public information in the market may lead to inefficiencies in the accurate long-run valuation of the company. Additional uncertainty results from the negotiation aspect of the bankruptcy procedure. Due to the conflict of interest among the impaired parties, often the company is valued at different dollar amounts by different groups of claimants. Such anomalous pricing (if it exists) raises several interesting questions: Does the stock market accurately value the securities of bankrupt firms? Are brokers promoting bankrupt stocks as "good bargains" to naive investors? Do shareholders gain or lose on balance by investing in low priced stocks of bankrupt companies? The current study is designed to examine the wealth effects of investing in common stocks of bankrupt firms.


Sample Selection

    A list of firms filing for Chapter 11 was identified from the Wall Street Journal Index and Moody's CD-ROM business database for the period January 1984 - December 1993. The dates when the reorganization plans were filed and confirmed were compiled in a similar manner. Only firms that were listed in the NYSE, AMEX or NASDAQ National Market System were considered for this study. Financial institutions were excluded because they are not subject to the same procedures under the Bankruptcy Code. A total of 299 Chapter 11 filings were identified for the period. One hundred and sixteen firms were eliminated because they could not be contacted or had insufficient trading history. Eight firms were deleted as they were still in Chapter 11. An additional twenty-one firms were dropped as they were privately held. Of the remaining 154 firms considered for this study, 49 firms were at the time that they filed for bankruptcy listed on NYSE, 32 on Amex while 73 firms traded on the NASAQ. Most of the relevant data were not available on the standard data tapes. Rather, we wrote and called the successor corporations and their professionals to obtain copies of the reorganization plans.

Return to the Pre-petition Stockholders

    The value of the final distribution to the stockholders was compiled from a variety of sources, including reorganization plans, annual reports, press releases, and direct interviews with the firm's legal and/or investor relations department. Pre-petition stockholders are compensated according to the terms provided in the confirmed reorganization plan. If they receive any distribution at all, they are usually issued a combination of equity and/or warrants in the reorganized company. Seldom is any cash distributed to equity holders. An accurate assessment of the value of the final distribution would require information on the (1) type and amount of securities received; and (2) market value of these securities on the emergence date. This information is usually not available in the reorganization plans and other public documents and hence had to be obtained directly from the company.

    We computed the percentage holding period return to the stockholders as follows:

    Return % = [Ending Value - Beginning Value] / Beginning Value


    Ending Value = Distribution (per share) made to stockholders

    = [ # of shares received * Price of share on issue (effective date)

    + # of warrants received * Value of warrant on effective date

    + Cash]

    Beginning Value = Stock price on the date of bankruptcy filing.

    If the old stockholders retained their stock, the ending value will be the market price on the emergence date.


In this section we first present descriptive data on the bankrupt firms. We then report evidence on the wealth effects to the pre-petition shareholders.

Descriptive Statistics

    We identified a total of 299 bankruptcy announcements during the period January 1984 - December 1993. The final sample consisted of 154 firms. Such survivorship problems are not unusual in bankruptcy studies.

    Table 1 documents the time spent in reorganization. An average 583 days (or about 19 months) elapsed between filing for Chapter 11 and approval of the reorganization plan by the court. However, the total time spent varied significantly among the firms, ranging from a low of 35 days (Gaylord Container) to a high of 2506 days (LTV). The results are consistent with Hotchkiss (1992) who found the average time for completed bankruptcy reorganizations to be approximately 18 months. Similar findings are reported by Altman (1993).

    Table 1

    Time Spent in Bankruptcy


    Time Spent




    Less than 100 days




    100 to 250 days




    251 to 500 days




    501 to 750 days




    751 to 1000 days




    More than 1000 days









    Table 2 presents the closing price of common stocks on the bankruptcy filing date. The stocks of about seventy-two percent of the firms had prices under $2 per share at the time of filing. Only about fourteen percent had prices greater than $5. The average price was observed to be $2.86.

    Table 2

    Bankrupt Stock Prices

    Price Range (P)


    Less than $1


    $1 < P < $3


    $2 < P < $5


    $5 < P < $10


    $10 < P < $15


    Greater than $15




    Standard Deviation


Return to Pre-petition Shareholders

    The Chapter 11 process is consummated with the approval of the reorganization plan by the court and distribution of assets to various claimants. In this section, we focus exclusively on the distribution made to pre-petition stockholders.


    Table 3

    Return to Pre-petition Stockholders

    Sample of Firms


    Mean Return*


    All the Firms




    Firms with positive return




    Firms with negative return**




    Firms with negative return

    (Excluding -100% return firms)




    Firms with zero recovery




    *: The mean return represents the return for the period in bankruptcy and not annualized returns.

    *: Includes three firms with zero return.

    Table 3 shows the return to pre-petition stockholders. The old stockholders usually received nothing or at most a small amount of new common stock and/or warrants to purchase additional shares in the reorganized firm. In fifteen cases, the stockholders retained their old common stock. However, the interests of the old stockholders were almost always significantly diluted by the issuance of common stock to satisfy the claims of various groups of creditors (often accompanied with reverse stock splits). For example, in Munsingwear the stockholders received one new share in exchange for each 25 old shares they held. The reverse stock split illustrates the fallacy of apparent bargains in "penny stocks". The shares of Munsingwear were selling for 93.75 cents at the time of bankruptcy filing. Thus the new share would have to trade at $23.4375 to correspond to the pre-split level. The new stock, however, started trading at just $6.125. Table 3 reveals that the old common stocks, on average, lost about seventy percent of their value during the bankruptcy period. If we exclude the fourteen firms with positive returns, the average loss figure increases by nearly a -30 percent to -89.76 percent. Indeed, stockholders of a total of 93 firms (out of our sample of 154) received nothing.

    The consistently negative holding period return across a broad sample of stocks stretching over a ten year period raises the question of why investors would invest in a security with a negative expected return? Perhaps the low priced stocks of bankrupt firms are attractive investments to risk-preferring investors who view investment in these stocks similar to buying lottery tickets. For example, in our sample, in 14 cases an investor could have made a significant return (average return = 114.59%) by buying stock after the bankruptcy filing. Also, the returns on bankrupt stocks were characterized by very high positive skewness (4.09). The other explanation could be that investors are not fully aware of the risk/return tradeoff involved in investing in bankrupt firms.

    The results also suggest that perhaps the penny stocks are, on average, overpriced. One is entitled to ask: Why has not the rational behavior of investors tended to eliminate it? We believe that at least two factors help answer the question: lack of serious work on the question and the difficulty of selling the stocks of bankrupt companies short. One who wishes to exploit a general tendency for the market to overprice bankrupt shares would need to be convinced that the tendency actually exists. A few isolated examples, even if well publicized, would not be convincing for most serious investors. Because of the difficulty of obtaining the needed data, this type of study has been much less likely to be undertaken than event studies that can use standard data tapes. Thus until now, the tendency, while suspected, had not been documented.

    Perhaps even more important is the role of short sellers, rules, restrictions and realities to one who would seek to profit from overpriced shares of bankrupt companies. First, one can only short stock on an uptick, which may well increase the difficulty of putting together a short position early in the post-bankruptcy period. The trades are considerably more likely to be on zero or down ticks than on upticks. The uptick rule is, however, much less of a problem than the rule that requires a short seller to find and borrow stock to short before the stock can be shorted. Most short sales on widely held stock are relatively easy to accomplish because large blocks of stock are held in street name. Such stocks can easily be borrowed to facilitate a short sale. The stock of bankrupt companies, in contrast, is generally much more difficult to find. Most institutions get rid of their stock early in the game. They do not want their quarterly statements to show them holding blocks of shares of bankrupt firms. Thus typically the stock has largely moved into the hands of individual investors. Such individuals have little or no reason to leave the stock in street name as its low price makes it effectively unmarginable. Thus the stock available to be borrowed is scarce and likely to be quickly borrowed to satisfy the demands of those who started early. Indeed, most of the available supply of shortable shares may have already been taken by the pre-bankruptcy filing short sellers. Without stock to short, those who would seek to profit from apparent overprice have no legal way to do so. A case in point is that of Chicago based investment firm, Scattered Corporation (NYT, 1993). Scattered generated a profit of around $27 million by selling short more shares than existed of LTV corporation when it was in bankruptcy process. Scattered simply sold shares but did not deliver to the buyer. They claimed that a technical reason allowed them to sell without borrowing the shares. So far at least, few if any other investors have sought to create large short positions in bankrupt shares the way Scattered did (by being "not long" but not technically short either).


The low priced stocks of bankrupt companies have (apparently) attracted numerous unsophisticated investors. The results of this study reveal the dangers of investing in common stocks of bankrupt companies. In the current sample, the pre-petition stockholders of 93 of 154 firms were wiped out. The shareholders suffered an average loss of around seventy percent. While a very few stocks in bankrupt firms may offer the potential for stratospheric gains, on a selective basis, the risk of loss is likely to be greater. Based on the results of this study, we conclude that the market for the stocks of bankrupt companies is certainly not an attractive arena for unsophisticated investors.



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