Capital Structure Waterfall and Priority of Claims

A waterfall allocates value under specified assumptions. It is useful for recovery math, but a single numbered list cannot describe every bankruptcy. A lender may have a claim against one company, collateral owned by that company, and a guarantee from another. Trace those rights before combining amounts into one pool.

How Do You Establish the Order of Claims?

For a simplified cash waterfall involving one debtor, a fully collateralized first-lien loan looks first to its collateral. General unsecured creditors look to available unencumbered value and any residual collateral proceeds. Contractually subordinated debt follows the specified subordination terms. Preferred and common equity have residual interests, subject to their preferences and the plan.

Do not treat this example as a rule that administrative expenses automatically come before every secured lien. Also do not assume every trade payable has the same priority. An ordinary pre-petition invoice without a lien or statutory priority is generally unsecured; qualifying recent goods or post-petition obligations can receive different treatment.

How Does the Absolute Priority Rule Apply in a Cramdown?

For an impaired unsecured class that rejects a corporate Chapter 11 plan, fair-and-equitable treatment generally requires one of two alternatives:

• Each holder receives property with value, as of the effective date, equal to its allowed claim.
• No holder of a junior claim or interest receives or retains property under the plan on account of that junior position.

A small recovery to the rejecting class does not authorize a smaller recovery for old equity. Conversely, a rejecting unsecured class can receive less than full value without violating this particular rule when no junior holder receives property on account of its junior position. Other confirmation requirements still apply.

A rejecting secured class has separate alternatives: retain liens and receive qualifying deferred cash payments; receive qualifying collateral-sale treatment, including applicable credit-bid rights and liens attaching to proceeds; or receive the indubitable equivalent of its secured claims. Do not substitute the unsecured-class rule for these protections.

New value is not an automatic escape. Old equity's proposed new investment raises a limited, fact-dependent doctrine. Future services are not money or money's worth. Cash alone does not guarantee approval: necessity, substantiality, the value of the equity received, and market testing matter. An exclusive opportunity reserved to old equity without market exposure can violate absolute priority.

Is Pro Rata Sharing the Same as Absolute Priority?

No. Pro rata sharing allocates a class distribution in proportion to allowed claim amounts. A $100 million class receiving $30 million pays 30% under a pro rata plan; a $10 million holder receives $3 million.

The plan generally must provide the same treatment for claims or interests within a class unless a holder agrees to less favorable treatment. This within-class requirement is distinct from the protections for a rejecting class in cramdown. In a calculation, use the distribution method supplied by the problem.

Where Do DIP Financing and Administrative Expenses Fit?

Debtor-in-possession (DIP) financing can take different forms. Ordinary-course unsecured credit may receive administrative-expense treatment. With the required findings and court authorization, financing may receive administrative superpriority, a lien on unencumbered assets, a junior lien, or a priming lien.

Administrative superpriority gives payment priority over specified administrative claims; it does not by itself displace an existing secured lien. A court-authorized priming lien can be senior or equal to an existing lien only when the debtor cannot obtain credit otherwise and the existing lienholder's interest is adequately protected. Adequate protection can include cash payments, additional or replacement liens, or other qualifying protection against loss of collateral value.

Allowed administrative expenses, such as qualifying professional fees, generally require full cash payment on the Chapter 11 plan's effective date unless the holder agrees to different treatment. Administrative priority is statutory and unsecured; it does not categorically prime valid collateral rights.

How Do Priority Unsecured Claims and Undersecured Loans Work?

Priority unsecured claims receive statutory treatment ahead of general unsecured claims. Categories include administrative expenses and certain wage, benefit, and tax claims, subject to their statutory qualifications and limits. A priority unsecured claim remains distinct from a secured claim.

An allowed secured claim is generally secured only to the extent of the creditor's interest in collateral value. The excess is generally an unsecured deficiency. For example, a $50 million loan backed by $30 million of collateral ordinarily has a $30 million secured portion and a $20 million unsecured deficiency. Chapter 11 elections and other special rules can affect treatment; use the assumptions stated in the question.

Where Do Mezzanine and Convertible Debt Rank?

Mezzanine describes a financing role, not a statutory bankruptcy class. It often involves subordinated debt or debt with equity features. Identify the obligor, liens, guarantees, and subordination agreement to establish its actual rank. Convertible debt remains debt until conversion; convertibility alone does not put it below every other debt instrument.

Structural subordination arises when a parent creditor depends on value flowing up from a subsidiary. If the parent owns only subsidiary common stock and has no subsidiary guarantee, its creditors look to the residual value of those shares after subsidiary-level claims. They do not gain a direct claim ahead of the subsidiary's creditors or preferred shareholders. Guarantees or other parent assets can change the analysis.

How Do You Calculate a Recovery Through Several Claims?

For a numerical problem, follow the priority and collateral assumptions explicitly supplied. Do not infer that every real capital structure shares one universal ranking. First identify value available after costs and higher-priority claims, then allocate remaining value to the next class. A class's recovery cannot exceed its claim under the stated cash waterfall.

If $180 million is available and $100 million must first pay senior claims, $80 million remains for a $160 million junior class. That class recovers 50% of face value. A holder with $20 million in that class receives $10 million. Its share of the class, rather than its share of all debt, sets the distribution.

For a stipulated undersecured claim, calculate the collateral recovery separately. A $90 million loan backed by $60 million collateral has a $30 million unsecured deficiency. If that deficiency shares a $20 million separate pool with $70 million of other unsecured claims, its unsecured recovery is 30 / (30 + 70) × 20 = $6 million. Total lender recovery is $66 million, including the collateral. Do not put the whole loan into the unsecured pool.

If the question's order pays senior debt, then junior debt, then preferred stock, subtract each before dividing the residual by common shares. With $250 million available and claims of $100 million, $80 million and $50 million, common holders receive $20 million. Ten million common shares recover $2 each.

Finally, distinguish recovery of face value from return on investment. A claim recovering $50 per $100 face has a 50% recovery rate. If an investor paid $30 for it and receives one immediate distribution, profit is $20 and return on cost is 20 / 30 = 66.7%. Timing and interim payments require a separate annualized-return calculation.

What Should You Check on Exam Day?

• Identify the debtor and collateral pool before ranking claims.
• Distinguish lien priority, statutory priority, and contractual subordination.
• Separate administrative superpriority from a priming lien and know the priming conditions.
• Apply the rejecting-unsecured-class rule to property received on account of a junior position; recognize the separate secured-class alternatives.
• Use the stated class distribution and collateral assumptions for recovery math.