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Absolute Priority Rule in Bankruptcy: Are You Atop the List?

If you are a vendor, service provider or another unsecured creditor to a chapter 11 debtor, you cannot be blamed for feeling like a duped lover after learning about the bankruptcy of your once devoted business companion. Despite the promises that “I’ll stand by you if you stand by me,” all those outstanding invoices won’t be paid after all. If it helps soothe the pain (and of course it won’t), it’s not just you. The landlord, the copier company, the messenger service, even the weekly “Power Lunch Yoga” instructor each fell for the same story. You’re in the same Chain of Fools, only now you contend with one another over the tiny bankruptcy dollars to be shared, pro rata, among all of the Debtor’s unsecured creditors.

What is the Absolute Priority Rule?

As the sting of the break-up starts to finally wear off, you will receive a “proof of claim” form and instructions from the bankruptcy court. You note that Section 5 of the official form has a blank line for “Amount entitled to priority.” Your first instinct may be: “That must be me!” After all, how many times did the Debtor tell you that your invoices are “priority number one” just as soon as you help the Debtor through its rough patch? Surely your claim must take priority over the lame claims of the yoga instructor, right? But before you fill in that tiny blank with “All of it!!!” make sure to read the small print. You’ll see that Section 5 permits you to file a claim for priority only if your claim is “entitled to priority under 11 U.S.C. § 507(a).”

[Editor’s Note: For more information on financially troubled customers, please see What to Expect and Do When Your Customer Becomes Insolvent.]

Section 507(a) of the Bankruptcy Code describes the types of unsecured claims entitled to priority status and reflects the bankruptcy policy of favoring certain types of creditors over others, even among creditors that hold no security for their claims. Section 507(a) is part of an overall scheme of priority promoted by the Bankruptcy Code that is critical to the function of the bankruptcy process. For example, with respect to chapter 11 plans of reorganization, the rule of “absolute priority” bars any class of creditors or interest holders from receiving any distribution on account of their claims unless all claims of each senior class are paid in full. Thus, all secured creditors must be paid in full before unsecured creditors may be paid anything; and all unsecured creditors must be paid in full before holders of equity receive anything. Section 507(a) provides further refinements of priority even among unsecured creditors, elevating the claims of certain unsecured creditors to “priority” status over the claims of “general” unsecured creditors. In a chapter 11 case, a plan of reorganization or liquidation cannot be confirmed unless the claims entitled to priority under Section 507(a) are satisfied in full in accordance with Section 1129(a)(9) of the Bankruptcy Code. Claims of general unsecured creditors – aka, the Chain of Fools – will share, pro rata, in whatever money is left over.

So what does this bankruptcy absolute priority policy mean for your claim? Can you check the box in Section 5 of the proof of claim form and elevate your unsecured claim to priority status, allowing it to be paid ahead of the rest of the Debtor’s spurned creditors? You can, of course, though your claim to priority probably will fall upon objection.

[Editor’s Note: For more information, please read The “Absolute Priority Rule” and Other “Rules” of “Priority” in Bankruptcy.]

Section 507(a) lists and ranks ten categories of priority claims. The listing and ranking reflect Congressional policy judgments and, perhaps, the effects of lobbying (for the more obscure ones). The types of priority claims, as ranked in Section 507(a), are as follows:

First, certain claims resulting from domestic and child support obligations. These types of claims are given priority for obvious reasons but are not relevant in most chapter 11 cases;

Second, costs incurred during the administration of the bankruptcy case. These include the fees and costs of professionals retained in the bankruptcy case;

Third, costs incurred before the entry of the “order for relief” in an involuntary bankruptcy case;

Fourth, claims of employees, subject to a cap, for salary, commissions and other benefits earned within the 180 days immediately preceding the bankruptcy;

Fifth, claims for contributions to an employee benefit plan, subject to a cap, incurred within the 180 days immediately preceding the bankruptcy;

Sixth, certain claims of grain farmers and fisherman against storage and processing facilities;

Seventh, certain claims of individuals related to deposits in connection with leases or purchases for personal, family or household use;

Eighth, certain unsecured tax claims;

Ninth, certain claims related to commitments for capital maintenance owed to a federal depository institutions regulatory agency; and

Tenth, claims for death or personal injury resulting from the operation of a motor vehicle or vessel while the debtor was intoxicated.

Deflated, you have found that none of these priority categories applies to your claim. Notwithstanding fervent promises of loyalty and affection by the Debtor in the days leading up to its bankruptcy, to the Bankruptcy Code most creditors’ claims are of the “general” unsecured claims only and will be treated no different than that of the yoga instructor, the copier company, the bike messenger, etc. No priority of payment for you. As a general unsecured creditor, you are left to await fractional payment, with that to come at some uncertain point in the future.

[Editor’s Note: Curious about what to do with your claim, read Dealing With Distress for Fun and Profit – Installment #15 – Protecting Your Bankruptcy Claim.]

If this dose of absolute priority reality is a little too depressing, and you’re still feeling blue over the break-up, you may want to consider a support group, the “Official Committee of Unsecured Creditors” … but that’s a topic for another day.

[Editor’s Note: This is an updated version of an article published in May of 2013.]

About Patrick Maxcy

Patrick Maxcy is a partner in the Chicago office of international law firm Dentons practicing in the firm's Restructuring, Insolvency and Bankruptcy group.  Patrick regularly represents lenders, insurance companies, financial institutions and other significant stakeholders in Chapter 11 bankruptcies, out-of-court restructurings and cross-border proceedings.  Among others things, Patrick counsels clients on bankruptcy and insolvency matters…

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Patrick Maxcy