Who gets paid first in a business bankruptcy?
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Federal rules regulate the order in which creditors receive payment when a company is liquidated through a business bankruptcy. That order is generally based on who assumed the most risk when issuing money to the company.
How Are Debt Payments Prioritized During a Business Bankruptcy?
- First priority for debt repayment usually goes to persons who become creditors after the company files for bankruptcy. The purpose of this rule is to enable the company to borrow if necessary to continue its operations and/or to effectively wind down its affairs.
- Secured creditors, such as banks lending money backed by a mortgage on real estate, typically bargained for a lower level of risk. These are the creditors to whom the business owes a debt for something with tangible value. In other words, something measurable “secures” the debt. In a Chapter 11 bankruptcy, secured creditors are paid first, sometimes partially through the return of the property. This is somewhat similar to an individual having his or her car repossessed and sold at auction in an effort to pay down debt.
- General creditors, such as suppliers of goods and services, and other lenders and bondholders, have a greater potential for recovering their losses than stockholders. These creditors loaned money to the business for general use or for intangible things such as credit lines. General creditors are fairly high in priority but not as high as secured creditors. This is true for bondholders as well because bonds represent the debt of the company and the company has agreed to pay bondholders interest and to return their principal.
- Stockholders are last in line. They own the company and take greater risk. Stockholders can make money if a company does well, but they can lose money if the company does poorly. The owners are last in line to be repaid if the company fails.
It’s important to note these are general guidelines established by Sec. 507 of the Bankruptcy Code. The code also includes various exceptions. For example, secured creditors may actually get bumped down in priority if they fail to file their proof of claim.
Whether you are a creditor or debtor, consulting with a lawyer is imperative if you wish to understand the payment order during the particular bankruptcy in which you are involved.