Dealing With Distress For Fun & Profit – Installment #13 – The Priority Scheme of Bankruptcy

A written tour of business bankruptcy and its alternatives

We started this series (click here to start reading from the beginning) with a broad overview of business bankruptcy but our last several installments have focused on one small, albeit important, aspect- the automatic stay.  We’ve heard from a number of readers that they would like to read more about the proverbial forest, rather than just the automatic stay tree.  And, so, with this installment we pan the camera back to explain a concept that is at play throughout a bankruptcy case, regardless of when in the process you are and what, in particular, you are focused on:  the priority scheme of bankruptcy.

The Big, Basic Picture

The priority scheme of bankruptcy dictates the order in which claims are paid. Before a claim can be paid, each claim with a higher priority must be paid in full. That is, every creditor in the most senior class must be paid in full before any claim in the next most senior class may be paid anything.  This rule continues down the “priority ladder.”

What happens if there is not enough money to pay a class in full? The basic principle is one of pro rata distribution among similarly situated creditors, with each creditor in the same class getting a share determined by the size of its allowed claim. This is supposed to supplant the “race to the courthouse” that would occur if not for automatic stay of bankruptcy.

It sounds simple and fair. But – as with many things in bankruptcy- it’s less simple than it initially appears, and fairness probably depends on what rung of the ladder you find yourself standing.

For example, suppose the Debtor has a total of just three creditors- and they are all in the same class.  They are owed $10, $20, and $30, respectively—a total of $60. The Debtor has $12—just 20% of what it owes these creditors. Under non-bankruptcy law, the $12 would go first to the fastest creditor- the one that either cajoled the Debtor the most or who obtained a judgment against the Debtor first. If the $10 creditor was fastest, it would be paid in full and the other $2 would be left to share between the other two creditors.

Under the pro-rata rule of bankruptcy, however, each of the three creditors would be paid 20% of its claim.  So, the three creditors get $2, $4, and $6, respectively.

Such is the basic bankruptcy scheme of bankruptcy. But several facts conspire to assure it almost never works out that way.

Additional Details that Matter

First, in most cases there are no assets to distribute to creditors. This is particularly true in chapter 7.

Second, the Bankruptcy Code itself mandates a schedule of priority claims which may result in such priority claims eating up all the assets before getting to the non-priority classes. See Bankruptcy Code §§507 and 726. More on this below.

Third, a creditor with a valid and perfected security interest on specific property of the estate will have first dibs on that property.  For example, in our case above, suppose the asset pool valued at $12 includes a widget, valued at $9, in which a one of the three creditors- the creditor owed $10- has a perfected security interest. That creditor is entitled to the entire $9 value of the widget. There is still $3 of value left in the estate, and that same creditor still has a $1 shortfall unpaid on his claim. That creditor will also share (on its $1 shortfall) pro rata with the other two on the remaining $3 to be distributed.   In practice, this concept commonly has huge implications in a bankruptcy case because many companies have pledged substantially all of their assets to a single lender.

The bankruptcy priority schedule is, as we say, explicit in the statute. However, what is interesting is that neither “pro rata” rule nor “secured comes first” rule is spelled out in any detail in the Bankruptcy Code.  There are plenty of Code provisions that recognize these basic rules, however, at least in a backhanded way.  If you want to some not-so-light reading on the issue, you can look at Long v. Bullard, 117 U.S. 617 (1886)and Dewsnup v. Timm, 502 U.S. 410 (1992).  One way to conceptualize the way a properly secured and perfected security interest works is to recognize that the creditor holding such an interest doesn’t really have to participate in the priority scheme of bankruptcy.  Stated another way, the priority scheme is applicable to unsecured creditors but not secured creditors.   To learn more about bankruptcy claims from a secured creditor’s perspective, start by reading this excellent article by Mark Maloney and Thad Wilson, of King & Spalding.  You may also be interested in this 90 Second Lesson about Professional Fee Carve-Outs and this article about how to determine the value of a secured claim.

Fourth, all of what we say above assumes that a creditor’s claim in an allowed claim.  The claim allowance process is worthy of its own installment, which we shall write.  In the meantime, suffice it to say, just because a creditor alleges it has a valid claim does not make it so.  Here is an excellent short article that explains this in more detail, by Lawrence V. Gelber and Erik Schneider, of Schulte Roth & Zabel LLP.

Fifth, the court in a chapter 11 case can vary the off-the-rack rules of distribution that constitute the default priority scheme of bankruptcy.   This can happen, for example, near the beginning of a case in the context of a court’s approval of a critical vendor motion or near the end of a case in the context of a Chapter 11 Plan which (within limits) can

Sixth, the Bankruptcy Code also provides that the court may, if appropriate, subordinate one claim to another under Bankruptcy Code§510.

Seventh, before almost any pre-petition unsecured claim can be paid anything, administrative claims must be paid in full.  Here is an excellent short article on the subject of administrative claims by Aaron Hammer and Michael Brandess of Sugar Felsenthal Grais & Hammer LLP.

The Priority Scheme for Unsecured Creditors

The priority scheme of bankruptcy among unsecured creditors are set forth in Bankruptcy Code §507. Note the section number, indicating that the priority rules are part of chapter 5, which applies to various bankruptcy cases, including chapter 7 liquidating cases and chapter 11 reorganization cases.  Read this for a refresher on the basic structure of the Bankruptcy Code.

Domestic Support Expenses and Trustee Fees

Bankruptcy Code §507(a)(1) gives first priority to domestic support expenses. This first priority for domestic support obligations is new law as of 2005, enacted as part of BAPCPA, but it doesn’t apply in corporate cases (corporations don’t get divorces). In individual cases, there are plenty of domestic obligation claims—but in the vast majority, there is no money to pay any claims at all, so the priority still doesn’t amount to much.

Administrative Expenses

Bankruptcy Code §507(a)(2) gives a second priority to “administrative expenses allowed under §503(b).” Bankruptcy Code §503(b)(1)(A) defines “administrative expenses” as “the actual necessary costs and expenses of preserving the estate.” This is the place where the lawyers get paid: fees for professionals who represent the estate are administrative expenses (subject to court control see, e.g., §§327, 330).

Note “necessary,” italicized above. BAPCPA reform legislation expanded this definition’s nonexclusive list of administrative expenses to include post-petition employee pay, NLRB back-pay rewards, up to two years of rent under a lease that is first assumed then rejected, the costs of closing a health care facility, and the value of 20 days of pre-petition goods delivered to the debtor. See Bankruptcy Code§503(b). This priority also encompasses post-petition taxes incurred by the estate. See §503(b)(1)(B)(i).

Taxes

Aside from administrative expenses, the next most important priority is the priority for taxes under §507(a)(8). Three quick points about the tax priority must be made:

• First, this tax priority stands only eighth on the statutory priority ladder. As a practical matter, however, the tax priority is a lot more important than several of those that precede it.
• Second, the priority applies only to unsecured tax claims. In several cases, the tax collector will have statutory tax lien. Working out the relationship between the secured lien claim and the unsecured priority claim is a bankruptcy subspecialty all its own.
• Third, the priority applies only to tax claims—not government claims in general. The government’s non-tax claims have no special priority under the Code, although what is and is not a tax claim is, again, something that can be fought over.

Employee Priorities

Bankruptcy Code §507(a)(4)-(5) address the claims of employees where the debtor is the employer. Subsection 507(a)(4) gives a limited priority for wage claims; subsection 507(a)(5), for claims under employee benefit plans.

These claims are often matters of great urgency to individual employees. Indeed, a practice has developed of paying these priority claims (up to about $10,000 per employee) soon after the case has been filed. There’s nothing in the Bankruptcy Code that specifically authorizes the court to grant such approval—but courts commonly grant the relief anyway.

In an operating chapter 11, the employee priority claims aren’t likely to be a deal-driver; most constituents generally agree that rank and file employees need to be paid.  On the other hand, issues of employer liability under a government-guaranteed pension plan, the matter of employee rights under a collective bargaining agreement, or proposed retention incentive plans- these can be significant issues that are hotly contested.

The Priority Scheme- In Context

Understanding where a creditor falls in the priority scheme is important for several reasons:  first, it is essential in order for a creditor to estimate how much it may hope to recover.  Second, as discussed above, there are ways a creditor can seek to improve its standing on the priority ladder.  Third, a debtor or another creditor may seek to improperly improve that creditor’s position at the expense of other creditors.  For this reason, it is important to be able to understand not just one’s own position, but also the position of others.

To read other installments in this series, click here.

If you found this article valuable you may also wish to view these webinars:  A Distressed Company and its Secured Lender;

Dealing with Defaults – When Your Company Runs Into Trouble; and

Basics of Bankruptcy Litigation for the Non-Bankruptcy Litigator.