If a Company Goes Bankrupt, Who Gets Paid First?

When a company faces severe financial distress, it may enter bankruptcy, a legal process designed to manage its debts and distribute its remaining assets. Understanding how claims are settled in bankruptcy is important for anyone with a financial connection to the company, whether as a lender, employee, or investor. This process involves a structured hierarchy that determines the order in which different parties receive payments from the company’s limited resources.

Understanding Bankruptcy Payment Principles

Bankruptcy law establishes a strict hierarchy for distributing a company’s assets among its creditors, rather than a first-come, first-served approach. This process, known as the Absolute Priority Rule, ensures fairness and predictability by providing a clear framework for how available funds are allocated, prioritizing claims based on their legal standing. This system aims to create an organized and equitable method for winding down a company’s financial affairs.

When a company files for bankruptcy, a trustee is often appointed to oversee asset liquidation or reorganization. The trustee distributes proceeds according to this established priority system, ensuring those with legally stronger claims are satisfied before others.

The Established Order of Priority

The U.S. Bankruptcy Code sets forth a specific sequence for how claims are paid from a bankrupt company’s assets. This order ensures that certain types of claims receive payment before others, reflecting a legislative determination of their importance.

Secured creditors generally hold the highest payment position due to their liens on specific assets. These claims are satisfied from the sale of the collateral. Following secured claims, administrative expenses incurred during the bankruptcy proceedings take high priority. These costs are considered necessary for preserving the bankruptcy estate and facilitating the process. After administrative expenses, various categories of unsecured claims are granted priority status. These claims are paid before general unsecured creditors.

Once these priority unsecured claims are addressed, any remaining funds are distributed to general unsecured creditors. At the bottom of this payment hierarchy are equity holders, such as shareholders, who are usually the last to receive any distribution.

Details of Claim Categories

Secured creditors are those with a legal right to specific property of the debtor, known as collateral. Common examples include mortgages on real estate or loans secured by equipment or vehicles. If the company defaults, secured creditors can generally repossess or foreclose on the collateral to recover their debt.

Administrative expenses encompass costs incurred after the bankruptcy filing that are essential for managing and preserving the bankruptcy estate. This includes fees for the bankruptcy trustee, attorneys, accountants, and appraisers, as well as costs for operating the business post-petition, such as utilities and rent. These expenses are given first priority among unsecured claims.

Priority unsecured claims, outlined in Section 507 of the U.S. Bankruptcy Code, are unsecured debts that receive preferential treatment over general unsecured claims. This category includes domestic support obligations like alimony and child support. Also included are certain wages, salaries, or commissions owed to employees, and certain tax claims. Additionally, consumer deposits for goods or services not delivered are granted priority status.

General unsecured creditors hold claims not backed by collateral and not granted priority status by law. This broad category includes many common business debts, such as outstanding invoices from suppliers, credit card debt, and most personal loans. These creditors typically face the highest risk of receiving little to no payment. Equity holders, including both preferred and common shareholders, are at the very end of the payment line. Their investment represents ownership in the company rather than a debt, meaning they only receive a distribution if all other creditor claims are fully satisfied.

Distribution and Outcome

The distribution of a company’s assets in bankruptcy strictly adheres to the established payment hierarchy. Funds are allocated sequentially, meaning that all claims in a higher priority class must be paid in full before any funds can be distributed to the next lower class. For example, secured creditors are paid from the sale of their collateral first, then administrative expenses, followed by other priority unsecured claims.

If there are insufficient funds to pay all claimants within a single priority class in full, the remaining funds are distributed on a pro-rata basis among those creditors. This means each creditor in that class receives a proportional share of the available money, based on the size of their claim. For instance, if a class is owed $100,000 but only $50,000 is available, each creditor in that class would receive 50% of their claim.

The practical implications of this payment hierarchy are significant for claimants. Higher-priority creditors, particularly secured creditors and those with administrative expense claims, generally have a higher likelihood of recovering a substantial portion of their owed amounts. Conversely, lower-priority claimants, especially general unsecured creditors and equity holders, often receive little to nothing. In many bankruptcy cases, the company’s assets are exhausted before reaching these lower tiers.