Preferred Creditor: Definition, How They're Paid, and Example

What Is a Preferred Creditor?

A preferred creditor, also known as a "preferential creditor", is an individual or organization that has priority in being paid the money it is owed if the debtor declares bankruptcy.

Understanding Preferred Creditors

Bankrupt entities do not have enough capital to fulfill all of their financial obligations, meaning that some investors who are owed money will get paid in part or not at all. Usually, a preferred creditor has the first claim to any funds that are available from the debtor.

In bankruptcy cases in most legal systems, the types of creditors with preferential status are defined by law and commonly include preferred bondholders, and sometimes tax authorities.

A preferred creditor can also be an economic development institution. For example, the World Bank might have priority to be repaid a loan it made to a country that experiences a financial crisis, even if this wasn't specified in the terms of the contract.

Types of Preferred Creditors

Preferred creditors can 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 (HMRC) in the United Kingdom, have the right to be paid for any tax liability before anyone else—after employees.
• Environmental remediation: When bankrupt companies are adjudged to have caused environmental damage as a result of their business operations, the clean-up costs might receive preferential treatment by the courts.
• 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

An unsecured creditor is essentially an individual or institution that lends money without obtaining specified assets as collateral. Unsecured creditors are generally placed into two categories: priority unsecured creditors and general unsecured creditors.

As their name suggests, unsecured priority creditors are higher in the pecking order than general unsecured creditors when it comes to claims over any assets in a bankruptcy filing. That said, when a person or business is unable to repay their outstanding debts, the resources of the economic value they hold are usually not sufficient enough to reimburse priority unsecured creditors entirely. 

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

Meanwhile, 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

Special Considerations

In general, preferred creditors take precedence over unsecured creditors. However, in some jurisdictions, as you can see above, preferred creditors are more likely to get paid than secured creditors whose security is floating, while, at the same time, taking a back seat to those with a fixed charge.

Banks and other lenders who hold title over business assets usually fall into the fixed charge category.