When a company faces financial distress or liquidation, not all creditors receive payments at the same time. Some get paid first—these are preferential payments. As someone who has analyzed corporate bankruptcies and restructuring for years, I find the mechanics of these payouts crucial for investors, creditors, and even employees.
Table of Contents
What Are Preferential Payments?
Preferential payments refer to legally mandated priorities dictating which creditors get paid before others when a company cannot meet all obligations. The U.S. Bankruptcy Code (specifically, Chapter 7 and Chapter 11) establishes a strict hierarchy.
The Payment Hierarchy
The typical order is:
- Secured creditors (those with collateral)
- Administrative expenses (legal fees, trustee costs)
- Priority unsecured claims (taxes, wages)
- General unsecured creditors (suppliers, bondholders)
- Equity holders (shareholders)
This structure ensures that secured lenders recover their dues first, while shareholders usually get nothing unless all higher-tier claims are satisfied.
Legal Framework: U.S. Bankruptcy Code
The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 refined these rules. Under §507 of the U.S. Bankruptcy Code, certain claims receive “priority” status. For example:
- Employee wages (up to $15,150 per employee, earned within 180 days before filing)
- Tax claims (federal, state, and local taxes)
- Pension fund contributions
If a company violates this order—say, by repaying a favored creditor just before bankruptcy—the court may claw back those payments as preferential transfers.
Mathematical Modeling of Payout Priorities
To quantify expected recoveries, I use a simple formula:
R_i = \min(C_i, \max(A - \sum_{j=1}^{i-1} C_j, 0))Where:
- R_i = Recovery for creditor class i
- C_i = Total claim of creditor class i
- A = Total available assets
Example Calculation
Suppose a bankrupt firm has:
- $10M in assets
- $6M in secured claims
- $2M in administrative expenses
- $5M in unsecured claims
Applying the formula:
- Secured creditors:
R_1 = \min(6, \max(10 - 0, 0)) = 6 ($6M paid)
Remaining assets: 10 - 6 = 4 - Administrative expenses:
R_2 = \min(2, \max(4 - 0, 0)) = 2 ($2M paid)
Remaining assets: 4 - 2 = 2 - Unsecured creditors:
R_3 = \min(5, \max(2 - 0, 0)) = 2 ($2M paid, prorated)
Equity holders receive nothing.
Case Study: Lehman Brothers (2008)
Lehman’s bankruptcy—the largest in U.S. history—illustrates preferential payouts.
| Creditor Class | Claims ($B) | Recovery Rate |
|---|---|---|
| Secured Creditors | 110 | ~100% |
| Administrative Expenses | 3.5 | 100% |
| Unsecured Creditors | 365 | ~21% |
| Shareholders | N/A | 0% |
Secured lenders (like JPMorgan) recovered fully, while unsecured bondholders got pennies on the dollar.
Strategic Implications
For Creditors
- Secured loans are safer but offer lower returns.
- Unsecured debt is riskier but may yield higher interest.
For Companies
- Debt structuring affects insolvency outcomes.
- Pre-bankruptcy maneuvering (like asset transfers) can trigger clawbacks.
Conclusion
Preferential payments ensure an orderly distribution of assets, but they also create winners and losers. By understanding the hierarchy, creditors can better assess risk, and companies can plan for financial distress. The math behind payouts isn’t just theoretical—it shapes real-world recoveries, as seen in cases like Lehman Brothers.
