Establishing creditor prioritization is an essential step of the Chapter 11 Bankruptcy process. The priority scheme is set forth by the United States Bankruptcy Code to dictate the order in which payments are distributed to Creditors in a fair and equitable manner.
While the Ch.11 process can be unpredictable and complex, creditor prioritization offers some clarity to Creditors on if, when, and how they will receive payment.
The Creditor priority scheme works similar to a ladder. The bankruptcy claims standing on the highest step of the ladder must be paid first and in full before any of the claims on the lower steps can be paid at all.
In other words, the highest priority classes of bankruptcy claims are paid first, then the next class below it. This continues until all claims are resolved or until the process reaches a class for which the Debtor’s assets are insufficient to pay the Creditors in full. If the available assets of the Debtor’s bankruptcy estate becomes limited or runs out after paying the first claims, the remaining Creditors may receive only a portion of their claim or nothing at all.
In this article, we will distinguish the different Creditor priority levels and how these impact the payment process on their bankruptcy claims.
How are Creditors and their bankruptcy claims classified?
Under Ch. 11 procedures, Creditors—holders of bankruptcy claims—are categorized into the following classes, ranked from the highest priority to lowest:
- Secured Claims
- Unsecured Priority Claims
- Unsecured Non-Priority Claims (General Unsecured)
- Equity Security Interests
If a Creditor possesses multiple claims each with different rights, the individual claims can be classified into different classes and types. These claims are classified based on their similarity of rights against the Debtor.
Generally speaking, if a Creditor’s claim is secured by assets or property of the Debtor (or Secured Creditors), they are in a superior position and will receive full payment before any other Creditor class through the Plan of Reorganization. However, there is much more that defines the distinction of the individual classes of bankruptcy claims that we will examine below.
A secured bankruptcy claim is guaranteed by collateral or a lien on property or assets belonging to the Debtor. Secured Creditors may be the holder of a real estate mortgage, a financial institution with a lien on all assets, a receivables lender, an equipment lender, the holder of a statutory lien or a number of other entities.
Because a secured claim is guaranteed against the value of collateral or a lien, a Secured Creditor will receive payment in association with the asset value of its collateral or lien from the available funds of the bankruptcy estate. Under Chapter 11 procedures, Secured Creditors will receive payment before the next class of Creditors—those with unsecured claims.
Secured claims can be oversecured, meaning the collateral is worth more than the debt, or undersecured, meaning the debt is worth more than the value of the collateral. For example, a Debtor has assets that are pledged to secure $20 million in first-lien debt, and $10 million in second-lien debt. If the Debtor’s assets are valued at $36 million, both the first-lien and second-lien creditors are oversecured and they are both entitled to full repayment that equates to the amount of their respective debts.
However, if the Debtor’s assets are valued at $27 million, then the first-lien creditor is oversecured but the second-lien creditor is undersecured. The second-lien creditor will have a secured claim for $7 million and an unsecured claim for the $3M debt remaining.
If for instance, the Debtor’s assets are valued at $18 million, both the first-lien and second-lien creditors are undersecured. The first-lien creditor will have a secured claim for $18 million and an unsecured claim for the $2 million debt remaining. In this situation, the second-lien creditor will have an unsecured claim for the entirety of their $10 million debt.
Given this example, Secured Creditors can end up being holders of unsecured claims despite their debt being secured by collateral or a lien. With all of these determining factors, one Secured Creditor may have a very different priority level than another in terms of repayment.
Unsecured Priority Claims
In contrast to secured claims, an unsecured claim is one that is not guaranteed by collateral or a lien. Classes of Unsecured Creditors will only receive recovery from the Debtor’s bankruptcy estate after distributions are made first to Secured Creditors. Creditors with unsecured claims, however, are not guaranteed payment.
While a priority claim is not secured by collateral, it is however treated with higher priority over other claims by Federal law. A priority claim is debt that is entitled to special treatment in the bankruptcy process and will get paid ahead of non-priority claims. These might include bank lenders, employees, the government if any taxes are due, suppliers, and investors who have unsecured bonds. Priority claims are dependent on unrestrained assets of an estate for payment. A Debtor must pay out a priority claim in full and in cash under the Chapter 11 Plan, unless the Creditor agrees to different terms.
Creditors with a priority unsecured bankruptcy claim typically carry priority for public policy reasons, which means the well-being of the public is dependent upon payment of these debt obligations. Furthermore, priority unsecured claims are non-dischargeable and if any amount of the debt is not paid, it will remain outstanding. A Ch. 11 bankruptcy does not eliminate the debtor’s obligation to repay priority unsecured debts until they are paid in full through the Plan of Reorganization.
What types of debt are given this special priority under Chapter 11? Examples of priority claims include: employee compensation owed, unpaid contributions to employee benefits plans, tax obligations owed to the government, pending personal injury or workplace injury or death claims, certain deposits given to the Creditor to secure future goods or services, alimony, child support, and costs of administering the bankruptcy case (e.g. professional accounting and legal fees).
What is unique to Priority Claims is that even though they are unsecured, they are specifically entitled to be placed ahead of other unsecured claims in repayment priority as deemed by Congress. There are a total of ten categories of statutory priority claims specified under US Bankruptcy Code Section 507, below is a summary of the most common ones:
- Priority for Administrative Expenses
The Bankruptcy Code under Section 507(a) states that administrative expenses receive first priority. Administrative expenses describe the necessary costs and expenses of preserving the bankruptcy estate. This also refers to the costs of legal fees, professional fees, and post-petition expenses of operating the Debtor’s business.
- Priority Tax Claims
Most government tax obligations are considered a priority claim, specifically unsecured tax claims.
This only applies to tax claims and not government claims in general. Government’s non-tax claims are not given any special priority under the Bankruptcy Code.
- Priority for Employee Claims
Under the circumstances that the Creditor is an employee and the Debtor is the employer, two subsections of the Bankruptcy Code 507 apply. These sections give limited priority for wage claims and for claims under employee benefit plans.
Employee claims are often matters that need immediate attention in the interest of individual employees. A practice has been developed that involves paying these priority claims relatively soon after Ch. 11 has been filed, dependent on court approval. While there is nothing in the Bankruptcy Code that specifically authorizes the court to grant approval, it is common for courts to grant this relief.
Furthermore, employee claims typically revolve around the issue of employer liability under a government guaranteed pension plan, employee rights under contract, or proposed retention of incentive plans.
Due to the special treatment afforded to these Priority Claims under law, these particular unsecured claims are classified ahead of all other unsecured claims in terms of repayment priority.
After Secured and Priority Unsecured claims, the next in line are Non-Priority Unsecured claims.
Unsecured Non-Priority Claims
General Unsecured claims are debts that are not guaranteed by any collateral or lien on the Debtor’s bankruptcy estate. Because they are not specifically given special priorities under law, these Creditors who hold general unsecured claims are classified as non-priority claims. These types of bankruptcy claims might include trade payables, employee claims over the statutory limit of $12,500, unsecured bonds, credit card bills, utility bills, medical bills, loans not collateralized, and underfunded pension liabilities.
Non-priority Unsecured Creditors have the lowest position in the priority scheme (aside from shareholders). This means that these creditors will most likely receive a pro rata distribution of any remaining funds only once a Debtor’s bankruptcy estate has paid administrative expenses, priority secured, and priority unsecured claims.
Unsecured Creditors are subject to only receiving partial claim value. It is also likely that the Debtor will create an installment payment plan to distribute their payout over time, or receive payment in the form of promissory notes or equity in the reorganized company.
However, in the event that there is nothing left from the bankruptcy estate after all secured and priority unsecured claims are paid, the bottom-tier unsecured claims will not receive any form of payment.
Unfortunately, general unsecured bankruptcy claims are typically dischargeable and any amount of the debt that is not paid through the Ch.11 process will be eradicated and the Debtor is not obligated to pay.
Equity Security Interests
An equity security interest holder is someone who possesses stock equity or ownership in the Debtor. This includes an entity with a share in the corporation, an ownership interest of a limited partner, or a right to purchase, sell, or subscribe to a share, security or interest of a share in a corporation or an interest in limited partnership. These stockholders reserve the right to vote on the Chapter 11 Plan of Reorganization and are allowed to file a Proof of Interest, as opposed to a Proof of Claim.
A Proof of Interest is filed for any security interest that is listed in the Debtor’s Schedules of Assets and Liabilities, unless it is designated as disputed, contingent, or unliquidated. If an equity security holder’s interest is not scheduled or is listed as disputed, contingent, or unliquidated, a Proof of Interest must be filed to allow for this security interest holder to be treated as a creditor. They can then be allowed to vote on the plan and receive distribution.
Although Ch. 11 bankruptcy allows an organization to continue trading stocks, the process can still have a negative impact on equity security stockholders. The company’s stock value is vulnerable to the risk of decreasing.
Equity security holders are the lowest on the priority scheme, and they often do not obtain a return on their investment or anything close to the full amount. Stockholders will no longer receive dividends and may have to return their stocks to be replaced with shares in the reorganized company after the Debtor re-emerges from Chapter 11.
Equity security holders are further subdivided into owners of preferred stock and owners of common stock. Owners of preferred stock are given priority in their recourse before owners of common stock. Under certain circumstances, stockholders are given the opportunity to purchase new warrants, which allow them to purchase new shares in the reorganized company at a set cost before a specific deadline.
After having discussed the claims classification process and the differences in Creditor Classes, we can dive into the specifics of how Creditors payouts take place.
How Do Creditors Get Paid?
The exercise of classifying claims into prioritized Creditor classes is a precursor to the Debtor’s formation of a Plan of Reorganization. In addition to detailing its proposed restructuring efforts, the Plan specifies how the Debtor will treat each Creditor class in paying their claims.
The Absolute Priority Rule
Before payments can be issued to Creditors, the Plan of Reorganization must be approved by the court, accepted by Creditors, and confirmed. The Plan must not discriminate unfairly and should be fair and equitable with respect to each Creditor class of claims.
A fundamental concept underlying the United States Bankruptcy Code is the principle known as the “absolute priority rule”, which mandates that Creditors of lower priority must not be paid until higher priority Creditors are paid in full. Within this construct, the Debtor’s Plan of Reorganization is therefore considered fair and equitable under law as long as the Creditor is paid the value of its claim, or if a lesser priority bankruptcy claim is not paid.
The “absolute priority rule” implies that if a Creditor of the highest priority (i.e. Secured Creditor), is paid in full under the Chapter 11 plan, then those of a lower priority (i.e. general Unsecured Creditor), must also be paid. However, if higher priority Creditor classes are not paid in full, then the lower priority Creditor classes are not entitled to receive anything. The rule also states that if the owners of a company, who are a class lower than general Unsecured Creditors, want to obtain an interest in the company, all general Unsecured Creditors must be paid in full first.
In concert with the absolute priority rule, the mechanics of Creditor claim payout follow what is known as the waterfall payment structure. Imagine a staircase with water flowing down from the top of its steps in a cascading order. The water must fully reach the edge of a step before it flows down to the next step below it. If there is insufficient water to reach the edge of a step in full, it will not flow downwards to the lower step.
In the same manner, the distribution of payment in a Debtor’s Plan of Reorganization depends on the availability of funds in the bankruptcy estate. If there are insufficient funds to pay Secured Creditors, the next tier of Unsecured Creditors will not receive payment. As mentioned above, the Creditors in each tier of the priority scheme are not paid until the Creditors of the tier above it receive payment in full.
The structure of waterfall payment requires that higher-tiered Creditors receive their payment and its respective interest in full capacity, before any other Creditors of the lower tiers can be paid back. This is done to give Debtors the opportunity to prioritize the highest-principal and most expensive debts first. Unsecured Creditors and other lower-tiered claims holders receive interest-only payments until all Secured Creditors or higher-tiered claim holders are paid in full.
Waterfall payments can be set up to pay off one loan at a time or pay all loans in a systematic fashion, depending on the Debtor’s agreed arrangement with Creditors. The total size of the Debtor’s debts decreases as payments are made in a cascading fashion, based on the Creditor’s priority, tier and tranch—a series of payments scheduled over a specified time period. This is likely because paying off larger debts first reduces the risk of insolvency for the Debtor and frees up cash for operations, capital expenditures and investments.
As an example, a Debtor owes debts to three Creditors, each in their own class in descending order of priority: Creditor X, Creditor Y, and Creditor Z. The arrangement for what the Debtor owes to each Creditor would be as follows:
- Creditor X is owed $4 million interest and $8 million principal, in total
- Creditor Y is owed $6 million taxes, in total
- Creditor Z is owed $2 million invoice total
If the Debtor only has $16 million in funds from its bankruptcy estate after confirmation of its Plan, it can pay off the entire $12 million owed to Creditor X, leaving it with $4 million remaining to pay off additional debts. This means that $4 million can be paid to Creditor Y, the result would be:
- Creditor X debt is fully paid
- Creditor Y is owed $2 million taxes, in total
- Creditor Z is owed $2 million invoice total
This simplified example illustrates how the process of a waterfall payment structure operates in the context of Ch.11, favoring the payment of higher tiered Creditors before lower tiered Creditors are paid. Creditor X receives a full recovery on its claim, while Creditor Y receives a partial recovery on its claim. For Creditor Z, because it is prioritized in a lower tiered Creditor class, and funds from the estate have been exhausted, it does not receive any recovery on its claim.
Pro Rata Distribution
The principle of pro rata distribution comes into play if all higher-tiered Creditors have been paid in full and there are no longer sufficient funds to pay the remainder of the lower-tiered Creditors in full. Pro rata works among similarly situated Creditors in the same class. Each Creditor receives a share of the remaining distribution determined by the size of their allowed bankruptcy claim, proportionate to the total claim size amount of the Creditor class.
For instance, suppose a Debtor owes debts to Creditors as follows:
- Creditor S $15 million
- Unsecured Priority
- Creditor T $25 million
- General Unsecured Non-Priority
- Creditor U $10 million
- Creditor V $20 million
- Creditor W $30 million
The Debtor has $55 million in its bankruptcy estate. Based on the waterfall structure, it first issues payment to Secured Creditor S for $15 million before paying Unsecured Priority Creditor T for $25 million. After this, the Debtor has $15 million left in its estate to distribute to the 3 General Unsecured Creditors U, V, and W—who together, hold claims totaling $60 million. By applying the principle of pro rata distribution, the $15 million remaining in funds equates to 25% of the total claim amount for this Creditor class, a sum of $60 million. Therefore, under pro rata each Creditor in the General Unsecured class would receive a share of the remaining funds from the bankruptcy estate, proportionate to 25% of the value of their claim. As a consequence, Creditor U would receive $2.5 million, Creditor V would receive $5 million, and Creditor W would receive $7.5 million. In other words, each Creditor in the General Unsecured class sacrifices in a proportionate amount in order to be repaid from the remainder of the estate.
Pro rata distribution is typical amongst general Unsecured Creditors (non-priority Unsecured Creditors) and equity shareholders, as they are the lowest classes of the priority scheme and last to receive repayment from the Debtor’s estate. General Unsecured Creditors that qualify for pro rata distribution will split the remaining assets evenly amongst themselves. However, it is still possible that Creditors will not recover any payment at all, especially for general Unsecured Creditors who are a lower tier and funds run out in paying off a higher tier of Creditors, such as those with secured and priority claims.
It is worth noting that according to the “absolute priority rule”, a higher priority level claim holder must receive 100% of their bankruptcy claim in full before any creditors of a lower priority level are entitled to receive any payment at all. This rule is commonly violated in Ch.11 cases when applying pro rata distribution, however, in order to pursue approval of the Plan of Reorganization from all Creditors involved.
Given the prioritization of Creditor claims, and the application of payment principles and their procedural mechanics, it is clear that not all Creditor claims can be paid in full at the conclusion of a Chapter 11 case. Furthermore, claim payouts are far from predictable or certain if a Creditor does not hold secured or priority claims.
Common Complications of the Payment Process
The Creditor claim payout process is further complicated by a number of other variables that can come into play during the pendency of a Ch. 11 case as well as afterwards. Summarized below are a few of these factors that can impact a Creditor’s prospects and expectations for claim payout.
In certain cases, the bankruptcy court might accept and confirm a Reorganization plan that limits or changes the rules of distribution. This could affect a Creditor’s priority level, limit their claim value, or delay the bankruptcy claims timeframe in which they receive payment.
Set forth by the rules of the Bankruptcy Code under section 544 and 549, a case Trustee or Debtor in possession is allowed certain “avoidance powers” that allow for the filing of adversary proceedings to gain back certain property that might have been transferred to other parties before the start of the Ch.11 case. Avoidance powers also allow a Debtor or Trustee to avoid any liens that were not correctly executed.
The Bankruptcy Code allows the debtor in possession or case Trustee to exercise avoidance actions in connection to exempt property if:
- It is avoidable by the Trustee under sections 544 or 548
- The Trustee does not seek to avoid the transfer
- The Debtor could exempt the property
- The transfer was involuntary
- The Debtor did not conceal the property
In other instances, the Creditor committee or an individual Creditor may initiate an adversary proceeding by either requesting the Debtor or Trustee take avoidance action or if the Debtor or Trustee refuses to do so. A Creditor may also initiate a proceeding if a claim of benefit to the estate is demonstrated. Furthermore, a Creditor may also institute an action on behalf of the Debtor in possession or the Trustee with authorization from the court.
If a Debtor exercises their avoidance powers on a claim, it can adversely impact the Creditor’s recovery amount, or result in additional litigation that delays the payout timing.
An impaired claim is one that is defective by the proposed terms of a Chapter 11 Plan of Reorganization. This happens when a Creditor’s rights to enforce its claim are changed or depreciated by the Debtor’s Plan.
A claim is impaired if it is not paid in full under the terms of the Plan, or if the original maturity date or other obligations outlined in the agreement upon which the claim is based are not met. However, a Debtor has the power to cure an obligation in order for a Creditor’s claim to be no longer impaired. This means that the obligation is made current, the Creditor is compensated for any expenses incurred by the Debtor’s default, and the Creditor’s rights under the obligation are unaltered moving forward.
Issues arising out of impaired claims, negotiating altered terms with the Debtor, and the resulting payout consequences can factor into a Creditor’s recovery, outlook, and timing of payment from the case.
Other factors that might further complicate a creditor’s payment and priority include the circumstance in which the court’s Judge orders a claim to be subordinated within a Creditor class. The Bankruptcy Code allows the court to rearrange priorities based on equitable principles, otherwise known as equitable subordination. Within a Creditor class, claims can be further prioritized to a lower payment priority as a result of subordination to higher priority claims within the same class. Therefore, claims that are subordinated by court order will likely encounter lower and possibly postponed payouts in contrast to the unsubordinated claims in the same Creditor class.
As described in section 361 of the Bankruptcy Code, adequate protection describes several different forms of promised relief to the Creditor, including periodic cash payments, payment of post-petition interest, or granting of additional liens to the Creditor on previously withheld assets. The form of adequate protection that the Creditor will receive will be determined by the level of risk, the use of the cash collateral, and what the Debtor is capable of offering. Creditors given adequate protection may be afforded favorable treatment and payment arrangements with the Debtor as a result.
A debtor is allowed to use a secured Creditor’s cash collateral in a Ch. 11 case. However, the use of the cash collateral could mean that the secured Creditor may be entitled to compensation for the loss of value that it has caused.
Special rules apply if the secured Creditor holds security interest in “cash collateral”, (which includes cash, cash equivalents, and cash proceeds of hard collateral). This means that the debtor will have to secure the Creditor’s consent or a court order if they wish to use the cash collateral.
Due to the financial distress the Debtor is experiencing when filing for Ch.11, they typically need immediate access to the cash collateral. In such cases, he or she will file an “emergency motion for authority to use cash collateral” early on. This presents an opportunity for the Secured Creditor to negotiate with the Debtor for certain rights in exchange for his or her consent to use the cash collateral. If the terms of the bargain do not appear unreasonable, the bankruptcy judge will enter a stipulated order to reflect the bargain.
In the event that the Debtor and Secured Creditor are unable to agree on the terms of the bargain, a contested hearing will be held to determine whether the Debtor should obtain the right to use the cash collateral. The Secured Creditor will need to prove by providing supporting evidence that the cash in question is, in fact, cash collateral. The Debtor will need to prove that he or she can provide “adequate protection” to the Secured Creditor in exchange for use of the cash collateral. Creditors in these scenarios can benefit from advantageous repayment terms in negotiation with the Debtor given the added risk they incur for permitting the use of their cash collateral.
During the pendency of a Chapter 11 Bankruptcy case, it is difficult for a Creditor to predict if, when, and how much of their own bankruptcy claim will be recovered. The process is complex and dependent on several factors that are out of the Creditor’s control.
While Creditor prioritization offers a certain amount of insight into what a Creditor can expect from the process, there are still several variables that can prolong the case, reduce the payout value of their bankruptcy claim, delay payment, or result in the eradication of claim recovery entirely.
Ultimately, the Chapter 11 process ensures the Debtor is given the opportunity to stabilize its finances through reorganization. For the Debtor to exit the Chapter 11 process, it must acquire Creditor approval and court confirmation on its Plan of Reorganization. Guided by the principles and procedures within the US Bankruptcy Code, the Plan is designed to ensure fair and equitable treatment of its Creditors, by class and by claim in a prioritized manner.