Preferred Debt: What It Is and How It Works in Finance

Companies and individuals rely on debt to finance operations, investments, and growth. However, not all debt holds the same priority in repayment. Preferred debt refers to obligations with a higher claim over other borrowings, making it a crucial concept for borrowers and creditors alike.

Understanding how preferred debt works helps investors assess risk and recovery potential in cases of financial distress. It also plays a key role in structuring loans and negotiating terms between lenders and borrowers.

Priority in Payment

When a company faces financial trouble, some creditors are repaid before others. The order of payment is determined by contractual agreements, legal frameworks, and the structure of a company’s obligations.

Preferred debt ranks above other borrowings, ensuring these lenders receive repayment first when assets are liquidated or cash flows are distributed. This priority is established through loan agreements that define repayment terms, interest rates, and conditions that must be met before other creditors receive payment. In corporate finance, senior secured loans take precedence over subordinated debt, ensuring repayment to these lenders before bondholders or equity investors.

Bankruptcy proceedings highlight the significance of payment hierarchy. Under U.S. bankruptcy law, secured creditors are repaid first from collateralized assets. Once secured claims are settled, unsecured creditors—including suppliers, bondholders, and certain tax obligations—receive payment based on statutory priorities. Some unsecured debts, such as employee wages (up to a federally set limit) and certain tax liabilities, are prioritized over general unsecured claims.

Common Security Structures

Preferred debt often includes security mechanisms that provide lenders with assurances of repayment. These structures reduce risk by granting creditors claims over specific assets or additional legal rights in case of default. The most common forms of security include liens, collateral pledges, and guarantees.

Liens

A lien grants a lender the legal right to claim a borrower’s asset until the debt is repaid. If the borrower defaults, the lender has priority over other creditors in seizing the asset. Liens can be specific, tied to a particular asset such as a mortgage on real estate, or general, covering multiple assets, as seen in tax liens.

In corporate finance, first-lien loans are the most secure, taking precedence over second-lien or unsecured debt. If a company issues a first-lien term loan backed by machinery, the lender can seize and sell that equipment in case of default. Under the Uniform Commercial Code (UCC), lenders file a UCC-1 financing statement to publicly declare their interest in collateral, ensuring priority among creditors.

Collateral Pledges

A collateral pledge involves a borrower offering specific assets as security for a loan. Unlike a lien, which grants a legal claim, a pledge may require the borrower to transfer control or ownership of the asset to the lender until repayment. This structure is common in margin loans, where investors pledge securities as collateral. If the value of these securities drops below a set threshold, the lender may issue a margin call, demanding additional collateral or partial repayment.

Businesses frequently use collateral pledges in asset-based lending, securing loans with receivables, inventory, or equipment. For example, a company may pledge its accounts receivable to obtain a working capital loan. If the company defaults, the lender can collect payments directly from customers. The Financial Accounting Standards Board (FASB) requires companies to disclose pledged assets in financial statements under Generally Accepted Accounting Principles (GAAP) to ensure transparency.

Guarantees

A guarantee is a contractual commitment by a third party to assume responsibility for a borrower’s debt in case of default. Guarantees can be issued by individuals, corporations, or government entities, providing lenders with an additional layer of security. Personal guarantees are common in small business loans, where business owners pledge personal assets to secure financing. If the business defaults, the lender can pursue the owner’s personal wealth, including bank accounts and real estate.

Corporate guarantees are often used in subsidiary-parent company relationships. A parent company may guarantee a subsidiary’s debt to reassure lenders of repayment, reducing risk and potentially lowering interest rates. In international finance, sovereign guarantees back infrastructure projects, ensuring repayment even if the project fails. The International Financial Reporting Standards (IFRS) require companies to disclose guarantees in financial statements, as they represent contingent liabilities that could impact financial health.

Legal Remedies in Insolvency

When a borrower becomes insolvent, creditors rely on legal mechanisms to recover outstanding debts. The process varies by jurisdiction, debt type, and the debtor’s financial condition. Courts, regulatory agencies, and contractual agreements influence the available remedies.

One tool creditors use is an involuntary bankruptcy petition. Under U.S. law, creditors meeting specific criteria can force a debtor into bankruptcy proceedings when obligations remain unmet. If the court accepts the petition, the debtor’s assets come under judicial oversight, allowing structured claims by creditors.

Receivership is another remedy, particularly for secured creditors. A court or lender-appointed receiver takes control of the debtor’s assets to preserve value and ensure repayment. This is common in real estate foreclosures, where a receiver manages rental income to repay loans. In corporate settings, a receiver may oversee business operations to prevent asset dissipation while creditors seek repayment.

Fraudulent transfer claims provide another avenue for creditors to recover funds. Under the Uniform Voidable Transactions Act (UVTA), transactions intended to hinder, delay, or defraud creditors can be reversed. For example, if a company transfers assets to a related entity for little or no consideration before declaring bankruptcy, creditors can challenge the transaction and seek to reclaim those assets. Courts assess factors such as insolvency at the time of transfer and whether the debtor received fair value.

Equitable subordination allows courts to demote certain claims in bankruptcy proceedings. If a creditor engages in misconduct—such as exerting excessive control over a debtor at the expense of other creditors—a judge may subordinate their claims, placing them lower in the repayment hierarchy. This is particularly relevant when insiders, such as executives or major shareholders, provide loans to their own company and later attempt to recover funds ahead of other creditors.

Contractual Covenants

Lenders use contractual covenants to impose financial and operational restrictions on borrowers, ensuring risk exposure remains within acceptable limits. These covenants fall into two categories: affirmative and negative obligations.

Affirmative covenants require borrowers to maintain specific financial conditions or fulfill reporting obligations. A company may be required to submit audited financial statements quarterly or meet financial ratios, such as a minimum interest coverage ratio or a maximum leverage ratio. If a borrower’s debt-to-EBITDA ratio exceeds a set threshold, lenders may declare a default or renegotiate terms.

Negative covenants restrict actions that could jeopardize repayment. These often include limitations on issuing additional debt, making large capital expenditures, or paying excessive dividends. For instance, a company with a restrictive dividend covenant may be prohibited from distributing earnings to shareholders if doing so would reduce cash reserves below a required level. Such provisions prevent excessive risk-taking that could impair repayment capacity.