NEW YORK (

TheStreet

-- Cancelled stocks are the walking dead in penny stock land.

They are set to die but continue to trade. These stocks are usually collateral damage from a bankruptcy ruling based on creditors demands to protect their assets, usually in bonds. Most often, a judge will divvy up the company's carcass, leaving the largest slice to bondholders while equity investors watch helplessly as a stock is cancelled.

Most sane investors would question why in such cases anyone would buy a soon-to-be-cancelled. The answer is simple: the low price, often in pennies, seems too good to pass up.

"A bunch of people trade in the Q's," said Zvi Rhine of Sabra Capital Partners, referring to companies in bankruptcy which have a "Q" added to their ticker. "Every now and then a Q stock will rip."

Cathy Hershcopf is a corporate bankruptcy lawyer at Cooley LLP who said she's always surprised that investors trade in equities that have almost no value and little prospects for improvement. "When a company declares bankruptcy, there usually isn't enough money left for the creditors to be paid in full, much less give any value to the equity," Hershcopf said.

Investors often lose money because they fall prey to speculation and rumor, the currency of Internet chat rooms. A common rumor is that an 'equity committee' will be formed to save a stock, thereby pushing the shares higher and sucking-in unsuspecting buyers. However, these rumors rarely pan out. Once a judge hears from creditors and declares a cancellation, the stock's life comes to an abrupt end, and shareholders lose all their money.

Rick Szambel of Albert Fried specializes in bankrupt stocks and says he's a frequent target of the bankrupt-stock rumor mongering.

"Even when I'm right, I am criticized as being wrong,'' Szambel said. "I quote directly from the disclosure documents, so I'm not wrong. Most regular people don't know where to find these documents or know how to understand them."

Nonetheless, anyone can say anything on the Internet, Szambel said. "Just because someone says it on the Internet, doesn't mean it's true."

In a 2001 study by Philip Russel and Ben Branch, "Penny Stocks of Bankrupt Firms: Are They Really a Bargain," the authors concluded that investors of bankrupt stocks suffered an average loss of 70%. A later study conducted in 2009 by Lily Li and Ken Zhong, entitled "Investing in Chapter 11 Stocks" found that investing in Chapter 11 stocks incurs large losses both before and after risk adjustment.

But some investors keep buying these stocks even when logic would tell them otherwise.

Take, for example,

K-V Pharmaceuticals

( KVPHQ). This St. Louis-based company stopped making and distributing almost all of its drugs in 2009 when it was discovered that some tablets were oversized, leading a K-V subsidiary to plead guilty to two felony charges and the company's former CEO to also plead guilty to two federal charges of misbranding drugs, both taking place in 2010. These events sent K-V shares plunging. The company filed for Chapter 11 bankruptcy in August of 2012 though as is common in such filings, the stock continued to trade.

As K-V's case crept through its bankruptcy proceeding, the stock looked certain to be cancelled. However, some shareholders insisted online that there were many things happening "behind the scenes,'' such as the formation of an equity committee, representing common shareholders. Such talk reversed the stock's fall, driving it from 17 cents to 70 cents.

But ultimately, such speculation was little more than hopefulness. No equity committee presented itself during the hearings on the bankruptcy plan. Shareholders were said to have had hired Katten Munchin to represent them, but spokeswoman Jackie Heard said the law firm hadn't done any work on behalf of K-V shareholders.

Another was the long-shot claim that the U.S. Senate would vote on legislation that intended to save the company. The legislation was aimed at keeping pharmacy compounders from making and distributing the drug. In truth, the legislation never came to a vote though these same parties insisted the Senate was poised to take a vote before adjourning for the summer.

Yet, as K-V moved through its proceeding, the stock fell back to 12 cents before reaching 16 cents when the bankruptcy was approved. The shares finally quit trading on September 16.

As the K-V situation shows, these penny stock companies use a variety of methods to talk the stock up. Aggressive shareholders sometimes go on stock message boards to appear as though they've discovered news that everyone else has ignored. Or they use newswires like

SBWire

to send out what looks like a legitimate stock report, click on the link in the release and the reader is redirected to the penny stock company. SBWire didn't respond to questions over the source of the news releases on KV Pharmaceutical.

These firms prey on investors who may not be aware of the extent of the difficulties faced by these bankrupt companies. "There is a lot of unscrupulous behavior that trickles into this trading," said Rhine.

A similar situation played out at

Orchard Supply Hardware

( OSHWQ), the San Jose-based home improvement chain that first opened it doors in 1931. Orchard was purchased by Sears in 1996, which then spun-out the company in January 2012 when it went public.

A year later, though, Orchard was bankrupt and sold its assets to

Lowe's

(LOW) - Get Report

. In several subsequent government filings, Orchard Supply said it expected "the Company's equity holders will experience a complete loss of their investments."

Yet as the bankruptcy process unfolded, investors were left with the impression that when Lowe's received approval to buy Orchard Supply, those assets would include the equity.

On June 19, Orchard Supply said shareholders would suffer a complete loss of their investment as a result of the bankruptcy, prompting the stock to tumble as the shares were delisted from the

Nasdaq

I:IXIC

. However, a press release from the company on August 20, states that Lowe's will acquire Orchard Supply's assets yet makes no mention of the equity having zero value. Penny stock investors jumped on the company's glaring omission and pumped the stock on the assumption that Lowe's would pick up the equity.

By Aug. 15, the Orchard Supply stock had fallen to 23 cents though it currently trades at about 33 cents.

None of this has been good for unsuspecting shareholders. Curiously, executives of bankrupt Orchard Supply were approved to receive a $3 million bonus plan on August 6 by Judge Christopher Sontchi in Delaware.

A123 Systems

, a Massachusetts-based battery-maker, provides another example of a bankrupt company's stock attracting unsuspecting investors.

In 2010, A123 received a $249 million grant from the Department of Energy of which it spent $129 million to build a plant in Michigan. By 2011, A123 Systems landed additional government contracts to continue developing its battery products. When its defective battery caused a Fisker Karma car to shut down during a Consumer Reports test, the company's shares began to fall. A123 Systems filed for bankruptcy in October 2012. Ninety minutes after the filing was submitted, A123 Systems said

Johnson Controls

(JCI) - Get Report

would buy its assets for $125 million.

A123 had become public in 2009 with a $371 million stock offering, the largest of the year and a 50% jump in its first day of trading. This was a hot stock. Three years later on October 16, 2012, A123 declared bankruptcy. In December of 2012, A123 said the stock would have no value.

The stock continued to trade well into the summer of 2013. It even spiked in May of 2013 after a May 20

Bloomberg

story stated that the company sold, "virtually all of its assets," and that a new company would be created though it didn't mention that the stock would be cancelled.

Stock pumpers cited this story and suggested that it meant that the newly formed company would convert the stock. Such assertions were inaccurate. Yet the worthless stock shot up from $0.023 to $0.054. Granted these are mere fractions of pennies, but it's still a huge run on a stock. Shares topped trading on July 8.

This pattern is often repeated with the same players. Bankrupt stocks are the best targets due to the lack of media coverage. Plus, reporters may neglect to include stock information when reporting on the bankruptcy because the judges are usually focused on dividing up assets between creditors. Unsuspecting buyers are sucked in due to the low cost of the stocks - just pennies. There is nothing illegal here, because it isn't against the law to lie about a stock if you aren't a licensed broker. However, a hack on a message board can inject lots of life into walking dead stocks.

--Written by Debra Borchardt in New York.

>To contact the writer of this article, click here:

Debra Borchardt

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