What is the Absolute Priority Rule and How does it Work?
The absolute priority rule (APR) ensures that higher-priority creditors are paid in full before lower-priority creditors or the company’s equity holders can recover anything from the bankrupt estate. This rule serves as a safeguard to prevent equity holders from wrongfully benefiting at the expense of creditors. Simply put, the rule upholds the hierarchy established in the bankruptcy process—ensuring fairness in payment distribution.
Key Takeaways
- The absolute priority rule ensures that higher-priority creditors must be paid in full before lower-priority creditors or equity holders receive any recovery.
- The rule establishes a clear hierarchy of claims, with secured creditors paid first, followed by priority unsecured creditors, general unsecured creditors, and finally, equity holders.
- Exceptions to the rule include the New Value Doctrine, where equity holders can retain interests by contributing substantial new value, and cases where higher-priority creditors vote to allow lower-priority recoveries.
- The rule is enforced during the Chapter 11 plan confirmation process to ensure "fair and equitable" treatment for all parties involved in the reorganization.
Hierarchy of Claims
Bankruptcy law establishes a clear order in which the various types of claims against a debtor must be satisfied, often referred to as the bankruptcy waterfall. This concept reflects the structured flow of payments, where creditors are paid in turn according to their respective priority levels, and only after higher-priority claims are fulfilled can payments "cascade" down to lower levels in the waterfall. The liquidation preference further clarifies which creditors or equity holders receive payment first in a liquidation scenario—often giving creditors with secured claims the first right to repayment before equity holders are considered. The typical order of priority is as follows:- DIP Financing: Debtor-in-Possession (DIP) financing lenders hold super-priority status, meaning they are paid first, even before secured creditors.
- Secured Claims: These are backed by collateral, giving creditors the right to recover their claims directly from the pledged assets.
- Priority Unsecured Claims: These include administrative costs (such as attorney’s fees) and other heightened claims, such as tax obligations.
- General Unsecured Claims: Most unsecured creditors, like suppliers or vendors, fall into this class. These claims are often settled at a reduced percentage after higher-priority claims are satisfied.
- Equity Holders: Shareholders or owners of equity interests are typically last and may receive little to no recovery.
Why the Hierarchy Exists
The hierarchy of claims in bankruptcy reflects the level of risk creditors assume and the legal protections they have:- DIP financing comes first because it provides essential funding to keep the business operational during the reorganization process, and lenders are granted super-priority status to incentivize them to lend to a company already in financial distress.
- Secured Claims come first because these creditors have collateral backing their loans, meaning they took on less risk knowing they could recover their claims through specific assets if the debtor defaults.
- Priority Unsecured Claims are essential for the functioning of the bankruptcy process itself, as they include administrative expenses (like legal fees) and obligations crucial to keeping the business going, such as taxes. These claims ensure the fundamental costs of bankruptcy are covered.
- General Unsecured Claims follow because these creditors, unlike secured creditors, have no asset backing, making their risk higher. Therefore, they are behind secured claims but can come before equity stakeholders.
- Equity Holders are last because they have the highest risk—owning shares in the company comes with no guaranteed repayment in case of failure, as their returns are tied directly to the company’s success or failure.
The Role of Secured vs. Unsecured Claims
In a Chapter 11 proceeding, the treatment of secured and unsecured claims can differ significantly:- Secured Claims: Creditors that hold collateral (like a mortgage or lien) are considered secured creditors. In a bankruptcy, debts backed by collateral are paid first, with claims limited to the value of the collateral. Secured loans, such as Debtor-in-Possession (DIP) financing, often have super-priority, meaning they are given precedence over existing secured claims.
- Unsecured Claims: Among these, some claims are given priority status, such as administrative expenses, court costs, or tax obligations. General unsecured claims, which include most trade creditors or debtholders without collateral, are usually much lower in priority and may receive only a small fraction of their total debts.