Meaning
Hierarchies of claims determine the order in which creditors receive payment from the liquidated assets of a debtor during bankruptcy. The priority ranking is established by a combination of statutory laws and the specific terms of the individual loan agreements. Secured lenders usually sit at the top of this list, followed by administrative expenses and finally unsecured creditors.
Seniority Level
Creditors with higher status are paid in full before those with lower status receive any funds at all. When a court determines the priority ranking, it looks at the date each security interest was perfected. A lender who filed their claim first typically has a better position than one who filed later.
This structure provides a predictable outcome for investors and banks when they decide how much risk to take with a borrower.
Subordination Agreement
Lenders can choose to change their standing through private contracts that favor one party over another. An existing creditor might accept a lower priority ranking to allow the debtor to take on new, essential debt. This is often done to help a struggling company get the cash it needs to stay in business.
The agreement clearly defines which loans are senior and which are junior in the event of a default.
Liquidation Preference
Distributions of cash are made strictly according to the legal standing of each claimant once the assets are sold. In a typical insolvency, the priority ranking means that unsecured creditors often receive only a small fraction of what they are owed. Shareholders are at the very bottom and rarely receive anything from the liquidation.
This risk is factored into the high interest rates charged by unsecured lenders compared to those who have collateral.
