Which Creditors Are Paid First in a Liquidation?

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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.

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.

1. 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.