Quick Answer
Distressed claims pay in a strict order: debtor-in-possession (DIP) super-priority financing first, then administrative expenses, then senior secured, junior secured, senior unsecured, subordinated debt, mezzanine, preferred stock, and common stock last. Each rank must be paid in full before the next receives anything (Absolute Priority Rule), and within a rank claims share pro rata.
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.
The Priority Waterfall, 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.
The Absolute Priority Rule
The Absolute Priority Rule (APR) is the engine that drives the waterfall:
- Each rank must be paid in full before the next rank receives anything
- Within a rank, allowed claims share pro rata
- The APR is enforced at plan confirmation in any cramdown (a non-consensual confirmation over a dissenting class's objection)
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 DIP Financing and Administrative Expenses Fit
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.
Where Mezzanine and Convertible Debt Sit
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.