(Robin Hartill, CFP®)
Revlon (NYSE: REV) is the latest company to file for Chapter 11 bankruptcy protection, only to see its stock price spike. Though shares have tanked this week, they’re still up nearly 400% since June 13. The same phenomenon occurred in 2020 when retail investors rushed to invest in big names like Hertz (NASDAQ: HTZ) and JCPenney after they filed for bankruptcy.
At least some of Revlon’s surge has been driven by meme stock enthusiasts in forums like Reddit’s WallStreetBets. Investors may also be drawn to the opportunity to buy stock in an iconic brand like Revlon at dirt-cheap prices. But the reality of buying stock in a bankrupt company isn’t pretty.
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What causes a bankruptcy rally?
Companies file bankruptcy when their debt becomes unmanageable. Revlon has debt to the tune of $3.3 billion, according to its latest quarterly earnings report. But there are a few reasons a bankruptcy rally can occur.
- Investor optimism: Some investors believe a deeply indebted company can emerge from bankruptcy in a stronger financial position. In Revlon’s case, rumors that Indian conglomerate Reliance Industries is eying a buyout helped fuel the uptick in the cosmetic giant’s share prices.
- Short-term trading: Sometimes, after a stock’s price plummets to unforeseen lows, its price temporarily rallies. This phenomenon is known as a dead cat bounce in investing. Day traders and other speculators jump in on what looks like a bargain, pushing up the stock’s price. This isn’t about business fundamentals, mind you. It’s simply a matter of trying to make a quick buck by timing the market.
- It’s a short-squeeze target: Retail investors may buy stock in a troubled company that’s been heavily shorted in hopes of triggering a short squeeze. As the stock’s price climb’s higher, those who are short must buy shares to close out their positions and avoid further losses. Think GameStop in 2021. With over 50% of Revlon’s free float sold short, this phenomenon is likely pushing the higher price.
Why bankruptcy will probably be ugly for Revlon investors
Things are unlikely to end well when you invest in a bankrupt company. Here’s what shareholders can expect.
After a company files for bankruptcy, it typically no longer meets the requirements of major stock exchanges, so it gets delisted. (As of this writing, Revlon is still trading on the New York Stock Exchange, but the NYSE has started the process of delisting the stock.)
But no law prohibits trading stock in a bankrupt company. Instead, companies in bankruptcy will often trade on over-the-counter markets, which have incredibly lax financial disclosure requirements. The stock will trade with a five-letter ticker ending in “Q.” Some traders will be able to profit off the stock’s wild price movements, though many will lose money if they don’t time things correctly.
Where things get really ugly is in bankruptcy court. In a Chapter 11 reorganization, common shareholders take their places in line with all the company’s other creditors. There’s a strict pecking order for who gets paid first in bankruptcy court. Though this is a bit oversimplified, it typically looks like this:
- Secured creditors, whose claims are backed by collateral; for example, a bank that owns a mortgage.
- Owners of preferred stocka type of security with features of both stocks and bonds.
- Owners of common stock
As you can see, common shareholders come in dead last. Common shareholders only get pieces of the scraps if each level of creditor above them has been paid in full. Typically, that means owners of common stock are left with nothing.
Though a company in Chapter 11 can continue operating, sometimes the court will approve what’s known as a Section 363 sale. But that isn’t good news for common shareholders. There’s rarely money left over to compensate for those who own common stock following the sale.
Even when a reorganization doesn’t result in a sale, common shareholders typically don’t recoup their investments. The most common scenario is that the reorganization cancels out existing shares, and only newly issued shares in the reorganized company will have value. Usually, that leaves common shareholders with little to nothing.
The Financial Industry Regulatory Authority (FINRA) warns: “Cases in which old shares may be exchanged for shares in the newly reorganized companies are especially uncommon.”
One notable exception to the rule is Hertz. The company emerged from bankruptcy in 2021 after a bidding war that injected $5.9 billion of capital into the car rental giant. After its initial bankruptcy filing, the stock dipped as low as $0.40 — but common shareholders walked away from the deal with around $8 per share. It seems some investors are buying Revlon shares, hoping it will follow a similar trajectory.
But Hertz’s situation was unusual. The company filed for bankruptcy at a time when travel was at a standstill due to COVID-19. The deal that brought Hertz out of bankruptcy came 13 months later amid a dramatic spike in car rentals and domestic travel.
In short, Hertz’s dramatic crash and rebound that happened under very unusual circumstances. Investors shouldn’t buy stock in bankrupt companies, expecting to score a similar deal.
Don’t count on Revlon sitting pretty
Though you’ll always hear stories of people who make big bucks on highly risky, short-term trades, long-term investing is the most proven way to build wealth. So, avoid investing in Revlon and other troubled companies just because they look like easy money. If you do choose to invest, make sure you’re comfortable with the high probability that you’ll lose big.
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Robin Hartill, CFP® has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.