When a corporation is liquidated in the U.S., its creditors are paid in a particular order, as required by Section 507 of the Bankruptcy Code. Secured creditors including secured bondholders get first priority. Next in line are unsecured creditors, which generally include the company's suppliers, employees, and banks. Stockholders are last in line.
Everybody in each tier of creditors must be paid in full before any money is repaid to the next tier.
Liquidation is the process of shutting down a business and distributing its assets to claimants. Its assets include any cash it still possesses and all of its physical property and equipment, or the cash that is raised by selling those assets.
Liquidation occurs when a company becomes insolvent, meaning that it cannot pay its obligations when they come due.
- If a company goes into liquidation, all of its assets are distributed to its creditors.
- Secured creditors are first in line.
- Next are unsecured creditors, including employees who are owed money.
- Stockholders are paid last.
How Assets Are Distributed in a Liquidation
Secured bondholders and other secured creditors are paid first because their money is guaranteed, or secured, by collateral or a contract.
Unsecured creditors are to be paid next, in a particular order. The first are those who are entitled to receive money from the company but have claims that are not secured or guaranteed. These creditors include bank lenders, employees, the government if any taxes are due, suppliers, and investors who have unsecured bonds.
Creditors in each tier are paid only after the claims of creditors in the higher tier are paid in full.
The last tier to be paid is known as the general creditors, and this group is largely made up of stockholders. They are paid only if there is any money left over after all the other creditors have been paid in full.
The general creditors are further divided into creditors who have preferred stock and those who have common stock. Preferred shareholders are paid before owners of common stock shares. Owners of preferred shares have priority for repayment after a bankruptcy by definition.
If there is no money left after the preferred shareholders are paid, the common shareholders are paid nothing.
Priorities in Repayment
Everybody is not always equal in the tiers of creditors.
For example, a company that files for bankruptcy protection and then is given court approval to give it another try may need to borrow money to stay afloat. If the company fails anyway and goes into liquidation, those last-ditch creditors are generally given priority for repayment over other creditors in their class.
The Bottom Line
Unsecured creditors are paid after secured creditors and bondholders because they did not receive a guarantee from the company. But unsecured creditors are paid before stockholders. Stockholders are owners of the company and therefore have accepted a greater risk.