Upon approval of the Debtor’s Plan of Reorganization, the process of paying out bankruptcy claims begins. For many Creditors, this means recovery is finally within reach. For others, however, it marks the start of another unpredictable waiting game.
The amount and order in which a Creditor is paid back is dependent on how their claim is classified in the Plan of Reorganization. Bankruptcy claims can be categorized into the following classes, listed in descending order of priority level: Secured, Unsecured priority, Unsecured non-priority, or Equity security interests.
In compliance with the absolute priority rule, Creditors with the highest priority claims must be paid out first and in full before the next classes receive any distribution. This process is administered through what is known as a waterfall payment structure.
Understanding Waterfall Payment Structure
The best way to understand a waterfall payment structure is to picture a cascading staircase, each step holding a bucket that represents each Creditor class. The water represents the funds from the Debtor’s bankruptcy estate. As the water flows from the top, it must fill each bucket to its full capacity before it overflows into the next.
Now, apply this same structure to bankruptcy claim payouts. The Debtor is required to issue payments to the higher priority bankruptcy claims in full before it moves onto the next step, or pays back the next class of priority claims.
Depending on the agreed upon terms of the Plan of Reorganization, waterfall payments can be arranged to either issue payment for one loan at a time, or all loans in an orderly system over a determined period of time. Creditors with lower-tiered claims will receive interest-only pay outs until all higher-tiered claims holders are paid the full capacity of their bankruptcy claims.
What happens if the Debtor’s bankruptcy estate runs out of funds?
As Secured and other high priority Creditors are issued their payments in full capacity, it is not uncommon for the Debtor’s bankruptcy estate to reach a point at which there are insufficient funds to pay the lower priority claims. This could mean unsecured Creditors and other claims holders will not receive a payout.
In the event that there are insufficient funds to pay the lower-tiered Creditors in full, the remaining funds in the Debtor’s estate are issued through pro-rata distribution. This means the remaining funds will be shared among the Creditors in the same class and similar position. The amount of each Creditor’s share is decided by the size of their claim compared to the total claim size of their Creditor class.
Example of Waterfall Payment Structure
In order to further demonstrate how the waterfall payment structure will pan out, here is an example. Assume the Debtor has outstanding debts to three Creditors: Creditor A, Creditor B, and Creditor C. This structure is designed so that Creditor A has highest priority and Creditor C has lowest priority. The Creditor’s owed bankruptcy claims are as follows:
- Creditor A is owed $8 million interest and $2 million principal, in total
- Creditor B is owed $6 million taxes, in total
- Creditor C is owed $2 million invoice total
Assume the Debtor is only allowed $14 million in funds from its bankruptcy estate as arranged by the Plan of Reorganization. In this instance, the results would be as follows:
- Creditor A is paid in full.
- Creditor B is paid $4 million and owed $2 million taxes, in total
- Creditor C is owed $2 million invoice total
Why is the waterfall payment structure enforced?
The waterfall payment structure was designed to ensure the Debtors’ most critical and expensive debts are paid back first. As payments are made in this cascading manner, the total amount of the Debtor’s debts decreases, which lowers the risk of conversion or insolvency and gives the Debtor access to cash that can be reinvested into their operations, expenditures and other investments.
While the waterfall payment system works in favor of the Debtor and high priority bankruptcy claims, it can cause an unfortunate outcome for lower priority claims. This is one of many unpredictable circumstances that can impact Creditor recovery from Chapter 11 bankruptcy.
With so many possible obstacles standing in the way of Creditor recovery, it’s wise to seek out alternative options to recoup their owed bankruptcy claim value. Fortunately, Creditors have the option of Claims trading which allows them to sell their claim and receive immediate cash on a much shorter and more predictable timeline.