Which Creditors Are Paid First in a Liquidation?

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Which Creditors Are Paid First in a Liquidation?

When a company in the United States is liquidated, its creditors are paid in a certain sequence, as required by Section 507 of the Bankruptcy Code. The sequence in which credits are awarded is quite strict and was meant to safeguard individuals who have a direct stake in the assets of the liquidated party.

The process of closing down a firm and distributing its assets to claimants is known as liquidation. Its assets include any remaining cash as well as all of its physical property and equipment, as well as any proceeds from the sale of those assets. Liquidation happens when a firm becomes insolvent, which means it is unable to meet its debts when they fall due.

Key Takeaways

  • If a corporation becomes bankrupt, all of its assets are divided to creditors in a predetermined priority sequence.
  • Secured creditors are first in line since their claims against assets are often backed up by collateral and a contract.
  • Some assets may be subject to numerous liens; in such circumstances, the first lien takes precedence over the second lien.
  • Unsecured creditors are separated into preferred and non-preferred categories, with workers and tax agencies receiving precedence.
  • Stockholders are often the last to receive funds, with preferred stock shareholders receiving preferential treatment over regular stock shareholders.

Factors Influencing Repayment

Several variables influence the order in which creditors are prioritized throughout a liquidation procedure. The key requirements are summarized here in broad strokes.

Secured/Unsecured Status

A secured credit is a loan from a lender that is directly linked to an asset or investment that has a lien on the debtor’s property. This lien is often agreed upon at the moment the debt is accepted and is usually held as security in the asset acquired or ownership of the debtor’s other possessions.

For example, if a borrower and a financial institution execute a mortgage agreement, the financial institution often gains secured status over the property if the borrower defaults. The bank acquires possible ownership rights over the property as collateral for lending out the mortgage.

Unsecured lenders, on the other hand, have outstanding debts with the debtor. Their agreements, however, do not provide them liens or the ability to seize the debtor’s assets. Credit card businesses and certain cash advance firms are examples of unsecured debtors.

Timing of Secured Status

A lien is a legal right that is put on an item that is often used as collateral to finance debt. When a single asset is used as collateral to get more than one line of credit, a problem may occur. This implies that many lenders may have a legitimate, secured claim on the same asset.

To resolve this contradiction, collateral pledged to finance funding is designated as either a first or a second lien. The priority claim on the collateral is held by the first lien, whereas the second lien has a lesser priority. The most general guideline regarding lien position is that the first to obtain gets precedence. Though this is not always the case, the creditor that obtained the original lien is more likely to get the first lien.

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Preferred/Preferential Status

A favored creditor is someone connected to the debtor who is granted certain priority during bankruptcy proceedings. Although these credits may not have held collateral or rights to assets, they are accorded preferential consideration during liquidation procedures. Preferred credits may be regarded a subset of unsecured creditors. Preferred creditors include the following:

  • Employees of the company Employees with overdue pay are given preferential treatment even if they do not directly control corporate assets.
  • Victims of torts If the debtor is facing a lawsuit, the victim is often positioned as a preference creditor awaiting the outcome of the legal proceedings.
  • IRS/taxing authorities In the case of delinquent taxes, government entities are given preferential treatment.
  • Claims about the environment If a company has received environmental clean-up fines as a result of its business activity, the court will prioritize providing cash to pay for the clean-up efforts.

Administrative expenditures of the bankruptcy proceedings are given priority under Section 507(a) of the United States Bankruptcy Code. As a result, the costs of managing the bankruptcy estate, such as legal fees, professional fees, and post-petition operational expenditures for the debtor’s firm, get preferential treatment.

Debt and Equity

A business may fund its activities in two ways. For starters, it may raise capital from investors. Second, by incurring debt, it may retain control of the firm. During the liquidation process, debt and equity are addressed differently since debtors have many different rights on the company’s assets than stockholders.

Preferred vs. Common Equity

During bankruptcy procedures, various types of people may be treated differently. The articles of incorporation will specify the various classes of shares (often preferred and ordinary shares) and the advantages connected with each. Preferred stock often receives preferential status over ordinary stock when it comes to obtaining liquidation money.

How Assets Are Distributed in a Liquidation

The profits of liquidation are dispersed in a very specified manner. If the bankruptcy estate runs out of cash before lower priority creditors have been paid in full, those creditors will be made whole as part of the bankruptcy processes. Even the highest priority creditors may not get their whole share if the collateral is devalued or worth much less than their loan holdings.

The following is a general priority list of creditors during a bankruptcy. Before any money is given to parties in the following tier, every entity in a higher tier of creditors must be paid in full.

  1. Secured Claims (1st Lien): During liquidation processes, secured claims often take precedence. This is generally because their funds are secured by a contract with a debtor and are guaranteed against collateral. Secured credits are given first priority when it comes to lien claims.

  2. Secured Claims (2nd Lien): A single asset might conceivably be subject to dozens of lien claims. After reviewing the priority list, each secured claim is still given first priority in receiving liquidation funds. Despite being paid before any other creditor, creditors with second or worse claims are treated unfairly in comparison to first lien claims.

  3. Unsecured Claims Have Priority. Creditors who have received preferential treatment must wait to be paid until all secured credit obligations have been met. Their preferred handling, however, pushes them ahead of other unsecured claims.

  4. Unsecured General Claims Creditors with general unsecured claims are often the last to be paid.

  5. Shareholders of Preferred Equity. Shareholders are often among the last creditors to get profits from liquidations. Preferred stock equity investors are given preference over common stock equity holders.

  6. Shareholders of common equity Common stock owners are sometimes given the lowest priority.

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Pro Rata Distributions

If there are insufficient funds to satisfy all creditors in the same priority tier, the liquidation profits are often allocated pro rata. Each creditor often gets a portion of the remaining dividend. If a pro rata distribution is necessary, all creditors below the tier receiving distribution will be barred from participating in any actions (as all funds will have been distributed before reaching their priority level).

Consider a corporation that has $20 million in liquidation profits and the following creditor claims:

  • Tier 1 and Tier 2 secured creditors: $10 million
  • $5 million in Priority Unsecured Claims
  • Unsecured General Claims: $10 million
  • $8 million in shares (common and preferred)

During the distribution of cash, both secured and priority unsecured creditors will be paid whole since there are sufficient funds to meet their claims. However, the remaining revenues will be just $5 million ($20 million total – $10 million Secured Claims – $5 million Priority Unsecured Claims). With general unsecured creditors requesting $10 million, everyone will likely get payment on just half of their claim value ($5 million left / $10 million General Unsecured Claims).

Common and preferred shareholders are not entitled to distribution profits since all funds were dispersed before each shareholder level and the priority level above the shareholders was not made entirely whole.

Business bankruptcy filings fell by about 34% between 2020 and 2021. Following more than 21,000 corporate bankruptcies in the United States in 2020, there were 14,347 in the fiscal year ending December 31, 2021.

Other Considerations

During the bankruptcy process, a court may rule that the defaulting corporation would be better off reorganizing rather than liquidating. Lower-tier stakeholders, such as common stockholders, may get profits in a reorganization that they would not have received in a liquidation.

According to the absolute priority rule of the United States Bankruptcy Code, if higher tied creditor classes are not paid in full, lower priority creditors are not entitled to any benefits. This payment system is sometimes referred to as a waterfall payment structure because one level must receive sufficient resources for resources to flow downhill to the next level.

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There are still various issues that might make determining creditor priority complicated. A bankruptcy court may adopt a Plan of Reorganization that alters the distribution guidelines. A creditor’s right to enforce a claim or subordinate claims within a certain creditor priority class might also be impaired by the bankruptcy court.

What Are Priority Creditors?

Priority creditors are those who have legal precedence throughout the liquidation process. Some parties are eligible to be made whole or receive revenues before others due to the nature of their connection with the insolvent party and the legal rights they have over assets. Alimony, child support, tax responsibilities, and liabilities for damage or death in specified cases are the most prevalent sorts of priority creditors or claims.

Why Are Secured Creditors Paid First?

Secured creditors are sometimes paid first in the bankruptcy process since they frequently have a claim against the insolvent party’s particular assets. The secured creditor is often entitled to either the property secured against or the revenues of the liquidation of that particular property.

Which Claims Have Lowest Priority in Payment?

Unsecured claims have the lowest priority in general. Unsecured creditors have no security interest in the debtor’s assets, and the unsecured creditor is unlikely to have obtained collateral or rights to particular assets as part of the loan term. Because unsecured loans are hazardous, financial institutions often demand higher interest rates or deny business arrangements for them.

What Is the General Rule of Priority?

The usual guideline for priorities is that the first party to complete security obtains precedence. This is important for parties in the same priority class, particularly if they hold liens on the same asset. If numerous creditors have a claim on the same asset, the widest principles dictate that the creditor who received the earliest claim has first priority.

Are Debt Holders Paid Before Equity Holders?

In a liquidation, shareholders are often among the last parties in terms of priority order. During a bankruptcy proceeding, creditors and debt holders often get money before shareholders. Shareholders have no precedence throughout the bankruptcy procedure since they have no rights against the defaulting party’s assets.

The Bottom Line

Navigating the priority list of creditors during a liquidation procedure is complicated. Secured creditors often have the greatest priority, followed by priority unsecured creditors. The remaining creditors are often reimbursed ahead of the equity stockholders. There are exceptions within these fairly broad principles that shuffle creditors about, reduce the value of their claims, and affect the priority level of who gets paid first during a bankruptcy.

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