Which Creditors Are Paid First in a Liquidation?

When a corporation is liquidated in the U.S., its creditors are paid in a particular order, as required by Section 507 of the Bankruptcy Code. The order in which creditors are paid is very specific and was designed to protect those with a direct interest in the liquidated party’s assets.

Liquidation is the process of shutting down a business and distributing its assets to claimants. Its assets include any cash it still possesses and all of its physical property and equipment, or the cash that is raised by selling those assets. Liquidation occurs when a company becomes insolvent, meaning that it cannot pay its obligations when they come due.

Key Takeaways

• If a company goes into liquidation, all of its assets are distributed to its creditors based on a pre-determined priority order.
• Secured creditors are first in line, as their claims over assets are often secured by collateral and a contract.
• Some assets may have multiple liens placed upon them; in these cases, the first lien has priority over the second lien.
• Unsecured creditors are divided between preferred and non-preferred, as certain unclaimed creditors like employees and tax agencies are given priority.
• Shareholders are often last in line to receive proceeds with preferred stock shareholders getting better treatment than common stock shareholders.

Factors Influencing Repayment

There are several factors that determine the hierarchy of which creditors receive priority during a liquidation process. A general outline of the major criteria is below.

Secured/Unsecured Status

A secured creditor is a lender directly tied to an asset or investment that holds a lien against a debtor’s property. This lien is often agreed upon at the time the debt is taken and most often held as collateral in the asset purchased or ownership of other belongings of the debtor. During bankruptcy, a secured creditors’ committee will represent the lenders who have the first claim to assets and funds.

For example, upon the execution of a mortgage agreement between a borrower and a financial institution, the financial institution often gains the secured status of the property should the borrower default. As collateral for loaning out the mortgage, the bank receives potential ownership right over the property as collateral.

Alternatively, unsecured lenders have outstanding loans with the debtor. The creditor’s committee represents the interests of unsecured creditors, who usually have smaller sums due to them. However, their agreements do not entitle them to liens or rights to claim the assets of the debtor. Unsecured creditors include credit card companies and some cash advance companies.

Timing of Secured Status

A lien is a legal right placed on an asset often used as collateral to secure debt. A problem may arise when a single asset is used as collateral to secure more than one line of credit. This means more than one lender may own a legal, secured claim against a single asset.

To navigate this conflict, collateral pledged to secure financing is noted as either a first lien or a second lien. A first lien has the priority claim on the collateral, while the second lien has a lower priority. The broadest rule for the position of liens is the first to secure receives priority. Though not always the case, whichever creditor secured the initial lien is more likely to be awarded the first lien.

Preferred/Preferential Status

A preferred creditor is an individual associated with the debtor that is given some priority during bankruptcy proceedings. These creditors might not have held collateral or rights to claim assets; however, they are given preferential treatment during liquidation proceedings. Preferred creditors may be considered to be a special type of unsecured creditor. Examples of preferred creditors include:

• Company Employees: Though they may not directly own company assets, employees with unpaid wages receive preferential treatment.
• Tort Victims: Should the debtor have a pending lawsuit against them, the tort victim is often positioned as a preferential creditor pending the outcome of court proceedings.
• Tax Agencies: Government bodies, such as the Internal Revenue Service (IRS), receive special treatment for their claim over unpaid taxes.
• Environmental Claims: If a business has been punished with environmental clean-up sanctions as part of its business actions, the court will prioritize allocating funds to pay for the clean-up efforts.

Note

Section 507(a) of the U.S. Bankruptcy Code states that administrative expenses of the bankruptcy proceedings receive priority. Therefore, the costs of overseeing the bankruptcy estate, such as legal fees, professional fees, and post-petition expenses of operating the debtor’s company, receive preferred status.

Debt and Equity

A company can choose to finance its operations in two ways. First, it can raise funds from investors. Second, it can preserve ownership of the company by raising debt. Debt and equity are treated differently during the liquidation process, as debtors have many different claims over the company’s assets compared to shareholders.

Preferred vs. Common Equity

Different classes of shares may receive different treatment during bankruptcy proceedings. The company’s articles of incorporation will identify different classes of shares (often preferred shares and common shares) and the associated benefits of each. It is common for preferred shares of stock to receive preferential treatment over common shares of stock in regards to receiving liquidation proceeds.

How Assets Are Distributed in a Liquidation

Liquidation proceeds are distributed in a very specific process. Should the bankruptcy estate run out of funds before lower priority creditors have received funds, those creditors will simply not be made whole as part of the bankruptcy proceedings. Even the highest priority creditors may not receive their full portion should the collateral be devalued or substantially less than their debt holdings.

Below is the broad prioritization of creditors during a bankruptcy. Every entity in a higher tier of creditors must be paid in full before any money is paid to parties in the next tier.

Secured Claims (1st Lien): Secured claims often have the top priority during liquidation proceedings. This is usually due to their money being guaranteed against collateral and secured by a contract with a debtor. Secured creditors first in line regarding lien claim take highest priority.

Secured Claims (2nd Lien): An asset can theoretically have dozens of lien claims against it. After assessing the priority order, each secured claim still receives top priority to receive liquidation proceeds. Though paid before any other creditor, creditors with second or worse claims receive unfavorable treatment compared to first lien claims.

Priority Unsecured Claims. Creditors with preferential treatment must wait to be paid until after secured credit obligations have been satisfied. However, their preferential treatment puts them ahead of other unsecured claims.

General Unsecured Claims. Creditors with general unsecured claims are often the last debt holders to be satisfied.

Preferred Equity Shareholders. Shareholders are often among the last creditors to receive liquidation proceeds. Preferred stock equity holders receive preferential treatment over common equity holders.

Common Equity Shareholders. Common equity shareholders often receive the lowest level of priority.

Important

The general rule on priorities is that the first party to secure most completely wins priority. This is relevant for parties within the same priority class, especially if they have liens against the same asset. Should multiple creditors have a claim against the same asset, the broadest rules state the creditor that received the earliest claim receives the first priority.

Pro Rata Distributions

Should there be insufficient funds to pay all creditors of the same priority tier, liquidation proceeds are often distributed pro rata. Each creditor often receives a share of the remaining distribution. If a pro rata distribution should be required, all creditors below the tier receiving distribution will not be entitled to any proceedings (as all funds will have been distributed before reaching their priority level).

For example, imagine a company with $20 million of liquidation proceeds and the following creditor claims:

• Secured Creditors (Tier 1 and Tier 2): $10 million
• Priority Unsecured Claims: $5 million
• General Unsecured Claims: $10 million
• Shareholders (Common and Preferred): $8 million

In the course of distributing funds, both the secured creditors and priority unsecured creditors will be made whole as there are enough funds to satisfy their claims. However, there will only be $5 million of remaining proceeds ($20 million total – $10 million Secured Claims – $5 million Priority Unsecured Claims). With general unsecured creditors demanding $10 million, they will each likely receive payment on only 50% ($5 million remaining / $10 million General Unsecured Claims) of their claim value.

Because all funds have been distributed before each shareholder level and because the priority level above the shareholders was not made fully whole, common and preferred shareholders are not entitled to distribution proceeds.

40.4%

The increase in business bankruptcy filings for the 12-month period ending March 31, 2024. Business filings increased from 14,467 in March 2023 to 20,316 in March 2024.

Other Considerations

During the process of bankruptcy, a judge may determine the defaulting company would have greater value should it reorganize rather than liquidate. In a reorganization, lower-tier parties such as common shareholders may receive proceeds that they otherwise wouldn’t have during a liquidation.

The absolute priority rule of the U.S. Bankruptcy Code implies that if higher tiered creditor classes are not paid in full, lower priority creditors are not entitled to receive any proceeds. This payment structure is often called a waterfall payment structure, as one level must receive enough resources for resources to then flow downwards to the next level.

There are still several complications that can make the prioritization of creditors difficult to assess. A bankruptcy court can approve a Plan of Reorganization that changes the rules of distribution. The bankruptcy court can also impair a creditor’s right to enforce a claim or subordinate claims within a given creditor priority class.

What Are Priority Creditors?

Priority creditors are parties that have legal priority during the liquidation process. Due to the nature of their relationship with the insolvent party and the legal claims they have over assets, some parties are entitled to be made whole or receive proceeds before other parties. Priority creditors or claims include alimony, child support, tax obligations, or liabilities for injury or death in specific situations.

Why Are Secured Creditors Paid First?

Secured creditors are often paid first in the insolvency process as they often have a claim against specific assets of the insolvent party. The secured creditor will often either take back the property they’ve secured against or will be entitled to proceeds from the liquidation of that specific property.

Which Claims Have Lowest Priority in Payment?

In general, unsecured claims have the lowest priority. Unsecured creditors do not have a security interest in any asset of the debtor, and the unsecured creditor likely did not obtain collateral or rights to specific assets as part of the loan condition. Due to this risky nature of unsecured loans, financial institutions will often charge higher rates or refuse business terms for unsecured loans.

Are Debt Holders Paid Before Equity Holders?

Shareholders are often among the last party in terms of priority ranking in a liquidation. It is usual for creditors and debt holders to generally receive payment before shareholders during an insolvency process. Shareholders have no priority during the bankruptcy process due to having no claims against any assets of the defaulting party.

What Is the Order of Priority for Creditors in the Silicon Valley Bank Collapse?

Silicon Valley Bank was shut down by regulators on March 10, 2023. The move came after customers became concerned about the bank’s financial future and pulled their money out of the institution. Their concerns were rooted in the bank’s announcement that it lost nearly $2 billion in the sale of a portfolio of U.S. securities.

Despite the general rule of priority normally laid out when a company becomes insolvent, federal regulators announced that depositors would be fully protected, meaning they would be able to access all of their money as of March 13 with no loss to the taxpayer. As such, regulators said that shareholders and certain holders of unsecured debt would not be protected.

The Bottom Line

There are a lot of intricacies when navigating the priority list of creditors during a liquidation process. In general, secured creditors have the highest priority followed by priority unsecured creditors. The remaining creditors are often paid prior to equity shareholders. Within these very broad rules, there are exceptions that move creditors around, impair their claim value, and change the priority level of who gets paid first during a bankruptcy.

Read the original article on Investopedia.