Why do Retail Investors Invest in Bankrupt Companies?

Public shareholding of the companies becoming bankrupt is increasing day by day as the retail investors assume this as an opportunity to invest. Bankruptcy is a legal proceeding involving a person or business that is unable to repay its outstanding debts. The companies which are heading toward bankruptcy have a large amount of debt on their balance sheet. There is an act called Insolvency and Bankruptcy Code in which it is stated that a trade creditor can drag a company into bankruptcy in court. Trade creditor is the lenders to the company. The recent companies which declared bankruptcy are DHFL, Bhushan Power and Steel, Essar Steel, Reliance Communication, Lanco Infra, Alok Industries, Jet Airways, and Sintex Industries all these companies are dragged to the court by their lenders. So, let’s know about a few of the pointers that one should keep in mind to avoid investing in such bankrupt companies in this article.

How do Identify bankrupt companies:

1) By looking at the Debt equity ratio-

• The debt-to-equity (D/E) ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders' equity.
• A high D/E means that a company has been aggressive in financing its growth with debt.
• For example, if we look at the D/E ratios of Sintex Industries it is continuously rising, in 2020 it was 2.07 and in 2021 it has increased to 3.49 which means an increase of 68.60% on a YoY basis.
• It means that the cash flow generated by the company is not adequate to service its debt and, in this situation, the company starts taking more loans to service its debt.
• Any retail investors who have a sound knowledge of the financials can easily identify it.
• When Sintex Industries was admitted by the NCLT (National Company Law Tribunal), whenever a lender takes the company into bankruptcy, they go to the NCLT from where all the liquidation procedures begin. The share price of the Sintex at this time was Rs. 4 to 5 and increased to Rs. 20 when news came that Reliance Industries will bid for this company and again there is a fall in the share price as there was a news that as per the new plan the acquirer will write off the equity of the company.
• Sometimes the retail investors know that the company is bankrupt but they invest because there is speculation that a big company will acquire it and the share price will go up. These things have happened like Ruchi soya it was a bankrupt company but then it became a multi-bagger stock, Ruchi soya is an outlier as there is also an example of Lakshmi Vilas Bank, DHFL, Lanco Infratech, Moser Baer, ABG Shipyard, etc.

The major change in the resolution of the Bankruptcy and Insolvency Code:

• This code came into the effect in 2016 and before it, there was a Corporate Debt Resolution as per this resolution creditors don’t have any right to drag the companies into the court. It was like that the company takes loans from the bank and when becoming bankrupt, the companies go to the bank and tell them they give us more loans to continue the operation and after continuing the operation we will generate the cash and then we will make the payment of both the loans. The banks don’t have an option, only to agree with the company and due to this only hair cut is done, which means some part of the loan is written off.
• As per the Insolvency and Bankruptcy Code, the lenders will take the companies to NCLT and then make a resolution plan like if the company is going to be acquired by someone then how the amount will be divided among all the companies and if lenders have to take a haircut and what will be the amount of hair cut taken by all. It is better than the corporate debt resolution, it also has small timelines than the earlier one. The Committee of Creditors Claim (CCC) also evaluates the claims of the lenders.

Structure of Liquidation under Insolvency and Bankruptcy Code:

There are a few priorities at the time of liquidation regarding who will receive the payment first.

• This is the order of the preference prescribed by the law for any liquidation/buyout amount that a company receives under IBC.
• Equity holders are the last in the pecking order and will get almost nothing if the lenders are taking a haircut.

Ruchi Soya Case:

• In 2017, lenders of Ruchi Soya dragged the company to bankruptcy court.
• Consequently, the company announced bankruptcy and was declared insolvent.
• In Nov 2019, the company was forced to delist by SEBI (compulsory delisting).
• Meanwhile, Patanjali won the bid to acquire Ruchi Soya in Apr-May 2019.
• 99% of the equity of the company was written off and 99% of the remaining was acquired by the Patanjali, which means the shareholder who has 100 shares will only have 1 share of Ruchi soya.
• Ruchi soya had a debt of Rs. 12000 crores but as the hair cut taken by the lenders only Rs. 4000 crores are left to pay which means Patanjali acquired the Ruchi soya for Rs. 4000 crores. Patanjali pledged their entire shareholdings to fund their purchase and it was agreed that the company will remain listed.
• This is very rare, when lenders are taking hair cut then there is very little chance that equity shareholders will receive anything.
• Due to demand and supply share price of the Ruchi soya increases also due to low free float.
• To remain public listed Ruchi soya has done (Follow-On Public Offer) FPO, as they have to maintain the 75% shareholding.

What should shareholders do?

Every time the company will show some sign that they are becoming bankrupt, investing in any of this kind of company will reward nothing. Retail investors think that these kinds of companies are cheap and that is the right time to buy but investors shoulder consider all the parameters to decide on whether they have to buy any stock or not. If any company is going to be bankrupt then there is very little chance that the shareholders will receive anything. Investors should always do a proper analysis of the company in which they are going to invest.

Disclaimer: The information here is provided for reference purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent are commendation to buy or sell stocks or MF.

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