Quick Answer
The absolute priority rule sets liquidation order: secured creditors, unsecured creditors, subordinated debenture holders, preferred stockholders, then common stockholders, with debt always paid before equity. Limited liability caps a shareholder's loss at their investment. Common stock carries voting rights and unlimited upside; preferred stock pays a fixed dividend first but has no vote.
Now that you understand the different types of equity securities, a critical question remains: when a company fails, who gets paid first? The answer follows a strict hierarchy.
The Liquidation Priority
When a corporation is liquidated (goes through bankruptcy), assets are distributed in a fixed order called the absolute priority rule. Each level must be paid in full before the next level receives anything.
Order of liquidation (who gets paid first):
| Priority | Who | Category |
|---|---|---|
| 1 | Secured creditors (secured bondholders) | Debt |
| 2 | Unsecured creditors (debenture holders, general creditors) | Debt |
| 3 | Subordinated debenture holders | Debt |
| 4 | Preferred stockholders | Equity |
| 5 | Common stockholders (residual claim) | Equity |
The key principle: Debt ALWAYS comes before equity. Within equity, preferred comes before common.
Exam Tip: Gotchas
The SIE loves testing liquidation priority. Remember: "Secured, Unsecured, Sub-debt, Preferred, Common" - debt holders are always paid before any equity holder receives a penny.
Limited Liability
- Shareholders (both common and preferred) can only lose what they invested
- Creditors cannot go after shareholders' personal assets
- This is a fundamental advantage of the corporate structure
- Even in bankruptcy, the worst case for a shareholder is a total loss of their investment; not personal liability for corporate debts
Exam Tip: Gotchas
Limited liability protects shareholders from losing MORE than their investment. On the exam, if an answer choice suggests shareholders owe corporate debts personally, that answer is wrong.
Common vs. Preferred Ownership Rights
| Right | Common Stock | Preferred Stock |
|---|---|---|
| Voting | Yes (statutory or cumulative) | Generally no |
| Dividends | Variable, not guaranteed | Fixed, paid first |
| Liquidation priority | Last (residual) | Before common, after all debt |
| Capital appreciation | Unlimited upside | Limited (fixed dividend) |
| Preemptive rights | May have (buy new shares) | Typically no |
Think of it this way: Common stockholders trade last-in-line status for unlimited upside. Preferred stockholders trade growth potential for a fixed dividend and a higher spot in the payout line. Neither choice is "better" - they serve different investor goals.
Exam Tip: Gotchas
- Common stockholders are LAST in liquidation and often receive nothing in bankruptcy
- Preferred stockholders rank above common but BELOW all debt holders
- In most bankruptcies, assets do not cover all creditor claims, so equity holders get zero
What Should You Check on Exam Day?
- Can you list the five-level order of payment in the absolute priority rule?
- Do you know why debt holders always get paid before equity holders?
- Can you explain what limited liability protects a shareholder from?
- Do you know which type of stock has liquidation priority over common stock?
- Can you explain the differences in voting, dividend, and liquidation rights between common and preferred stock?