June 16, 2010 - There are rumors that British Petroleum (BP) may declare bankruptcy. That way it can avoid some of the liabilities from the giant oil spill in the Gulf of Mexico. No one knows what BP will do, and it seems to be making a concerted effort to do the right thing, especially since the President of the United States has taken a personal interest. We can only hope for the best.

The first thing to understand is that a company is a legal entity unto itself. While there is management to run it, the company, in the eyes of the law, is almost like a person, responsible for its actions. So think of it as a breathing, living being.

The second thing to remember is that there is a hierarchy of claims when a company goes bankrupt, with certain investors holding higher priority on a company's assets. As a shareholder, you have the lowest priority with bond holders and preferred shareholders having seniority. There are some bonds that are sold against specific assets (think of the airlines and their jets or railroads and their engines). Holders of these type of investments can claim the underlying asset in case of bankruptcy, taking it out of the overall mix of assets available for all stakeholders.

Having stated those two elements of a company, shareholders must realize that they own stock in a unique, living entity, and that certain investors will have priority on the assets and remains of their company once a bankruptcy is set in motion.

Remember that stockholders own a percentage of the company and its profits. That's all. When a company is flourishing and profits are growing, usually the price of the stock is as well. Investors buy into prospering businesses. Conversely, when a company goes out of business, stockholders flee as fast as possible, hoping to salvage a little of their investment.

When a company goes out of business, it eliminates shareholders right away. There is no more company there. It is wiped away. Whatever liabilities it has, it now has to resolve through a legal process. Most of the time, there aren't enough assets to cover the liabilities. That's why a company declares bankruptcy, to get out from under the constant payment of debt or, as in the case of BP, the potentially large payments stemming from the company's actions. Again, this is not to say BP is going bankrupt, only that it is an option they may consider. Stockholders need to think about what that might mean.

Shareholders that are left can only sit on the sidelines and hope. They have no stake in the bankruptcy game. They do if there are any assets left after all liabilities are paid. That rarely happens. Like never. That's because there weren't enough assets to pay the liabilities in the first place. If there were, there would be no need for bankruptcy.

Whether it's BP and a seemingly endless line of lawsuits waiting to happen or any other company that goes out of business, know that as shareholders you will not receive any of the distributions a company makes. Your stock will be worthless. And if the company emerges from bankruptcy (as GM is doing), you have no stake in the new company. Your stock is in the old company. In order to own the new GM, you will need to buy stock in the new entity, just as all other investors do.

That's why buying into a stock like BP that has even the remotest chance of declaring bankruptcy is a total gamble. While the chance is very, very slim, if it does, you lose every penny of your investment overnight (sometimes not every penny since the stock trades for pennies for a while as the shorts cover their positions and a few clueless investors buy stock because they think it's cheap). Bankruptcy wipes out stockholders. Keep that in mind if you're looking at BP or any other stock that seems very attractive based on a dividend or price to book or any other valuation metric that seems cheap. If you like playing with dynamite, you'll like buying stocks that might go bankrupt.

- Ted Allrich