Quick Answer
Debt securities follow loan documents and the bankruptcy regime: senior vs. subordinated (priority), secured vs. unsecured (collateral), and affirmative, negative, and financial covenants. Chapter 7 is liquidation; Chapter 11 is reorganization. Liquidation priority runs secured creditors, administrative expenses, unsecured creditors, subordinated debt, then equity. The principal must disclose covenants, defaults, and bankruptcy risks.
The Series 24 tests bankruptcy and loan-document mechanics because the principal supervising a debt offering or distressed M&A must understand what risks need to be disclosed and how creditor claims rank when the issuer fails.
Fundamental Terms of Loan Documents
Loan documents fall into a small set of structural choices the principal must recognize when reviewing a debt offering:
Senior vs. Subordinated Debt
| Category | What It Means |
|---|---|
| Senior debt | Paid first among debt obligations; lower coupon (lower risk to the lender) |
| Subordinated debt | Paid only after senior debt is satisfied; higher coupon (higher risk) |
| Mezzanine debt | Subordinated debt that may also include warrants or equity participation; sits between senior debt and equity |
Secured vs. Unsecured
| Category | What It Means |
|---|---|
| Secured debt | Collateralized through liens, security interests, or specified assets; in default, the secured lender has a direct claim on the collateral |
| Unsecured debt | No specific collateral; the lender has a general claim on the issuer's assets shared with other unsecured creditors |
Covenants
Covenants are promises by the borrower that constrain its behavior during the life of the loan:
| Type | What It Requires |
|---|---|
| Affirmative covenants ("must do") | Provide financial statements, maintain insurance, comply with laws, pay taxes |
| Negative covenants ("must not do") | Incur additional debt above limits, sell major assets, change capital structure, pay dividends without lender consent |
| Financial covenants | Maintain leverage ratios (Debt / EBITDA), interest coverage (EBITDA / Interest), minimum net worth, working-capital ratios |
Events of Default
An event of default lets the lender accelerate the loan (demand immediate full repayment):
- Payment default: missed interest or principal
- Covenant breach: violation of an affirmative, negative, or financial covenant
- Cross-default: default on another debt instrument triggers default here (a "cross-default" clause)
- Bankruptcy: any bankruptcy filing by the borrower
- Material adverse change (MAC): catch-all for major negative developments
Acceleration
Upon a default (and after any cure period), the lender can accelerate the loan, demanding immediate full repayment of principal and accrued interest. Acceleration is the lender's primary enforcement mechanism short of foreclosure.
Indentures (Public Bonds)
Public bond offerings use an indenture governed by the Trust Indenture Act of 1939:
- A trustee acts on behalf of bondholders
- Modification provisions specify what changes require bondholder consent
- Redemption / call provisions specify when the issuer can repay early
- Sinking fund provisions specify mandatory periodic principal repayment
- Conversion provisions (if a convertible bond) specify when bondholders can convert to equity
Exam Tip: Gotchas
- Cross-default clauses cascade. A default on one debt instrument can trigger defaults on every other instrument with a cross-default clause. A relatively small covenant breach can unwind the entire capital structure if cross-defaults are widely written.
- Acceleration requires actual default, not anticipated default. Most covenants require an actual breach plus expiration of any cure period before acceleration is available.
- The indenture trustee acts for bondholders, not for the issuer. The trustee's job is to enforce covenants on behalf of the bondholders, including filing claims in bankruptcy.
Bankruptcy: Chapter 7 vs. Chapter 11
Two bankruptcy chapters are tested:
| Chapter | What Happens |
|---|---|
| Chapter 7 (Liquidation) | Assets are sold; proceeds distributed to creditors per priority; the entity ceases to exist |
| Chapter 11 (Reorganization) | Debtor remains in possession; proposes a plan of reorganization approved by creditor classes and confirmed by the court; equity may be diluted or eliminated, but the entity may continue operating |
In Chapter 7, the trustee liquidates assets and distributes proceeds. In Chapter 11, the existing management team (called the "debtor-in-possession" or DIP) typically continues to operate the company while it negotiates a plan with creditors.
The exam usually focuses on Chapter 7 priority because the priority rules are explicit. Chapter 11 outcomes vary by plan. Creditors may receive cash, new debt, or shares while the company continues operating.
The plan identifies claim classes and states how each is treated. The related disclosure gives holders enough information to evaluate that treatment. Creditors still need to understand what they would receive even though the company is reorganizing rather than selling all its assets.
Exam Tip: Gotchas
- Chapter 11 does NOT mean the company "fails" or stops operating. Chapter 11 is a reorganization tool. Many large companies emerge from Chapter 11 still operating (often with new owners and a restructured balance sheet).
- In Chapter 7, common shareholders almost always receive nothing. The waterfall typically runs out before reaching common equity. Preferred shareholders sometimes receive a partial recovery; common shareholders rarely do.
Priority of Claims in Liquidation
The priority of claims is the single most-tested fact in bankruptcy. The order from first paid to last paid:
| Priority | Class | Why |
|---|---|---|
| 1 (paid first) | Secured creditors | Up to the value of their collateral; if the collateral covers the debt, they recover in full |
| 2 | Administrative expenses | Allowed post-petition operating and professional costs, including unsecured post-petition credit granted ordinary administrative-expense status |
| 3 | Priority unsecured claims | Certain wages (within statutory dollar caps), certain taxes (within statutory caps), certain consumer deposits |
| 4 | General unsecured creditors | Trade creditors, deficiency claims of secured creditors (the unsecured portion), unsecured bondholders |
| 5 | Subordinated debt | Subordinated bondholders (paid after general unsecured but before equity) |
| 6 | Preferred shareholders | Equity claim, junior to all debt |
| 7 (paid last) | Common shareholders | Residual equity claim |
Key Distinctions
- Secured creditors get paid first up to the value of their collateral. If the collateral is worth less than the secured debt, the unsecured "deficiency" rolls down to general unsecured (priority 4)
- Administrative expenses include allowed case costs and qualifying unsecured post-petition credit. DIP financing is not one universal priority class: the statute and court order may authorize ordinary administrative treatment, superpriority, or liens. This simplified hierarchy does not replace reviewing collateral and financing terms.
- Priority unsecured (priority 3) is a small bucket of statutorily preferred claims (capped wages, taxes within limits, consumer deposits). It is much smaller than general unsecured
- General unsecured (priority 4) includes the unsecured bondholders, trade creditors, and the unsecured-portion deficiency of any secured creditors whose collateral was insufficient
- Subordinated debt (priority 5) is still a debt claim, paid after general unsecured but before any equity holders
- Preferred shareholders (priority 6) are equity, paid after all debt classes
- Common shareholders (priority 7) are the residual equity claim, paid last (and usually nothing)
Think of it this way: The waterfall has three big buckets: secured creditors and administrative expenses at the top, all unsecured creditors (priority, general, and subordinated) in the middle, and equity (preferred and common) at the bottom. The middle bucket is where the action is in most bankruptcies because secured creditors usually get paid in full and equity usually gets nothing.
Exam Tip: Gotchas
- Common shareholders are last in liquidation but FIRST in upside. The exam often asks "in a Chapter 7, who is paid before unsecured bondholders?" The answer is secured creditors, administrative expenses, and priority unsecured claims (not other classes of equity).
- Preferred shareholders are paid AFTER all bondholders, NOT before unsecured bondholders. A common trap is to treat preferred stock as senior to unsecured debt because of the "preferred" label. Preferred is always equity, always junior to debt.
- Subordinated bondholders are still BONDHOLDERS, paid before preferred and common shareholders. Subordination is between debt classes, not between debt and equity. A subordinated bondholder ranks above equity but below other unsecured creditors.
- A secured creditor with insufficient collateral is split. The portion covered by collateral is paid as priority 1; the deficiency rolls down to priority 4 (general unsecured). The same creditor can thus recover in two priority buckets.
Implications for the Underwriting Principal
The principal supervising a registration statement has three deliverables tied to this material:
| Deliverable | What It Requires |
|---|---|
| Risk factor disclosure | Material loan covenants, events of default, cross-default risks, and bankruptcy outcomes must be disclosed in the registration statement's risk-factor section under Regulation S-K |
| Going-concern qualifications | If the auditor's report contains a going-concern qualification, this must be prominently disclosed; if a going-concern issue emerges between filings, an 8-K may be required |
| Distressed M&A and debt restructuring | In a distressed transaction (Chapter 11 plan, exchange offer for unsecured bonds), the principal must oversee the firm's analysis of claims priorities, valuation of claims classes, and disclosure of restructuring outcomes to investors |
A debt-for-equity exchange in a Chapter 11 plan, for example, calls for a clear account of which claim classes receive new shares and how existing equity is affected. The principal reviewing restructuring materials should check that the proposed treatment of bondholders is explained in the context of other classes and the company's value.
Exam Tip: Gotchas
- Material covenants must be disclosed even if they are "standard." A cross-default clause that is common in industry credit agreements is still a material risk factor if a breach would cascade through the issuer's debt structure. "Standard" does not mean "immaterial."
- Going-concern qualifications between filings trigger 8-K considerations. If a going-concern issue emerges after the last 10-K but before the next 10-Q, an 8-K may be required because the issue is a material change to the issuer's circumstances.
- Chapter 11 is a reorganization, but creditors still receive treatment under a plan. A bondholder might exchange a claim for new shares rather than receive cash from a sale of assets. Priority and value inform an estimated recovery when one is presented; there is no universal requirement to state a fixed recovery percentage for every class.
What Should You Check on Exam Day?
- Can you list the liquidation priority order from secured creditors down to common shareholders, including where subordinated debt ranks?
- Do you know why a secured creditor with insufficient collateral recovers in two different priority buckets?
- Can you distinguish Chapter 7 liquidation from Chapter 11 reorganization, and confirm a company can keep operating in Chapter 11?
- Do you know when a going-concern qualification between filings can trigger a requirement to file an 8-K?