:max_bytes(150000):strip_icc():format(jpeg)/GettyImages-1005470094-0b560f58af7c45508be54d84801860b7.jpg)
Key Takeaways
- Liquidation sells a company’s assets to pay creditors when it’s insolvent.
- Secured creditors are paid first under U.S. Bankruptcy Code Section 507.
- Unsecured creditors and shareholders are paid after secured creditors.
- The process involves liens, pro rata distributions, and preferential status.
Get personalized, AI-powered answers built on 27+ years of trusted expertise.
Liquidation involves selling a company’s assets to pay off creditors when the business becomes insolvent. Under U.S. Bankruptcy Code Section 507, creditor claims are settled in a specific order, with secured creditors receiving payment first. Unsecured creditors are next in line, followed by preferred and then common shareholders if any funds remain.
It’s a complex process, involving multiple liens, pro rata distributions among creditors, and certain creditors’ preferential status, all of which influence how the company’s remaining assets are ultimately distributed.
Discover the hierarchy of creditor payments during liquidation, focusing on secured, unsecured, and shareholder priorities to understand who gets paid first and why.
Creditor Hierarchy in Liquidation Explained
Several factors determine the hierarchy of creditors during a liquidation process. A general outline of the major criteria is below.
Secured/Unsecured Status
A secured creditor is a lender connected to an asset or investment with a lien on a debtor’s property. This lien, agreed upon when the debt is issued, is often collateral tied to the purchased asset or other belongings of the debtor. In bankruptcy, a secured creditors’ committee represents lenders with the first claim to assets and funds.
For example, when a borrower and a financial institution enter into a mortgage agreement, the financial institution often gains the secured status of the property if the borrower defaults. As collateral for loaning out the mortgage, the bank receives potential ownership rights over the property as collateral.
Unsecured lenders have outstanding loans without claims to debtor assets. A creditor’s committee represents their interests, usually involving smaller amounts. Unsecured creditors include credit card companies and some cash advance firms.
Timing of Secured Status
A lien is a legal right placed on an asset often used as collateral to secure debt. A problem may arise when a single asset is used as collateral to secure more than one line of credit. This means that more than one lender may own a legal, secured claim against a single asset.
To navigate this conflict, collateral pledged to secure financing is noted as either a first lien or a second lien. A first lien has the priority claim on the collateral, while the second lien has a lower priority. Generally, the first creditor to secure a lien gets priority. While not always true, the creditor with the first lien is usually prioritized.
Preferred/Preferential Status
A preferred creditor is an individual associated with the debtor who is given some priority during bankruptcy proceedings. These creditors might not have held collateral or rights to claim assets; however, they are given preferential treatment during liquidation proceedings.
Preferred creditors may be considered to be a special type of unsecured creditor. Examples of preferred creditors include:
- Company employees. Though they may not directly own company assets, employees with unpaid wages receive preferential treatment.
- Tort victims. Should the debtor have a pending lawsuit against them, the tort victim is often positioned as a preferential creditor pending the outcome of court proceedings.
- Tax agencies. Government bodies, such as the Internal Revenue Service (IRS), receive special treatment for their claim over unpaid taxes.
- Environmental claims. If a business has been punished with environmental cleanup sanctions as part of its business actions, the court will prioritize allocating funds to pay for the cleanup efforts.
Fast Fact
Section 507(a) of the U.S. Bankruptcy Code states that administrative expenses of the bankruptcy proceedings receive priority. Therefore, the costs of overseeing the bankruptcy estate, such as legal fees, professional fees, and post-petition expenses of operating the debtor’s company, receive preferred status.
Debt and Equity
A company can choose to finance its operations in two ways:
- First, it can raise funds from investors.
- Second, it can preserve ownership of the company by raising debt.
Debt and equity are treated differently during the liquidation process, as debtors have many different claims over the company’s assets compared to shareholders.
Preferred vs. Common Equity
Different share classes may receive different treatment during bankruptcy proceedings. The company’s articles of incorporation will identify different classes of shares (often preferred shares and common shares) and the associated benefits of each.
It is common for preferred shares to receive preferential treatment over common shares when receiving liquidation proceeds.
What Is the Liquidation Asset Distribution Process?
Liquidation proceeds are distributed in a specific order. If the estate runs out of funds, lower-priority creditors won’t be fully paid. Even top-priority creditors might not get their full share if the collateral is devalued or worth less than the debt.
Below is the broad prioritization of creditors during a bankruptcy. Every entity in a higher tier of creditors must be paid in full before any money is paid to parties in the next tier.
-
Secured Claims (1st Lien): Secured claims often have the top priority during liquidation proceedings. This is usually due to their money being guaranteed against collateral and secured by a contract with a debtor. Secured creditors, first in line regarding lien claims, take the highest priority.
-
Secured Claims (2nd Lien): An asset can theoretically have dozens of lien claims against it. After assessing the priority order, each secured claim still receives top priority to receive liquidation proceeds. Though paid before any other creditor, creditors with second or worse claims receive unfavorable treatment compared to first-lien claims.
-
Priority Unsecured Claims. Creditors with preferential treatment must wait to be paid until after secured credit obligations have been satisfied. However, their preferential treatment puts them ahead of other unsecured claims.
-
General Unsecured Claims. Creditors with general unsecured claims are often the last debt holders to be satisfied.
-
Preferred Equity Shareholders. Shareholders are often among the last creditors to receive liquidation proceeds. Preferred stock equity holders receive preferential treatment over common equity holders.
-
Common Equity Shareholders. Common equity shareholders often receive the lowest level of priority.
Important
The general rule on priorities is that the first party to secure most completely wins priority. This is relevant for parties within the same priority class, especially if they have liens against the same asset. Should multiple creditors have a claim against the same asset, the broadest rules state that the creditor that received the earliest claim receives the first priority.
The Role of Pro Rata Distributions in Liquidation
Should there be insufficient funds to pay all creditors of the same priority tier, liquidation proceeds are often distributed pro rata. Each creditor often receives a share of the remaining distribution. If a pro rata distribution is required, all creditors below the tier receiving distribution will not be entitled to any proceedings (as all funds will have been distributed before reaching their priority level).
For example, imagine a company with $20 million of liquidation proceeds and the following creditor claims:
- Secured Creditors (Tier 1 and Tier 2): $10 million
- Priority Unsecured Claims: $5 million
- General Unsecured Claims: $10 million
- Shareholders (Common and Preferred): $8 million
In the course of distributing funds, both the secured creditors and priority unsecured creditors will be made whole as there are enough funds to satisfy their claims. However, there will only be $5 million of remaining proceeds ($20 million total – $10 million Secured Claims – $5 million Priority Unsecured Claims). With general unsecured creditors demanding $10 million, they will each likely receive payment on only 50% ($5 million remaining ÷ $10 million General Unsecured Claims) of their claim value.
Because all funds have been distributed before each shareholder level, and because the priority level above the shareholders was not made fully whole, common and preferred shareholders are not entitled to distribution proceeds.
7.1%
The increase in business bankruptcy filings for the 12 months ending Dec. 31, 2025. Business filings increased from 23,107 through December 2024 to 24,737 through December 2025.
Additional Factors in Liquidation Proceedings
During the bankruptcy process, a judge may determine that the defaulting company would have greater value should it reorganize rather than liquidate. In a reorganization, lower-tier parties like common shareholders may receive proceeds that they otherwise wouldn’t have during a liquidation.
The absolute priority rule of the U.S. Bankruptcy Code implies that if higher-tiered creditor classes are not paid in full, lower-priority creditors are not entitled to receive any proceeds. This payment structure is often called a waterfall payment structure, as one level must receive enough resources for resources to then flow downwards to the next level.
There are still several complications that can make the prioritization of creditors difficult to assess. A bankruptcy court can approve a Plan of Reorganization that changes the rules of distribution. The bankruptcy court can also impair a creditor’s right to enforce a claim or subordinate claims within a given creditor priority class.
What Are Priority Creditors?
Priority creditors are parties that have legal priority during the liquidation process. Due to the nature of their relationship with the insolvent party and the legal claims they have over assets, some parties are entitled to be made whole or receive proceeds before other parties. Priority creditors or claims include alimony, child support, tax obligations, or liabilities for injury or death in specific situations.
Why Are Secured Creditors Paid First?
Secured creditors are often paid first in the insolvency process, as they often have a claim against specific assets of the insolvent party. The secured creditor will often either take back the property they’ve secured against or will be entitled to proceeds from the liquidation of that specific property.
Which Claims Have Lowest Priority in Payment?
In general, unsecured claims have the lowest priority. Unsecured creditors do not have a security interest in any asset of the debtor, and the unsecured creditor likely did not obtain collateral or rights to specific assets as part of the loan condition. Due to this risky nature of unsecured loans, financial institutions will often charge higher rates or refuse business terms for unsecured loans.
Are Debt Holders Paid Before Equity Holders?
Shareholders are often among the last party in terms of priority ranking in a liquidation. It is usual for creditors and debt holders to generally receive payment before shareholders during an insolvency process. Shareholders have no priority during the bankruptcy process due to having no claims against any assets of the defaulting party.
What Is the Order of Priority for Creditors in the Silicon Valley Bank Collapse?
Silicon Valley Bank was shut down by regulators on March 10, 2023. The move came after customers became concerned about the bank’s financial future and pulled their money out of the institution. Their concerns were rooted in the bank’s announcement that it lost nearly $2 billion in the sale of a portfolio of U.S. securities.
Despite the general rule of priority normally laid out when a company becomes insolvent, federal regulators announced that depositors would be fully protected, meaning they would be able to access all of their money as of March 13 with no loss to the taxpayer. As such, regulators said that shareholders and certain holders of unsecured debt would not be protected.
The Bottom Line
The repayment process in a liquidation follows legal frameworks such as Section 507 of the U.S. Bankruptcy Code and typically uses a “waterfall” structure, where each priority level is paid in full before moving to the next. Secured creditors receive the highest priority because their claims are backed by collateral. Unsecured creditors are next, followed by preferred and common shareholders.
Lien status, secured vs. unsecured claims, and specific bankruptcy arrangements can influence how funds are distributed, making it a complex and highly structured process.
