Absolute Priority: What it Means, How it Works

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.

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.

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.