Insolvency of shareholder

Investing in shares is risky. There is no way of getting away from this. One of the reasons the stock market produces a higher average return than, say, putting the money into a building society or a bank savings account, is to offset this danger by compensating investors. But note the word ‘average’. Some shares are more risky than others and, short of buying into hundreds of companies, the investor will be involved in shares that are a mixture: some are a success – if lucky, some of those spectacularly so; some are pretty ho-hum performers; and some, rarely, are complete collapses.

Occasionally collapses are signalled well ahead. The shares show a steep and pretty continuous slide, and the statements from the company mix profit warnings with promises of restructuring, refinancing, search­ing for alliances, appointing new executives and new policies on the way. This usually ends in a suspension of dealings in the shares, a move that is commonly said to be to help shareholders. Pure bunkum: it is a com­plete disaster for shareholders who cannot therefore sell shares at any price to rescue even a tiny portion of their investment money. The people it helps are the stock market traders who are fearful of dealing without adequate information and cannot face being swamped by people stam­peding out of the company.

Companies seldom return from that sort of suspension. There are other reasons for suspension, such as during the final stages of a major acquisition, but those really are benign and are to prevent total market chaos when there is not enough known about the deal details to set a fair price. But being suspended because the company has run out of money offers few roads back.

By the time the shares are suspended they are seldom worth more than a few pence in any case. But not all collapses are so well signposted. Are there any more covert signs of impending doom that canny share­holders may be able to spot? Many people have tried drawing up signs, including Britain’s top liquidator in the 1960s, Bill Mackie. The specifics of his warning signals, including flamboyant headquarters and profligate top management, may now seem dated, but the underlying principles are still sound. We may no longer have flagpoles and tanks of tropical fish but there are plenty of other loud signals that the organization thinks appearance more important than efficiency.

Investors should be monitoring the business and how it is managed. Profit margins are a good sign, so one should check whether they are as high as they were and at least as great as those at other similar companies, and whether the business is generating sufficient cash for its needs and ambitions. When external money is being raised through loans, rights issues and the like, it should be for expansion rather than baling out the current problems. Accounts being late or fudged, lack of information on auditors’ qualifications, suggestions of window-dressing in the accounts and extremely sophisticated financial dealings are causes for concern. With small businesses, most of that does not apply and you have little recourse but to judge by the managers. The point about small businesses is that the profit can be spectacular but the collapses sudden.

When a company’s share dealings are suspended, that is commonly a sign that the company’s managers, bankers and set of insolvency account­ants are going into confab. One route is for the company to try for a voluntary arrangement under which its creditors hold off knocking bits off the corporate structure to sell as a way of recovering their money and allow it to try trading out of its problems. Courts can appoint an admin­istrator who also continues to trade and holds off creditors.

Another route is taken by secured creditors, normally the banks, which have run out of patience with the company’s excuses and are worried their loans could soon become irrecoverable. They appoint a receiver with the sole task of keeping the business going just long enough to recover the banks’ money. Tax authorities have also been pretty active in this route to make sure their money is paid. Occasionally the directors ask for the appointment because they can see a default on debts looming or because they are in danger of ‘overtrading’, which is the criminal offence of continuing in business once the company is insolvent. A specialist accountant is then appointed and moves in to run the business briefly to extract some money or sell assets for paying the debt. In theory the administrator then moves out and the company reverts to business as usual. That seldom happens in practice because the receiver’s task entails selling off the assets against which the money was lent, or trading long enough to generate the cash to pay off the loan. That usually does not leave much, and the company is often passed to a liquidator.

As that name implies, the liquidator’s job is to turn anything saleable into something more liquid like cash. Fire sales like that seldom produce anything like the book value of assets.

In all of these procedures there is a hierarchy of creditors, and the holder of ordinary shares stands at the back of the queue. The govern­ment takes its taxes off the top, and is followed by secured lenders with a claim on the property and employees, and the banks with other guarantees. Then there are bond holders and owners of preference shares. Once all these people have had their take there is seldom anything left for the holders of ordinary shares.

The one comforting thought is that relatively few quoted companies do actually go bust. And if your investment happens to be one of them, try and look for the silver lining: you can cash in some really profitable investments and set off the capital gains against the losses on the crashed company.

Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.