Can I Recover If the Company I Invested In Is Insolvent?

Where investors stand in a bankruptcy

The Bankruptcy Code pays claims in a fixed order, and investors are at the bottom of it. Secured creditors take their collateral or its value. Administrative and other priority claims come next. General unsecured creditors, including trade creditors and ordinary note holders, share what is left. Only after every class of creditors is paid in full do holders of preferred and then common stock receive anything. In a Chapter 11 plan that a class rejects, 11 U.S.C. § 1129(b) enforces this as the "fair and equitable" or absolute priority rule: a dissenting class of unsecured claims must be paid in full or no junior class, including equity, may receive or retain anything.

A second provision closes the obvious workaround. An investor who was defrauded might try to assert a damages or rescission claim as a creditor rather than as a shareholder. Under 11 U.S.C. § 510(b), a claim for rescission of a purchase of the debtor's securities, or for damages arising from that purchase, is subordinated to all claims senior to or equal with the security itself; if the security was common stock, the fraud claim has the priority of common stock. The result is that a shareholder's fraud claim against the bankrupt company is worth what the shares are worth, which is usually nothing. A note holder's claim on the note itself, by contrast, remains a general unsecured claim, so a note holder files on the debt rather than on the fraud.

What the automatic stay does and does not stop

The moment a petition is filed, 11 U.S.C. § 362(a) stays the commencement or continuation of any action against the debtor, enforcement of judgments against it and any act to collect a prepetition claim from it or its property. By its terms the stay protects the debtor and the estate. It does not protect the company's founders, officers, directors, control persons, salesmen, auditors or lawyers, so claims against them proceed in the ordinary courts or in FINRA arbitration. Two cautions. A claim that really belongs to the company, such as a claim that the officers breached duties to the company and depleted its assets, becomes property of the estate and may be pursued only by the trustee or with the bankruptcy court's permission. And a bankruptcy court can, in unusual cases, extend the stay to insiders whose defense would drain the estate, for example because the company owes them indemnity. An investor's direct claims for fraud in the sale of the security are not the company's claims and are not stayed.

The people and firms who still have assets

The control-person claim is the workhorse. It does not require proof that the founder intended anything; it requires proof that the company sold the security by means of a material misstatement or omission, or without a required registration, and that the founder controlled the company. The founder then carries the burden of proving ignorance despite reasonable care, which is a hard burden for the person who ran the business. The guide on control persons and aiders covers the elements, and the one on claims against accountants and advisors covers the professionals.

Example

Suppose a Dallas investor bought $300,000 of preferred shares in a regional restaurant group after a memorandum stated that all 12 locations were profitable. Three were losing money and the founder knew. The group files Chapter 11 eighteen months later, and the plan pays unsecured creditors 20 cents on the dollar and equity nothing. Inside the bankruptcy the investor's claim is hopeless: under § 510(b) her fraud claim ranks with the preferred shares. Outside it, the founder is a control person under section 4008.055 and a direct speaker for fraud, the bank that arranged the raise and distributed the memorandum may be a seller or aider, and the group's D&O policy covers the founder's defense and settlement. The stay does not touch any of those claims. Her case is filed in Dallas County district court against the founder and the placement agent while the bankruptcy proceeds separately.

Receiverships and regulator-driven cases

When the collapse involves fraud, a court may appoint a receiver rather than, or before, a bankruptcy trustee: a federal court at the SEC's request, or a Texas court at the request of the attorney general on the Securities Commissioner's referral under Government Code chapter 4007, or at a creditor's or owner's request under Texas receivership law. The receiver gathers assets, pursues clawbacks from those who received the company's money and distributes what is collected pro rata through a claims process. Investors file claims with the receiver and may also sue third parties the receiver is not pursuing, subject to any litigation injunction the court enters. The guide on recovering losses from a Ponzi scheme explains how the receiver's process and private suits fit together, and the guide on Texas receiverships covers the state-court version.

SIPC: what it covers and what it does not

If the failed company was a brokerage firm, the Securities Investor Protection Corporation steps in. SIPC protects customers of a failed SIPC member for securities and cash missing from their accounts, up to $500,000 per customer, including a $250,000 limit for cash. It restores the securities themselves or their value. It does not protect against a decline in the value of investments, losses from a broker's bad advice, worthless securities sold to a customer, or assets that are not securities, including digital assets that do not qualify as securities. In other words, SIPC addresses custody failures at the broker, not investment losses in the companies the broker sold.

Steps that preserve recovery

1. File a proof of claim in the bankruptcy or receivership by the bar date, even if the expected distribution is small. A note holder files on the debt; a shareholder files to preserve any equity distribution and to receive notices.
2. Identify the control persons and sellers and their insurance before suing. A judgment against a founder with no assets and no coverage is paper.
3. Watch the clocks. The Texas Securities Act's three-year discovery and five-year repose periods and the federal two- and five-year periods are not paused by the company's bankruptcy; only claims against the debtor itself are affected by the stay. Each period must be dated separately.
4. Preserve the offering materials, your communications and the company's investor updates. The trustee or receiver will have the company's records; you need your own.
5. Coordinate with other investors. Shared counsel or a group action spreads cost and improves settlement position against insurers, and avoids a race to the founder's assets.

When to involve a litigator

As soon as the company stops answering, before a petition is filed if possible, because prejudgment remedies against founders and transfers to insiders are easier to address before a stay and a trustee complicate the picture. Tina Wysk represents investors and companies in securities and investment disputes in Dallas state and federal courts, including claims against control persons and professionals after a company's collapse.