What is a Preferred Creditor

A preferred creditor is an individual or organization that has priority in being paid the money it is owed if the debtor declares bankruptcy. Because bankrupt entities do not have enough money to fulfill all of their financial obligations, some investors that are owed money will get paid in part or not at all. A preferred creditor has the first claim to any funds that are available from the debtor. A preferred creditor is also known as a "preferential creditor."

Breaking Down Preferred Creditor

In bankruptcy cases in most legal systems, types of creditors that are preferred are defined by law and commonly include preferred bond holders and sometimes tax authorities. A preferred creditor can also be an economic development institution, such as the World Bank, that has priority in being repaid a loan it has made to a country in the event the country experiences a financial crisis.

In general, preferred creditors take precedence over unsecured creditors, though in some jurisdictions, such as the United Kingdom, preferred creditors take precedence over secured creditors whose security is floating while those with a fixed charge take precedence over preferred creditors. The claims of preferred creditors may be covered entirely or up to a certain percentage.

Preferred Creditor Classes

Preferred creditors may take many different forms or classes, each with a claim that may take precedence over another claimant depending on the jurisdiction. They include:

  • Employees: Workers at a bankrupt company who are owed pay for work that has been performed (wages) are the top preferred creditor.
  • Tax and revenue authorities: Government tax authorities, such as the Internal Revenue Service (IRS) in the United States and HM Revenue and Customs in the United Kingdom, have the right to be paid for any tax liability before anyone else (after employees).
  • Environmental remediation: When bankrupt companies that have been found to have caused environmental damage as a result of their business operations, the clean-up costs may receive preferential treatment by the courts in some jurisdictions.
  • Tort victims: Victims of such a "civil wrong" may be given preferred creditor status in some jurisdictions based on their status as an involuntary creditor. Since tort victims did not make the choice to become a creditor to a bankrupt entity, they are generally not penalized.

Preferred Creditors vs. Unsecured Creditors

Unsecured creditors are generally placed into two categories: priority unsecured creditors and general unsecured creditors. Unsecured priority creditors have the first claim over any assets in a bankruptcy filing over general unsecured creditors. In many bankruptcies, assets are not sufficient to pay back priority unsecured creditors entirely or general unsecured creditors at all. 

In the U.S., the order of creditor and contributory ranking on a debtor's insolvency is as follows: 

  1. Secured claims
  2. Administrative expenses and priority claims
  3. General unsecured claims
  4. Subordinated claims
  5. Equity interests

Similarly, in the U.K. the creditor order is: 

  1. Fixed charge holders
  2. Liquidators' fees and expenses
  3. Preferred creditors
  4. Floating charge holders
  5. Unsecured creditors
  6. Interest incurred on all unsecured debts post-liquidation
  7. Shareholders