Quick Answer
Distressed claims pay in strict order: debtor-in-possession (DIP) super-priority financing, administrative expenses, senior secured, junior secured, senior unsecured, subordinated debt, mezzanine, preferred stock, then common stock last. Under cramdown, the Absolute Priority Rule bars any junior class from receiving value unless each dissenting senior class is paid in full, with claims sharing pro rata within a rank.
The waterfall is the spine of every distress topic. Once you can rank a hypothetical capital stack from top to bottom and identify where post-petition financing and administrative expenses fit, you can answer most questions about who recovers what in a Chapter 11 reorganization or a Chapter 7 liquidation.
How Do You Rank Claims in the Priority Waterfall, from Highest to Lowest?
| Rank | Claim Type | Examples | Collateralized? |
|---|---|---|---|
| 1 | DIP financing (super-priority) | New post-petition credit approved by the bankruptcy court | Often super-priority status plus a priming lien |
| 2 | Administrative expenses | Professional fees (debtor's and committees' counsel and financial advisors), post-petition trade payables, post-petition wages | Unsecured but paid in full as a Chapter 11 confirmation condition |
| 3 | Senior secured creditors | First-lien (1L) term loans, asset-based revolvers, mortgage debt | Yes, perfected first priority |
| 4 | Junior secured creditors | Second-lien (2L) term loans, senior subordinated secured notes | Yes, perfected but junior to 1L |
| 5 | Senior unsecured creditors | Senior unsecured notes, trade suppliers, vendor payables, pension claims | No collateral |
| 6 | Subordinated debt | Senior subordinated notes (contractually subordinated to senior unsecured); junior subordinated debt | No collateral; contractually subordinated |
| 7 | Mezzanine / convertible debt | Subordinated notes with warrants, convertible bonds, payment-in-kind (PIK) notes | Generally unsecured and structurally subordinate |
| 8 | Preferred stock | Preferred equity (cumulative or non-cumulative) | No; equity interest |
| 9 | Common stock | Common equity, founders' stock | No; residual claim only |
Exam Tip: Gotchas
- DIP financing can be senior to pre-petition secured creditors. A priming lien sits ahead of the existing first lien if the court finds adequate protection for the primed lender and the debtor could not obtain credit on less burdensome terms.
- Trade suppliers are senior unsecured creditors, ranking ahead of subordinated debt and mezzanine but BEHIND all secured creditors. The vendor sitting at the loading dock is not a secured party unless it perfected a purchase-money interest.
How Does the Absolute Priority Rule Control Recoveries in a Cramdown?
The general tier ordering comes from lien priority, statutory priority, and administrative superpriority (DIP financing and administrative expenses ahead of the ordinary secured and unsecured ranks). The Absolute Priority Rule (APR) is a distinct, class-specific rule that governs cramdown (non-consensual plan confirmation over a dissenting class's objection):
- Under cramdown, a dissenting senior class must be paid in full before any junior class may receive or retain value
- Within a rank, allowed claims share pro rata
- The APR is enforced at plan confirmation in a cramdown; it is not the source of the general waterfall ordering
The practical effect: a junior class cannot retain or receive anything under a plan unless every dissenting senior class is paid in full. This is the single sentence that controls the math of nearly every Chapter 11 plan negotiation.
Exam Tip: Gotchas
- Equity gets wiped before junior debt is impaired. If unsecured creditors are not made whole, common and preferred holders generally receive nothing on account of their stock. Old equity can sometimes acquire reorganized equity by contributing new value (the "new value exception"), but the contribution must be substantial, necessary, and money or money's worth.
- "Pro rata within a rank" matters because allowed claim amounts get reduced. A $100 million senior unsecured class with $30 million of recovery shares the $30 million proportionally; individual creditors do not get to negotiate side deals that jump them ahead of peers in the same class.
Where Do DIP Financing and Administrative Expenses Fit in the Waterfall?
Two categories of post-petition claims sit ABOVE pre-petition secured creditors in most cases:
- DIP super-priority financing: post-petition credit that the bankruptcy court has approved with super-priority administrative status, often combined with new liens on previously unencumbered assets or priming liens on already-encumbered assets
- Administrative expenses: the ongoing cost of operating the estate during the case, including professional fees, post-petition operating obligations, and necessary post-petition trade credit
Administrative expenses are technically unsecured but must be paid in full on the effective date of any Chapter 11 plan. They cannot be confirmed away.
Exam Tip: Gotchas
- The DIP super-priority and administrative-expense priority are administrative-status claims (post-petition), not pre-petition claims. The pre-petition waterfall (secured before unsecured, etc.) only runs AFTER administrative claims have been satisfied.
- Most DIP facilities are consensual. The pre-petition senior secured lender usually agrees to be primed (and often becomes the DIP lender itself) to preserve its leverage in the case. Contested priming is the exception, not the rule.
How Do Priority Unsecured Claims and Undersecured Collateral Split Recoveries?
Two related refinements sit inside the waterfall table above and are worth separating out:
- Priority unsecured claims rank between administrative expenses and general (senior) unsecured claims. The Bankruptcy Code lists them in a defined statutory order, including certain domestic-support obligations, limited pre-petition wages and employee-benefit-plan contributions up to a dollar cap, and certain tax claims. They are unsecured (no collateral) but paid ahead of general unsecured claims because the Code singles them out for protection.
- An undersecured secured claim splits into two pieces. A secured creditor's claim is secured only up to the value of its collateral; any excess balance becomes a general unsecured deficiency claim that recovers alongside (not ahead of) other general unsecured creditors. A $50 million loan secured by $30 million of collateral is a $30 million secured claim plus a $20 million unsecured claim.
Exam Tip: Gotchas
- "Priority unsecured" is not the same as "secured." It is still an unsecured claim; it simply jumps ahead of general unsecured claims in the pecking order by statute, not by collateral.
- Collateral value, not the loan's face amount, sets the secured portion. An undersecured lender does not recover its full claim as "secured"; the shortfall falls back into the general unsecured pool.
Where Do Mezzanine and Convertible Debt Rank in the Capital Stack?
Mezzanine debt is a recurring exam trap because it sounds like equity and often acts like equity but ranks as debt:
- Mezzanine and convertible debt rank above preferred stock and common stock
- Mezzanine and convertible debt rank below senior secured, junior secured, senior unsecured, and senior subordinated debt
- Mezzanine is typically unsecured and structurally subordinate (sometimes formally subordinated by contract, sometimes effectively subordinated because it sits at a holding company above the operating subsidiaries that own the assets)
Think of it this way: mezzanine is the bottom shelf of the debt cabinet. Everyone in the debt cabinet gets paid before any of the equity holders, but mezzanine is the last to be paid among them.
Exam Tip: Gotchas
- Treating mezzanine as "equity-like" is wrong for priority purposes. It is a debt claim that ranks above preferred and common stock.
- Treating mezzanine as "senior debt" is also wrong. It sits below the senior unsecured class and is regularly subordinated to bank debt by intercreditor agreement.
What Should You Check on Exam Day?
- Can you rank the nine-tier waterfall from DIP financing down to common stock without hesitating, and place mezzanine correctly below senior unsecured and above preferred?
- Do you know that DIP super-priority and administrative expenses are post-petition claims that sit ahead of the pre-petition secured-before-unsecured order, not inside it?
- Can you state the Absolute Priority Rule precisely: each rank paid in full before the next receives anything, pro rata within a rank, enforced at confirmation in a cramdown?
- Do you know a priming lien needs adequate protection for the primed lender plus a showing the debtor could not obtain credit otherwise, and that most DIP facilities are consensual rather than contested?