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Creditor protection during bankruptcy

| Feb 1, 2021 | Corporate Finance, Credit & Bankruptcy |

During the current difficult economic climate, businesses in distress are being forced to merge, liquidate or restructure debt in order to stay afloat. Creditors should know that they have rights, however, in the event of a corporate bankruptcy proceeding.

It is important to have the assistance of an internationally recognized business law team to represent creditors, lenders and shareholders during corporate liquidation, either privately or under Chapter 7 or Chapter 11 of the U.S. Bankruptcy Code.

Creditors and shareholders

When a company goes bankrupt, both creditors and shareholders stand to lose. However, according to U.S. bankruptcy law, it is the debt owners, or creditors, who will be paid back before the equity holders, or shareholders.

A corporate bankruptcy occurs when the company has larger financial obligations than assets and is unable to meet those obligations now or in the future. Bankruptcy provides a legal means of dividing available assets among the various lending sources, whether it is lending institutions that provided private loans, or bondholders.

Whether the company is public or private, the main difference between debt holders and shareholders is that bondholders are legally due a return on their bond with interest, whereas shareholders are not. Known as the absolute priority rule, when the company’s assets are liquidated in a Chapter 7 filing, the cash will go toward paying off creditor debts first, and shareholder debts second.

The hierarchy of debt

There is an order in which debt is paid back to creditors. During the liquidation, senior debt is backed by company assets and paid back to the senior debt holders. These creditors are typically commercial loan providers or banks.

Junior debt, also called subordinated debt, is not secured by assets and can only be paid back after all senior debt has been satisfied. These include high yield bonds, vendor notes or payment in kind notes.

Then comes preferred stock, a category that does not have voting rights on company issues. The last category of lender is voting stock, the category with the lowest priority for repayment in bankruptcy but which has the most power to control the company.

While a Chapter 7 filing will result in liquidation of assets, if the company can reorganize and become solvent once again, the court may determine that a Chapter 11 filing is preferable.