When a company emerges from bankruptcy, do old shares become worthless? Or are they converted to new shares?

When companies emerge from bankruptcy, they typically distribute new shares listed on a stock exchange under a new ticker symbol. The old shares are usually cancelled — they can't be sold for as much as a penny.

That's a real bummer for shareholders who have hung on in the hopes of recovering some of their losses. Take, for example, Kmart (KMRT), which filed for bankruptcy in January 2002. At the time, many existing shareholders clung to their stock, optimistic that Kmart would rise like a phoenix from the ashes. And rise it did: When the retailer emerged from bankruptcy in May 2003, its stock closed at $15 on its first day of trading. Now it trades at more than $100, and the company has even announced that it will acquire rival Sears (S). But those rewards weren't enjoyed by the shareholders who owned the stock before the bankruptcy. Those shares — which used to trade under the symbol KM — are now worth absolutely nothing.

That's the way it goes in at least 75% of all corporate bankruptcy cases, says Harlan Platt, professor of finance at Northeastern University. To emerge from bankruptcy, a company must pay off existing debt, starting with its creditors, namely the institutions and individuals who own the company's bonds. Companies often do this by issuing new stock, which is then distributed to the bondholders. In most cases, by the time the bondholders are paid back, very little or nothing is left for the old stock investors. "It's actually a very fair process," Platt says. "The equity is the one with the risk and the gain. The bondholder is the one with less risk, but more safety in bankruptcy."

Granted, in some cases, existing shareholders may get some new shares. But even then it's usually a small fraction of what they used to own. For example, when software development company Peregrine Systems (PRGN) announced its emergence from bankruptcy in August 2003, it said the owners of its old shares (PRGNQ), which were then canceled, would receive one new share for approximately every 49 shares of its old common stock.

Investors can often tell if a bankrupt company's stock will be eliminated by taking a look at its SEC filings. In its 2003 Annual Report (Form 10-K) filed with the SEC, Solutia's management stated that it "believes that its plan of reorganization will result in cancellation of its existing shares of common stock" and warned that it was unlikely that its current shareholders "will receive any consideration for that stock... in such a plan of reorganization." (Solutia has not yet emerged from bankruptcy.)

What's an investor to do when a company's shares appear to be in their final death throes? In most cases, the choices are to sell now, while the stock is worth almost nothing, or sell later, once it's officially deemed worthless.

The path you choose won't make a big difference — both can provide a tax break on your capital loss, although your loss might be slightly different, based on the current value of the stock. (For all the nitty-gritty details on capital gains and losses, click here.) Folks who are confident that they will not receive any new shares for their old ones are better off selling right away, says Venky Panchapagesan, assistant professor of finance at Washington University in St. Louis, Mo.

The advantage of this strategy that is you can take a capital loss right away, rather than waiting for the stock to be declared worthless sometime in the future. The downside is that you'll have to pay a commission for the transaction.

Should you decide to go this route, keep in mind that once a company has filed for Chapter 11 bankruptcy its stock will likely be delisted from its stock exchange, says Panchapagesan. Once that happens, it starts trading on the so-called pink sheets. There, it can be bought and sold by the same brokers who trade on the Nasdaq or NYSE, but the pink sheets are much less loosely regulated than are major stock exchanges. "It's almost the old cowboy kind of environment, where it's up to you to take all the precautions," says Panchapagesan. So if you're planning to buy or sell stocks that trade there, use a trusted broker.

If, on the other hand, you decide to wait until the stock loses all of its value, you'll have to keep track of the company's situation to find out when the stock is officially deemed worthless. One way to do so is to check out the CCH Capital Changes Reporter, a publication that maintains a list of worthless stocks and securities. For tax purposes, investors who go this route should be sure to request a letter from their broker stating that the stock has no value or that it cannot be traded, explains Martin Nissenbaum, national director of personal income-tax planning at Ernst & Young. The capital loss should be taken for the same year that the stock is declared worthless, and is subject to the $3,000 per-year limitation (the rest could be rolled over year to year, until you've exhausted your loss). Since the stock is no longer trading, there's obviously no broker fee.