Lesson 1 of 7
Who gets paid first
A company's claims are paid in a fixed order, and a common shareholder is paid only after every other claim is paid in full.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A company's claims are paid in a fixed order: secured lenders, then unsecured lenders, then preferred stock, then common stock.
- A shareholder's claim is whatever is left after every other claim is paid in full, which can be a lot, a little, or nothing.
- The order is set by contract and by the Bankruptcy Code long before a company is in any trouble.
Every company's claims sit in a line, and the line is fixed before anyone needs it. A common shareholder stands at the back, with a claim on whatever remains once every lender and every other class of stock has been paid in full.
One company's claims, paid first to last
Paid first
- Secured loan · claim on named assets$400m40%
- Senior bonds · unsecured, ranks above the rest$300m30%
- Subordinated notes · unsecured, ranks below senior debt$200m20%
- Common equity · whatever is left$100m10%
Paid last
Total$1,000m
The order is set by contract
A secured loan is backed by a named asset, a factory or a receivable, and gets paid from selling that asset before anyone else sees a cent of it. Unsecured bonds rank behind secured debt but ahead of stock, and a bond's own indenture can rank it below other unsecured debt, which is what "subordinated" means. Preferred stock sits below every bond, because it is stock, but above common stock, because its holders were promised a fixed payment first. The US Bankruptcy Code writes this order into law as the absolute priority rule, enforced by a court when a class of creditors objects. A class of claims is not paid until every class ahead of it is paid in full.
In bankruptcy, new rescue loans that finance the case, the costs of the case itself, and some taxes and wages come ahead of the bonds. A secured lender is secured only up to what its collateral is worth; anything owed beyond that value ranks as an ordinary unsecured claim.
Equity is the residual claim
Common stock has no fixed payment and no maturity date. It carries neither the lender's promise nor the lender's protection. In exchange, it owns everything above the last dollar owed, with no ceiling on the upside. That is why a common share is called the residual claim: not the weakest claim in every case, but the one defined entirely by what is left after every other claim is settled.
Preferred stock sits in between
Preferred stock is easy to place wrong, because it is called stock but behaves like debt. It usually carries a fixed dividend, ranks ahead of common stock in any liquidation, and often has no vote. A company under strain can suspend a preferred dividend without defaulting the way it would by missing a bond coupon, which is one more way preferred sits between the two. Some preferred stock is cumulative, meaning skipped dividends still accrue and must be paid before common stock receives anything. Two preferred issues can therefore carry different real protection despite sitting in the same rank on paper.
Check yourself
A business sells for 850 against secured debt of 400 and senior bonds of 300. What is left for a class of subordinated notes owed 200?
- 200, paid in full
- 150, three quarters of what is owed
- 0
Show the answer
Answer: B.
Secured and senior claims take 700 of the 850 first. The 150 that remains covers three quarters of the 200 owed to the subordinated notes.Why is common stock called the residual claim?
- Because it is always the largest claim
- Because it is paid only from whatever is left after every other claim is paid in full
- Because it is guaranteed a fixed dividend
Show the answer
Answer: B.
Common stock carries no fixed payment and no maturity. It owns whatever remains once every claim ahead of it is settled, which can be a great deal or nothing.Where does preferred stock usually rank?
- Above secured debt
- Below every bond, but above common stock
- Exactly level with common stock
Show the answer
Answer: B.
Preferred stock is stock, so it ranks below debt, but its fixed dividend and liquidation preference put it ahead of common stock.Sources
- US Bankruptcy Code, Chapters 7 and 11, and the absolute priority rule.
What this leaves out
- The order here is the general rule. A specific company's actual ranking is set by its own loan agreements and bond indentures, which can differ from this in the details.
- Debt at a holding company ranks behind the operating subsidiaries' own creditors, called structural subordination, and leases, pensions and suppliers stand in line too.
- The worked example uses round invented numbers and a single sale price. A real recovery depends on how a business is valued and sold, which this lesson does not cover.
- Nothing here says what any company's debt or equity is worth, or what recovery any real claim would get. Nothing here is advice about any security.