What is the Absolute Priority Rule (APR)?
The Absolute Priority Rule (APR) refers to the underlying principle dictating the order of claims by which recoveries are distributed to creditors. The Bankruptcy Code mandates compliance to the strict hierarchy of claim payouts for the “fair and equitable” distribution of recovery proceeds.
- What purpose does the absolute priority rule (APR) serve in the Bankruptcy Code?
- Which factors are considered when putting claims into different classifications?
- Name one instance when senior creditors might give consent for the APR to not be followed?
- What is the typical hierarchy of the priority of claims waterfall?
Table of Contents
- Absolute Priority Rule (APR) Overview
- APR Role in Bankruptcies
- Distribution of Proceeds Based on Absolute Priority Rule
- “Value Break” Considerations
- Absolute Priority Rule: Classification of Creditor Claims
- “Super Priority” DIP Financing & Carve-Out Fees
- Secured Claims (1st or 2nd Lien)
- Unsecured “Priority” Claims
- General Unsecured Claims (“GUCs”)
- Preferred and Common Equity Holders
- Absolute Priority Rule: Claims “Waterfall” Structure
- Priority of Claims Summary Chart
Established on the prioritization of claims and placement of creditors into different classifications, the APR sets forth the order upon which the payout of creditors must abide by.
In accordance with APR, the recoveries received are structured to ensure the classes comprised of higher priority creditor claims are paid first. Therefore, lower priority claim holders are not entitled to any recovery unless each class of higher ranking received full recovery – the remaining creditors receive either partial or no recoveries.
Compliance with the absolute priority rule is mandatory in both Chapter 7 and 11 bankruptcies.
- If the debtor were to be liquidated, a Chapter 7 trustee would be responsible for the proper allocation of sale proceeds, as well as ensuring there were no violations of the APR.
- Under Chapter 11, the plan of reorganization (POR) and disclosure statement proposes the restructuring plan, while categorizing all claims on the debtor into distinct classes.
In effect, the treatment of claims and the anticipated recoveries of each creditor is a function of the classification of claims and prioritization among each class.
Absolute Priority Rule (APR) Overview
APR Role in Bankruptcies
Under the APR, a lower-priority creditor class should not receive any compensation until all the higher priority classes were paid in full and received full recovery.
First and foremost, establishing the prioritization in creditor claims is an essential step in all bankruptcies.
The Bankruptcy Code defines a claim as either the:
- Right of the Creditor to Receive Payment (or)
- Right to an Equitable Remedy Post-Failure of Performance (i.e., Contractual Breach ➞ Right to Payment)
However, not all claims are created equal – the payout scheme in bankruptcies must be administered in descending order of priority to remain in compliance with APR.
The Bankruptcy Code contains parameters for how a POR can place claims or interests in a particular class – for example, in order to be put in the same class:
- Grouped claims must all share “substantial” similarities distinctively found among the class
- Classification decision must be grounded on well-reasoned “business judgment”
Once creditors are put into classes based on commonalities in claims/interest, the classes can be ranked by priority, which ultimately serves as the decisive factor in the treatment of a claim.
Creditors holding the highest priority claims, most likely 1st lien debt (e.g., term loans and revolvers), must be paid out first before subordinate claim holders next in line such as bondholders receive any share of the proceeds.
In effect, APR is designed to ensure the higher priority debt holders are rightfully paid back first.
Distribution of Proceeds Based on Absolute Priority Rule
“Value Break” Considerations
To begin, proceeds first get distributed to the most senior class of creditors until each class is paid in full before moving onto the next class and so forth, until there are no remaining proceeds left.
This tipping point is often referred to as the “value break” – a concept directly tied to the fulcrum security.
- Chapter 11: Claims below the tipping point receive either partial or no recoveries, and if the case is a reorganization, the received form of consideration would come with more uncertainty surrounding its value (i.e., equity interests in the post-emergence debtor).
- Chapter 7: In the case of a straight liquidation where the residual value has diminished entirely, the chance of recovery by the remaining creditors would be zero
Running out of allocatable funds is very common in a liquidation, as the rationale for filing for bankruptcy is insolvency.
So the question becomes: “Could the debtor rehabilitate itself and return to becoming solvent from a reorganization?”
If so, on a “going concern” basis, the value break would no longer be a relevant concept as the debtor is not insolvent anymore.
Absolute Priority Rule: Classification of Creditor Claims
“Super Priority” DIP Financing & Carve-Out Fees
Per the Bankruptcy Code, short-term post-petition financing called DIP financing becomes accessible. To encourage lenders to provide financing to the debtor, “super-priority” status can be provided by the Court.
Most of the time, the DIP loan is funded by 1st lien prepetition secured lenders to maintain their position of leverage in the restructuring process. But there are instances when a lower priority claim holder takes on the duties of the DIP lender (and their claims “roll-up” into higher status).
In terms of the hierarchy of claims, DIP lenders holding “super-priority” status are required to be paid in full before 1st lien secured creditors – placing them at the top of the waterfall structure.
Secured Claims (1st or 2nd Lien)
Before becoming insolvent and in a state of financial distress, the debtor in all likelihood first raised outside financing from risk-averse lenders. The inexpensive pricing associated with senior debt capital comes in exchange for protective clauses included as part of the signed lending agreement.
For instance, the borrower may have pledged its assets to negotiate friendlier terms while raising debt financing. And in exchange, the secured lender holds a lien on the collateral and more measures meant for downside protection – which is the reason why the lower pricing terms (e.g., reduced interest rate, no prepayment penalty) were agreed upon in the first place.
But the cheaper financing terms also came in lieu of other drawbacks, such as restrictive covenants and the increased complexity in selling assets in distressed M&A, especially in the case of out-of-court restructuring where protective measures are not provided by the Court.
Unsecured “Deficiency” Claims
Not that not all secured debt actually receives priority treatment – as the secured claim amount must be weighed against the collateral value. In short, a claim is secured up to the value of the lien (i.e., interest on the collateral).
For secured debt backed by collateral (i.e., lien), the claim would correctly be viewed as fully secured if the collateral value is in excess of the claim value. In cases when the collateral is worth more than the 1st lien claim(s), the secured claims are deemed “over-secured” and the pledged collateral can proceed further down the payment structure to the 2nd lien.
On the other hand, if the reverse is true and the collateral value is the greater of the two, the under-collateralized portion of the claim is treated as an unsecured deficiency claim. Here, a portion of the claim is secured, whereas the remaining amount is considered “under-secured”.
The takeaway is that despite a claim holding secured status, the real determining factor on its treatment is the collateral coverage. Under the Bankruptcy Code, when the claim is less than the lien, the claim is bifurcated for differential treatment.
Unsecured “Priority” Claims
Secured claims are higher seniority claims backed by a lien on the collateral pledged by the debtor, and thus have a far higher chance of full recovery.
On the other hand, unsecured Claims are less senior claims that do NOT possess a claim on any of the assets of the debtor. Classes of unsecured creditors will only receive recovery after secured creditors are paid in full.
But while unsecured claims are associated with much uncertainty and are improbable to receive full recoveries, there are certain claims that receive priority treatment over other unsecured claims:
One noteworthy Court-mandated rule is that the entire balance of administrative claims must be paid in full to emerge from Chapter 11 – unless the terms were renegotiated and revised.
In addition, administrative claims can include payments to 3rd parties for goods and/or services received post-petition.
One notable example would be payments to critical vendors – if the motion had been denied, the suppliers/vendors would be treated as GUCs. Unsecured priority claims are still behind secured claims but it is nevertheless treated with higher priority than other unsecured claims.
General Unsecured Claims (“GUCs”)
If a creditor falls under the GUC classification, recovery expectations should be low – as receiving no payment is highly plausible due to being a bottom-tier unsecured claim.
General unsecured claims (“GUCs”) are neither protected by a lien on the collateral of the debtor nor prioritized to any extent. Hence, GUCs are often called unsecured non-priority claims.
Aside from equity holders, GUCs are the largest group of claim holders and the lowest in the priority waterfall – therefore, recoveries are normally received on a pro-rata basis, assuming there are any funds remaining.
Preferred and Common Equity Holders
The placement of preferred equity and common equity at the bottom of the capital structure means that equity holders have the lowest priority for recoveries among all claims.
However, equity, as well as lower-class unsecured claims in certain cases, can potentially receive a nominal payment in the form of equity in the post-bankruptcy entity (called an equity “tip”).
The equity tip is meant to receive their cooperation in the proposed plan and expedite the process. In doing so, the senior creditors can prevent lower-class stakeholders from intentionally holding up the process and disputing matters through litigation threats that drag out the process.
Despite conflicting with the APR, the hand-out of equity “tips” receive the approval of the higher-priority creditors, who likely decided it would be better over the long run to avoid the potential for disputes and additional costs to the debtor, as opposed to receiving marginally more recovery.
Absolute Priority Rule: Claims “Waterfall” Structure
Priority of Claims Summary Chart
In closing, the classification of claims can depend on a multitude of factors, such as collateral interests, senior or subordinated status, the timing of the lending, and more.
The order of creditor claims generally follows the structure depicted below: