When a Company Goes Bankrupt Who Gets Paid First?

When a company faces severe financial distress, it may seek protection under federal bankruptcy laws. This process provides a structured framework for addressing claims and distributing assets. Understanding the order in which different creditors receive payment is important for anyone involved with a financially struggling business. This article explains the hierarchy of payments in corporate bankruptcy.

Understanding Bankruptcy Proceedings

Corporate bankruptcy proceedings primarily fall under two chapters of the U.S. Bankruptcy Code: Chapter 7 and Chapter 11. These chapters dictate how a company’s assets are managed and distributed, influencing the recovery prospects for creditors. While their approaches differ, both types of bankruptcy adhere to established principles of creditor priority.

Chapter 7 bankruptcy involves the liquidation of a company’s assets. In this process, a court-appointed trustee takes control of the company, sells off its non-exempt assets, and distributes the proceeds to creditors according to a legally defined order of priority. The company ceases operations, and its existence concludes after the liquidation is complete. This type of bankruptcy is pursued when a business is no longer viable or reorganization is not feasible.

In contrast, Chapter 11 bankruptcy provides for the reorganization of a company’s debts. Under Chapter 11, the company continues its operations as a “debtor in possession,” working to restructure its financial obligations and plan for future viability. This reorganization plan, which must be approved by the bankruptcy court and often by creditors, outlines how the company will pay its debts over time. The goal is to allow the business to emerge from bankruptcy as a healthier entity, though it may involve selling some assets or renegotiating terms with creditors.

Despite their differences, both Chapter 7 and Chapter 11 cases follow similar principles of payment hierarchy. Even in a Chapter 11 reorganization, a proposed payment plan must respect the statutory hierarchy of claims, ensuring higher-priority creditors are addressed before those with lower priority.

The Concept of Creditor Priority

A principle in bankruptcy law is creditor priority, which establishes a hierarchy for satisfying claims against a bankrupt company. This system provides fairness and predictability in asset distribution. Without it, claim resolution could become chaotic, leading to disputes and inefficient unwinding of the company’s financial affairs.

This priority system distinguishes between “secured” and “unsecured” creditors. A secured creditor holds a claim backed by specific collateral, meaning they have a legal right to certain assets of the debtor if the debt is not repaid. For instance, a bank that loaned money for equipment and holds a lien on that equipment is a secured creditor. Their claim is tied directly to the value of the asset securing their loan.

Conversely, an unsecured creditor does not have a claim backed by specific collateral. This category includes a broad range of creditors, such as suppliers who provided goods on credit, general lenders without specific asset liens, and service providers. Their ability to recover debt depends entirely on the availability of funds after secured claims and other higher-priority claims have been satisfied.

Secured creditors hold a stronger position in the payment hierarchy because their claims are attached to specific assets. If the company’s assets are sold during bankruptcy, proceeds from the sale of a secured asset are used to pay the secured creditor first, up to the value of their collateral. Any remaining debt exceeding the collateral’s value then becomes an unsecured claim.

The Payment Hierarchy

When a company enters bankruptcy, the distribution of its available assets follows a payment hierarchy established by law. This order ensures certain types of claims are satisfied before others, moving from highest to lowest priority.

Administrative Expenses

At the top of the payment hierarchy are administrative expenses. These are costs incurred by the bankruptcy estate after the petition has been filed, necessary for the estate’s preservation and administration. Examples include fees for attorneys, accountants, other professionals hired to manage the process, and trustee fees. Operational expenses incurred during bankruptcy, such as utilities, rent, and employee salaries for post-petition work, also fall into this category. These expenses are paid first because they are necessary for the orderly winding down or reorganization of the business.

Secured Creditors

Following administrative expenses, secured creditors are paid from the proceeds of the specific assets that collateralize their loans. For example, if a bank holds a lien on a company’s machinery, proceeds from the machinery’s sale would first satisfy the bank’s claim, up to the debt amount. If the collateral sale does not cover the full secured debt, the remaining debt converts into an unsecured claim. Conversely, if the collateral’s value exceeds the debt, the surplus becomes part of the general bankruptcy estate for other creditors.

Priority Unsecured Creditors

After secured claims are addressed, certain categories of unsecured creditors receive priority payment over general unsecured creditors. These priority claims are specifically designated by law due to public policy considerations.

One such category includes employee wages and benefits. Claims for wages, salaries, commissions, vacation pay, severance pay, and sick leave are given priority status, up to a certain monetary limit per employee. This limit is $15,150 per individual, provided wages were earned within 180 days before the bankruptcy filing or the cessation of the debtor’s business. Any amount exceeding this limit or earned outside this timeframe is treated as a general unsecured claim.

Another priority class covers certain customer deposits. Claims by individuals for deposits made for the purchase, lease, or rental of property or services for personal, family, or household use are prioritized. This priority is limited to $3,800 per individual claim.

Certain tax claims also receive priority status. These include income taxes for tax years ending on or before the bankruptcy filing date, provided the tax return due date (with extensions) was within three years of the petition. Other priority tax claims can include payroll taxes for which the debtor is liable, like those withheld from employee wages, and sales or property taxes recent enough to qualify under statutory look-back periods. These tax obligations are prioritized to ensure governmental entities can recover important revenues.

General Unsecured Creditors

Once administrative expenses, secured claims, and priority unsecured claims have been satisfied, remaining funds are distributed to general unsecured creditors. This broad category includes trade creditors, vendors, bondholders, and any portion of secured or priority claims exceeding their limits or collateral values. These creditors receive a pro-rata share of the remaining assets. In many bankruptcy cases, especially liquidations, general unsecured creditors may receive only a fraction of what they are owed, or even nothing at all, as assets are often exhausted by higher-priority claims.

Equity Holders (Shareholders)

At the bottom of the payment hierarchy are the equity holders, or shareholders, of the company. Shareholders represent ownership and their investment is at the highest risk. They have a claim only to assets remaining after all creditors—secured, priority unsecured, and general unsecured—have been paid in full. In most corporate bankruptcy cases, there are no assets left after creditors are satisfied, meaning shareholders receive nothing for their investment. This position reflects the principle that debt obligations must be fully met before any returns can be distributed to owners.