What Is Absolute Priority?

Absolute priority, also known as "liquidation preference," is a rule governing the order of payment among creditors and shareholders in the event of a corporate liquidation. The absolute priority rule is used in corporate bankruptcies to decide the portion of payment that will be made to each participant. Debts to creditors will be paid off first, then shareholders divide the remaining assets. Absolute priority also applies to individuals who are liquidating their assets in order to settle claims. Secured claims always take precedence over unsecured claims.

Regarding the estate of a deceased person, the absolute priority rule ensures the payment of outstanding debts before the distribution of assets to beneficiaries.

Key Takeaways

  • Absolute priority is a rule that's used in corporate bankruptcies to determine the order of payment among creditors and shareholders; it also applies to individuals who are liquidating assets to settle claims.
  • This rule also ensures the payment of outstanding debts on the estate of a deceased person before the distribution of assets to beneficiaries.
  • In a liquidation plan, the U.S. Bankruptcy Code states that creditors must receive "fair and equitable" treatment, and absolute priority specifies the payment pecking order to fulfill that directive.
  • Courts have affirmed that secured creditors must be paid first, then unsecured creditors, and lastly equity holders, if any assets remain.

How Absolute Priority Works

Under Section 1129(b)(2) of the U.S. Bankruptcy Code, a liquidation plan must be "fair and equitable" to creditors. Setting aside certain provisions to handle back wages, benefits, and tax claims, absolute priority specifies the payment pecking order to fulfill the directive for fair and equitable treatment. Senior creditors are paid in full before junior creditors are paid unless the senior creditors consent to subordinate some of their claims to those unsecured creditors. After the claims of junior creditors are satisfied, any remaining funds are handed over to equity holders.

In estate cases, if the resources of the estate are insufficient to pay off the debts, assets will be liquidated in order to satisfy the remaining debt obligations.

Courts Intervene to Affirm Absolute Priority

In some litigated cases, courts have had to affirm the absolute priority rule. Such cases involved cooperation between certain creditors and debtors who sought to exclude sets of other claimants from liquidation proceeds. The courts hearing these cases deemed that secured creditors must be paid first, then unsecured creditors, and lastly equity holders, if any assets remain. Unless extraordinary circumstances exist, or if secured creditors consent otherwise, no prearrangements may break this sequence.