Understanding Bankruptcy Claim Prioritization: How are Different Creditors Paid Out?

Understanding Bankruptcy Claim Prioritization: How are Different Creditors Paid Out?

Bankruptcy Claim Prioritization

When a debtor files for bankruptcy, creditors are left with the uncertainty of how, when, and how much they will be paid.

This process of prioritizing different claims is referred to as "claims priority." Different types of debtors will have different levels of priority when it comes to paying out their creditors. This directly affects the payment process of the bankruptcy plan of reorganization.

How are claims classified?

One of the most common misconceptions about bankruptcy priority claims is that all creditors in a bankruptcy case are treated equally. In reality, some creditors have higher priority than others and must be paid out first when the debtor’s assets are liquidated. 

  1. Secured Claims (1st Lien) 
  2. Secured Claims (2nd Lien) 
  3. Priority Unsecured Claims 
  4. General Unsecured Claims
  5. Preferred Equity Shareholders
  6. Common Equity Shareholders

Bankruptcy priority claims are given to certain types of creditors who have a greater legal right to receive payment over other creditors in a bankruptcy case. Bankruptcy code dictates that all priority claims must be paid off in full before non-priority creditors receive anything from the estate’s assets (if there are any left). This is also referred to as the Absolute Priority Rule, which ensures that all creditors are treated equitably and fairly, and that a debtor's plan of reorganization is not discriminatory.

Non-priority claims, on the other hand, are those debts that have a lower priority when it comes to payment. Non-priority creditors may not receive any money at all after the bankruptcy process is complete.

Generally speaking, secured creditors and higher-tiered claim holders are paid first, with unsecured creditors and other lower-tiered claims holders receiving interest-only payments until the higher-tiered creditors are paid in full. 

However, while secured debts typically take precedence over unsecured debts there are cases where unsecured debts may receive priority if they meet certain requirements. 

Examples include:

Administrative expenses: Unsecured claims for expenses incurred by the bankruptcy estate, such as legal and accounting fees, may receive priority over secured claims.

Priority claims: Certain unsecured claims, such as tax debts and wages owed to employees, may be considered priority claims and given priority over secured claims.

Equity security holders: In some cases, equity security holders may be entitled to priority treatment, such as when the equity security represents:

  • a claim for damages arising from the purchase or sale of securities;
  • a claim for damages arising from a violation of securities laws;
  • or entitles the holder to a right to payment that is senior to the claims of all other equity security holders, as long as the holder does not have a right to participate in any distribution that is also available to holders of general unsecured claims.

It is important for creditors to familiarize themselves with the potential ramifications of filing a bankruptcy claim and how their claim might be affected depending on its status as either a priority or non-priority claim.

Knowing your rights as a creditor can help you determine how much of your debt will be repaid through the bankruptcy process.