What Is “Absolute Priority” in Bankruptcy and Debt Repayment?

The term absolute priority refers to a legal principle in bankruptcy law that dictates the order in which creditors and stakeholders are paid when a company or individual goes through liquidation or reorganization. It establishes a clear hierarchy, ensuring that higher-priority creditors are paid in full before lower-priority creditors or equity holders receive anything.

Absolute priority plays a crucial role in corporate bankruptcy cases, particularly under Chapter 7 and Chapter 11 of the U.S. Bankruptcy Code. Understanding how this rule works is essential for creditors, investors, and business owners navigating financial distress and insolvency.

Defining Absolute Priority

In bankruptcy proceedings, creditors and claimants are ranked based on their legal rights to the debtor’s assets. The absolute priority rule (APR) ensures that secured creditors—who have collateral backing their loans—get paid before unsecured creditors, and that unsecured creditors are compensated before shareholders receive any remaining funds.

This principle is meant to protect creditors from unfair losses while also maintaining confidence in financial markets by enforcing a structured repayment order.

Understanding the Hierarchy of Debt Repayment

Under absolute priority, the order of repayment typically follows this structure:

1. Secured Creditors: Banks, bondholders, and lenders with collateralized loans are repaid first.
2. Administrative and Legal Expenses: Lawyers, accountants, and other professionals involved in the bankruptcy process are paid next.
3. Unsecured Creditors: Credit card companies, suppliers, and landlords receive payment after secured creditors and administrative expenses.
4. Subordinated Debt Holders: Junior creditors who agreed to take on higher risks in exchange for potentially higher returns.
5. Preferred Stockholders: Investors who hold preferred shares have priority over common stockholders but come after all creditors.
6. Common Stockholders: Shareholders are last in line and often receive nothing if debts exceed available assets.

In most cases, if the company’s assets are insufficient to cover secured and unsecured creditors, shareholders walk away empty-handed.

How Absolute Priority Applies in Chapter 7 vs. Chapter 11 Bankruptcy

Absolute priority plays a different role depending on the type of bankruptcy a company files:

• Chapter 7 Bankruptcy (Liquidation): The company’s assets are sold, and funds are distributed according to absolute priority. Since all assets are liquidated, common shareholders usually receive nothing.
• Chapter 11 Bankruptcy (Reorganization): The company restructures its debt, and creditors may negotiate repayment plans. The absolute priority rule still applies, but some lower-priority stakeholders may receive partial payments depending on court approval.

Examples of Absolute Priority in Action

To better understand this principle, here are some real-world examples:

• Retail Chain Bankruptcy: A large retailer files for Chapter 7 bankruptcy. The company’s remaining assets are used to repay secured creditors, including banks that provided loans backed by inventory. Next, unsecured creditors, such as suppliers, receive partial payments. Finally, since the debts exceed available assets, shareholders get nothing.
• Airline Chapter 11 Case: An airline enters Chapter 11 bankruptcy and restructures its debt. Under the absolute priority rule, bondholders (secured creditors) must be paid in full before any restructuring benefits common shareholders.
• Real Estate Developer Liquidation: A property developer goes bankrupt, with real estate assets used as collateral. The mortgage lenders receive repayment first, followed by construction contractors, and then any remaining funds go to preferred shareholders—if there are any assets left.

Exceptions to the Absolute Priority Rule

While absolute priority is a fundamental rule, there are exceptions where lower-ranked stakeholders may receive compensation before higher-priority creditors:

• “Cramdown” Provisions in Chapter 11: A bankruptcy court may approve a reorganization plan that allows junior creditors or shareholders to receive payments if the plan is deemed fair and necessary.
• Negotiated Settlements: Creditors sometimes accept less than full repayment in exchange for a faster resolution or equity in the reorganized company.
• Government Intervention: In some high-profile bankruptcies, government agencies may step in to adjust creditor repayment structures (e.g., bailouts during financial crises).

How Investors Can Protect Themselves in Bankruptcy Cases

If you’re an investor, it’s important to consider how the absolute priority rule could impact your holdings. Here are some strategies to safeguard your assets:

1. Invest in Secured Debt: Secured bonds and loans offer greater protection than unsecured investments.
2. Analyze Financial Health: Research a company’s balance sheet and debt structure before investing.
3. Diversify Holdings: Reduce risk exposure by investing across multiple industries and asset types.
4. Monitor Bankruptcy Proceedings: Stay informed about legal rulings and creditor negotiations in distressed situations.

Notable Bankruptcy Cases That Followed Absolute Priority

Throughout history, major bankruptcy cases have demonstrated the absolute priority rule in action:

• Lehman Brothers (2008): When Lehman Brothers collapsed, secured creditors were paid first, while common shareholders lost their entire investment.
• General Motors (2009): The U.S. government’s intervention altered the priority structure, benefiting some stakeholders over others.
• Enron (2001): Following its accounting scandal, Enron’s bankruptcy followed the absolute priority rule, leaving shareholders with nothing.

Why Absolute Priority Matters for Businesses and Investors

Absolute priority is a cornerstone of bankruptcy law, ensuring that creditors are paid in a structured order. For businesses, understanding this principle helps in managing financial risk, while for investors, it clarifies the risks associated with different types of securities.

If you’re considering investing in a company with financial difficulties, understanding absolute priority can help you make more informed decisions. Do you think this rule is fair? Have you ever been impacted by a bankruptcy case? Share your thoughts in the comments below!