What Is the “Absolute Priority Rule” in Bankruptcy Law?

The Absolute Priority Rule (APR) is a fundamental principle in U.S. bankruptcy law that governs how debts are repaid when a business undergoes financial restructuring or liquidation. It ensures that higher-priority creditors receive full repayment before any lower-priority creditors or equity holders receive distributions.

While similar to the broader concept of absolute priority, the Absolute Priority Rule is a legally binding requirement under the U.S. Bankruptcy Code, particularly in Chapter 11 reorganization cases. Understanding how the APR works is critical for investors, creditors, and business owners navigating bankruptcy proceedings.

How the Absolute Priority Rule Works

The Absolute Priority Rule establishes a strict repayment hierarchy, ensuring that secured creditors are paid first, followed by unsecured creditors, and finally equity holders. The rule prevents lower-priority stakeholders from receiving distributions unless those above them in the repayment order have been fully satisfied.

Under Chapter 11 bankruptcy, the rule plays a crucial role when creditors and courts evaluate a company’s reorganization plan. If a proposed plan violates the APR—meaning it gives lower-priority creditors or shareholders value before senior creditors are fully repaid—the court may reject it.

Order of Repayment Under the Absolute Priority Rule

In bankruptcy, the APR mandates the following repayment structure:

1. Secured Creditors: Banks, bondholders, and lenders with collateral-backed loans are repaid first.
2. Administrative and Legal Costs: Bankruptcy attorneys, financial advisors, and administrative professionals are compensated next.
3. Unsecured Creditors: Credit card companies, suppliers, and contractors are next in line.
4. Subordinated Debt Holders: Junior lenders who took on higher risk are paid after unsecured creditors.
5. Preferred Shareholders: If any assets remain, preferred stockholders are repaid before common shareholders.
6. Common Shareholders: The lowest priority, common stockholders are typically last in line and often receive nothing.

Legal Basis of the Absolute Priority Rule

The Absolute Priority Rule is primarily outlined in Section 1129(b)(2) of the U.S. Bankruptcy Code. This section states that a reorganization plan must be “fair and equitable,” ensuring that lower-ranking creditors and shareholders do not receive compensation until senior creditors are fully repaid.

In bankruptcy courts, the APR is often applied when creditors reject a reorganization plan and the debtor seeks to impose a “cramdown”—a court-approved restructuring that forces creditors to accept terms. The cramdown is only allowed if the plan follows the Absolute Priority Rule.

Exceptions to the Absolute Priority Rule

Despite its strict structure, there are notable exceptions and ways around the APR:

• New Value Exception: Shareholders can retain ownership in a reorganized company if they contribute “new value” (e.g., fresh capital or assets) to the business.
• Creditor Consent: If senior creditors agree to a restructuring plan that deviates from the APR, courts may approve it.
• Government or Special Bailouts: In rare cases, government intervention can modify the traditional bankruptcy hierarchy.

Absolute Priority Rule in Chapter 7 vs. Chapter 11 Bankruptcy

The Absolute Priority Rule is most commonly applied in Chapter 11 reorganization cases, but it also plays a role in Chapter 7 liquidation:

• Chapter 7 (Liquidation): The APR ensures assets are distributed in the correct order when a company is dissolved.
• Chapter 11 (Reorganization): The rule prevents equity holders or lower-ranking creditors from receiving payment unless senior creditors are made whole.

Real-World Examples of the Absolute Priority Rule

Several high-profile bankruptcy cases have demonstrated the importance of the APR:

• Lehman Brothers (2008): When the investment bank collapsed, secured creditors were repaid first, while common shareholders lost everything.
• General Motors (2009): The U.S. government’s bailout of GM altered traditional bankruptcy priority, favoring certain creditors over others.
• Purdue Pharma (2021): In a controversial case, courts debated whether members of the Sackler family (former owners) could receive protection despite the APR.

How the Absolute Priority Rule Affects Investors and Creditors

The APR has significant implications for different financial stakeholders:

• Bondholders: Secured bondholders have the highest likelihood of recovering their investment in bankruptcy.
• Stockholders: Common shareholders face the greatest risk, as they are the lowest priority in repayment.
• Unsecured Creditors: These lenders must often negotiate settlements to recover partial payments.

Strategies for Investors to Navigate Bankruptcy Risks

Investors should be aware of the risks posed by the Absolute Priority Rule and take steps to protect their capital:

1. Prioritize Secured Investments: Investing in secured debt reduces the risk of losing capital in bankruptcy cases.
2. Analyze a Company’s Debt Structure: Understanding who gets paid first can help gauge the risk of an investment.
3. Diversify Across Asset Classes: Spreading investments reduces exposure to any single company’s financial troubles.
4. Monitor Bankruptcy Proceedings: Following court rulings and creditor negotiations can offer insights into expected recovery rates.

Why the Absolute Priority Rule Still Matters Today

The Absolute Priority Rule remains a cornerstone of bankruptcy law, ensuring a fair and predictable distribution of assets when companies fail. While exceptions exist, the rule provides structure in complex financial reorganizations and helps creditors understand their potential recoveries.

Have you ever been involved in an investment or business affected by the Absolute Priority Rule? What are your thoughts on its fairness? Share your experiences in the comments below!