In the U.S. when a company is liquidated, its creditors are repaid in a specific order. This is required by Section 507, of the Bankruptcy Code. 1. The order of payment is designed to protect the people who have a direct stake in the assets of the liquidated party.
Liquidation refers to the process of closing down a company and distributing assets among claimants. Assets include the money it has left, its property and equipment, or any cash raised from selling these assets. A company liquidates when it becomes insolvent and cannot pay its debts.
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Takeaways From the Key Notes
- When a company is liquidated, its assets are distributed according to a priority order.
- Secured creditors come first since their claims on assets are usually secured by collateral or a contract.
- In some cases, there may be multiple liens on an asset. The first lien will always take priority.
- Unsecured creditors are divided into preferred and non-preferred as certain unclaimed creditors such as employees and tax agencies receive priority.
- The last to receive profits is often the shareholder, with preferred stockholders getting a better deal than common stockholders.
Factors Influencing Repayment
There are a number of factors that influence the order in which creditor priority is given during a process of liquidation. Below is a general overview of the main criteria.
Secure/Unsecured Status
The lien can be agreed upon at the time of debt and is most commonly held as security on the asset or other property of the debtor.
If the borrower defaults, the financial institution will often gain the status of secured property. The bank may receive the right to own the property in exchange for lending out the mortgage.
In addition, some unsecured creditors have outstanding debts with the borrower. The Creditor’s Committee represents unsecured creditors who are usually owed smaller amounts. Unsecured creditors include credit card companies and some cash advance companies. Credit card companies and some cash advance companies are examples of unsecured creditors.
When to Apply for Secured Status
When a single assets is being used to secure multiple lines of credit, a lien may be created. It means that more than one lender can have a secured claim on a single asset.
To avoid conflict, collateral pledged as security for financing is designated either a first lien or a second lien. The first lien is the claim that has priority on the collateral. A second lien is a claim with a lower priority. Priority is given to the lien that was first secured. Although this is not always true, the creditor who secured the initial lien has a greater chance of receiving the first lien.
Preferred/Preferential Status
The preferred creditor can be any individual who is associated with the debtor and is accorded some priority in bankruptcy proceedings. They may not have had any collateral or claim rights, but they receive preferential treatment in liquidation proceedings. Preferred creditors can be viewed as a type of unsecured creditor. Examples of preferred creditors include:
- Employees of the company: Even though they do not own assets directly, employees who have unpaid wages are treated preferentially.
- Tort Victims If the debtor has a lawsuit pending against them, then the tort victims are often considered as preferential creditors pending the outcome.
- Tax Agencies Government bodies such as the Internal Revenue Service receive special treatment when they claim unpaid taxes.
- Environmental Claims The court will give priority to the payment of clean-up costs if a company has been penalized for its actions.
Debt and Equity
Two options are available to a company for financing its operations. First, it may raise money from investors. It can also preserve the ownership of the business by raising debt. Equity and debt will be treated differently in the liquidation since creditors have different claims on the assets of the company than shareholders.
Preferred Equity vs. Shared Equity
Different classes may be treated differently during bankruptcy proceedings. In the articles of incorporation, you will find a list of different classes of shares and their benefits. When it comes to liquidation proceeds, preferred shares are often given preferential treatment.
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How Assets are Distributed in Liquidation?
The distribution of liquidation proceeds follows a specific procedure. If the bankruptcy estate runs out of money before the lower priority creditors receive funds, they will not be compensated as part of bankruptcy proceedings. Even the highest priority creditor may not get their full share if the collateral is devalued or significantly less than the debt they hold. 10
The following is a general priority of creditors in a bankruptcy. Prior to any payment being made, all parties on the higher tiers of creditors have to be fully paid.
- Secured Claim (1st Lien). In liquidation, secured claims are often given the highest priority. It is because their money has been guaranteed and secured with collateral by a contract. Priority is given to secured credits in regard to lien claims. 11
- Secured Claim (2nd Lien). A single asset could theoretically be subject to dozens of lien claims. Each secured claim is still given top priority for receiving liquidation proceeds after assessing the order of priority. Creditors with second or worse-ranked claims are not treated as favorably as those with first-lien claims, even though they receive payment before anyone else.
- Priority Unsecured Claims. Priority creditors must wait until secured credit obligations are satisfied before they can be paid. Their preferential treatment places them above other unsecured claims. 11
- Unsecured General Claims. Creditors who have general unsecured claims often are the last to be paid.
- Preferred equity shareholders. Shareholders often receive the liquidation proceeds last. Preferred equity holders are given preferential treatment compared to common equity holders. 11
- Common Equity shareholders. Common equity holders often receive the lowest priority.
What Are Priority Creditors?
Priority creditors have priority in the liquidation process. Some parties have the right to receive money or be compensated for their legal claims over the assets of the insolvent party due to the nature and relationship they share with the insolvent. Priority creditors include those who owe alimony or child support or have tax obligations or are liable for injuries or deaths in certain situations.
Why Are Secured Creditors Paid First?
Secured creditors often receive payment first during the insolvency procedure because they have a claim on specific assets. Secured creditors are often entitled to either the return of the property that they have secured or the proceeds of the liquidation. 11
Which Claims Are Paid in the Lowest Priority?
Due to the risky nature of unsecured loans, financial institutions often charge higher rates or refuse business terms for unsecured loans. Financial institutions often refuse to offer business terms or charge higher rates for unsecured loans due to their risky nature.
Do Equity Holders Get Paid Before Debt Holders?
In a liquidation, shareholders are usually the last in line in terms of ranking. During insolvency, creditors and debt holders are usually paid before shareholders. Because they have no claim on the assets of the defaulting parties, shareholders do not receive priority in the bankruptcy process.
Bottom Line
The priority list is a complex process. Priority unsecured creditors are paid before secured creditors. Equity shareholders are usually paid before the remaining creditors. There are exceptions to these broad rules that can move creditors, reduce their claim values, or change the priority of who receives payment first in a bankruptcy.
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