The absolute priority rule is used in corporate bankruptcy cases to determine the portion of the payment that will be made to each member.
First, debts to creditors are paid off, and then shareholders divide the remaining assets. Absolute priority also applies to persons liquidating their assets in order to settle claims. Secured claims always have priority over unsecured claims.
With respect to the decedent’s estate, the absolute priority rule ensures that outstanding debts are paid before assets are distributed to beneficiaries.
What Is Absolute Priority Rule?
Absolute priority rule prevents a plan of reorganization from crowding out unsecured creditors if security holders junior to unsecured creditors do not receive distributions. As a consequence of the absolute priority rule, a plan of reorganization is prohibited from paying a class more than it is entitled to (although this principle is not expressly stated in the Bankruptcy Code).
A principle of bankruptcy law that requires the claims of a dissenting class of creditors to be paid in full before any class of creditors junior to such dissenting class can receive or retain any property to satisfy their claims.
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How Does Absolute Priority Rule Work?
According to the rules of absolute priority, outstanding debts of creditors are paid first. After repayment of creditors’ claims, shareholders receive the remaining amount.
It prioritizes and secures unpaid claims of creditors against shareholders. The absolute rule also applies to persons liquidating their assets to settle outstanding claims. A secured claim always takes priority in payment over an unsecured claim.
This also applies even in the event of the liquidation of the deceased person’s assets. All outstanding debts of the deceased will be paid before any assets are distributed to the beneficiaries.
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Do Courts Intervene to Affirm Absolute Priority?
In some court cases, courts have had to confirm the rule of absolute priority. Such cases involved cooperation between certain creditors and debtors seeking to exclude a class of other claimants from liquidation proceeds.
Courts handling these cases have held that secured creditors should be paid first, then unsecured creditors, and finally stockholders, if there are any remaining assets.
Unless there are extraordinary circumstances, or if the secured creditors agree otherwise, no prior arrangements may disturb this sequence.
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Absolute Priority Rule Individual Chapter 7
In Chapter 7 bankruptcy, the absolute priority rule determines the order in which debts must be paid. Under this rule, unsecured debt is divided into classes or categories, with each class receiving priority for payment.
Secured debt is debt secured by collateral to reduce the risk associated with lending, such as a mortgage. Unsecured priority debts are paid first. Examples of unsecured priority debts include tax debts, child support, and personal injury claims against the debtor.
Then the secured debts are paid. The latter is the payment of non-priority, unsecured debt with funds remaining from the liquidation of assets. If there are insufficient funds to pay a non-priority unsecured debt, the debts are paid proportionately.
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New Value Exception to Absolute Priority
An exception to the absolute priority rule, which allows equity holders to retain their equity interests in the debtor even if the senior non-acceptance class has not been paid in full, is if the equity holders contribute new equity or some other form of eligible “value” to the debtor.
The rationale for the new value exception (or new value effect, as it is sometimes called) is that if stockholders contribute “new value” to the plan, they do not violate the absolute priority rule’s fundamental prohibition against holding or receiving property “on account of” their existing property rights of the debtor.
The elements of the new value exception have been judicially created and include that the value must actually be “new” (rather than something already provided by stockholders).
It must be in the form of money or money’s worth (not in the form of “equity” or any other intangible form of contribution), must be material and have a value equivalent to or greater than that which the stockholder would receive under the plan.
Creditors have routinely attacked new valuation plans as violating the absolute priority rule, arguing that regardless of what new value stockholders offer to contribute, the exclusive ability to acquire or retain shares of the debtor’s stock is itself property acquired by stockholders in connection with existing interests in the debtor.
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Absolute Priority Rule
“Super Priority” DIP Financing & Carve-Out Fees
Short-term post-petition financing called DIP financing becomes available under the Bankruptcy Code. To encourage creditors to provide financing to a debtor, the court may grant “super-priority” status.
In most cases, the DIP loan is financed by the first-lien lenders in order to maintain their leverage position in the restructuring process. But there are cases where a lower priority claim holder takes on the responsibilities of a DIP lender (and their claims are “collapsed” to a higher status).
In terms of the hierarchy of claims, DIP creditors that have a “senior” status must be paid in full before the 1st secured creditors, i.e. place them at the top of the cascading structure.
Secured Claims (1st or 2nd Lien)
Before becoming insolvent and financially distressed, the debtor most likely first raised external financing from risk-averse lenders. The inexpensive price associated with the principal debt capital comes in exchange for protective clauses included in the signed loan agreement.
For example, a borrower could pledge their assets to negotiate more favorable terms when raising debt financing. And in return, the secured lender holds the collateral and other measures designed to protect against defaults – which is why the lower pricing terms were agreed upon in the first place (eg, reduced interest rate, no early repayment penalty).
But cheaper financing terms have also replaced other disadvantages, such as restrictive covenants and the increased complexity of selling assets in troubled M&A, especially in the case of out-of-court restructuring, where the Court does not provide for protective measures.
Unsecured “Priority” Claims
Secured claims are higher-priority claims secured by a lien on the collateral the debtor has pledged, and therefore have a much higher chance of being fully recovered.
On the other hand, unsecured claims are lower-priority claims that do NOT have a claim on any of the debtor’s assets. The unsecured creditor classes will receive reimbursement only after the secured creditors have been paid in full.
But while unsecured claims involve great uncertainty and are unlikely to be fully recovered, there are certain claims that are prioritized over other unsecured claims:
One noteworthy rule established by the court is that all outstanding administrative claims must be paid in full to exit Chapter 11 unless the terms have been reviewed and revised.
General Unsecured Claims (“GUCs”)
General unsecured claims (“GUCs”) are not protected by the garnishment of the debtor’s collateral and do not have any priority. Therefore, GUCs are often referred to as unsecured non-priority claims.
Apart from equity holders, GUC is the largest group of claim holders and the lowest in the priority cascade, so reimbursements are usually made on a pro rata basis, assuming there are any remaining funds.
Preferred and Common Equity Holders
The placement of preferred equity and common equity at the bottom of the capital structure means that shareholders have the lowest priority for reimbursement of all claims.
However, the equity, as well as the unsecured claims of the lower class, can potentially receive a nominal payment in the form of equity in the bankruptcy entity in certain cases (a so-called equity “tip”).
The equity prompt is intended to encourage their cooperation in the proposed plan and speed up the process. By doing so, senior creditors can prevent lower class stakeholders from intentionally stalling the process and litigating matters through threats of litigation that drag out the process.
Despite the conflict with the APR, giving out equity “advice” has been approved by higher priority lenders, who probably decided it was better in the long run to avoid potential disputes and additional costs to the debtor, as opposed to receiving a slightly higher recovery.
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Conclusion
Absolute priority is a rule whereby secured claims are paid in full before primary claims in the liquidation of a corporation. To expand on the concept, equity holders are paid only after all creditors, as equity is considered the residual value of the business.
This rule is used in a Chapter 7 bankruptcy case to determine how much of the firm’s net assets will be distributed among each claimant. When a business instead reorganizes under Chapter 11 (so that it continues to operate after exiting bankruptcy), the absolute priority rule is not as strictly enforced.
Absolute Priority Rule FAQs
Is There An Exception To The Absolute Priority Rule?
There is an exception to absolute precedence known as the new value exception. This exception helps shareholders retain their equity interest until any outstanding creditor claims are settled. Such an exception applies if the shareholders contribute money or something equivalent to cash value for the restructuring of the company
How Do I Qualify For Relief Under Chapter 7 Of The Bankruptcy Code?
Pursuant to Chapter 7 of the Bankruptcy Code, a debtor may be an individual, partnership, corporation, or other business entity 11 U.S.C. §§ 101(41), 109(b). Subject to the means test described above for individual debtors, Chapter 7 relief is available regardless of the amount of the debtor’s debts and whether the debtor is solvent or insolvent.
How Does Counselling And Forms In Bankruptcy Process Work?
Individuals who file must first undergo credit counselling within six months of filing before starting a Chapter 7 bankruptcy. If the county does not have an approved counselling agency, they can waive this step. Depending on the debtor’s circumstances, other exceptions may apply.
A petitioner must fill out several forms, including a petition to the court, to start a formal Chapter 7 proceeding. The forms contain detailed personal information such as the debtor’s finances, creditors, assets, income, and expenses. Once a petition is filed, there is an automatic stay that prevents creditors from collecting on their debt.
