What Does Priority Mean in the Context of Debt or Insolvency?

If your company intends to become a party to a debt agreement, either as a borrower or creditor, you should know the order of repayment. This is also called the “waterfall”. This article will explain the lawful order of priority under insolvency law and provide an overview of some key concepts and their commercial implications. 

Order of Creditors and Insolvency Law

When Party A owes Parties B, C, and D money, the law says Party A owes the others a debt obligation. Ideally, Party A repays each creditor according to the terms of their debt agreement, and neither party gives the agreement much thought. However, problems arise when a borrower runs into financial difficulties and cannot honour the debt obligation. Furthermore, if a company does not have enough money to repay one creditor, it will not have enough money to repay all the creditors together. 

When a company cannot pay its debts (i.e. insolvent) and cannot agree with its creditors on how to restructure the debt, the outcome is liquidation. Liquidation is where a court-appointed professional sells off the company’s assets to repay the creditors according to the order of priority. 

Insolvency law addresses what happens when there is not enough money to repay each creditor. Specifically, it deals with insolvent liquidation.

The Order of Priority

One of the most fundamental areas of insolvency law is the order that the law entitles creditors to receive payment in the event of insolvency. This list is known as the order of priority. Overall, the law recognises different classes of creditors depending on the type of interest they have in the company’s property.

Secured Creditors 

A secured creditor is a creditor that has a security interest in the debtor company’s property. There are various types of secured creditors, and each type depends on the security interest they have in the company’s property.

For example, secured creditors with fixed charges (fixed charge holders) or mortgages (mortgagees) over the company’s property have the strongest security interest. Accordingly, they have the right to take possession of certain property as set out under the terms of the loan agreement. These rights arise under specified conditions, such as an event of default. The most common secured creditor is a bank that has loaned a company a business loan. Thus, most loan agreements grant the bank a fixed charge over all the company’s property.

Wind Up Costs 

The company’s liquidator/administrator and financial and legal advisors will receive priority before every other creditor other than the secured creditors. 

Preferential Creditors 

The law protects preferential debts. Some common examples are:

• salaries the company owes employees (up to four months before insolvency limited to £800 per employee);
• unpaid obligatory payments towards employee pension schemes; and
• tax money owed to HMRC.

Floating Charge Holders

Floating charges provide secured creditors with less protection than fixed charges or mortgages. 

However, before paying floating charge holders, a portion of the company’s remaining assets are ring-fenced out of this total amount and held on reserve for the unsecured creditors. 

Unsecured Creditors and Pari Passu 

Unsecured creditors will receive any remaining amount left over, up to the total value of their debt. Generally, this will often be a very small amount.

Common unsecured creditors are trade creditors such as suppliers and customers. 

Shareholders 

Shareholders receive a portion of the remaining assets. However, this will often be a very small sum of money.

Case Study 

For example, suppose you are a trade supplier to BadCo Ltd, which has recently entered insolvent liquidation. BadCo Ltd has no secured debt, and the total value of its assets is £100 000. BadCo’s creditors and the amounts it owes them consist of:

The calculations showing how BadCo’s assets are to be paid out are:

The principle of pari passu means that the unsecured creditors will be paid £0.40 per £1 owed (£40,000/£100,000). Therefore, if BadCo owes you £10,000 for the cost of goods you supplied it, this means you will receive £4,000 as an unsecured creditor.

Commercial Considerations

Strictly speaking, the order of priority only has a legal effect when a company is in liquidation. In practice, many insolvency proceedings do not reach this final stage because it is not to any party’s advantage. Only secured creditors are guaranteed any sum of money. Even so, depending on the company’s asset value, the amount of money for distribution may be minimal. Instead, the various creditors usually strike a deal amongst themselves and the company, sometimes using the court for help. 

Nevertheless, the order of priority exists as the worst-case scenario if the parties cannot agree. For this reason, appreciating your order as a creditor (or the order of your fellow creditors) will help you determine your negotiating position and leverage. For instance, as a trade creditor, you may require your customer to agree to a retention of title clause to avoid being a mere unsecured creditor. 

Key Takeaways 

Overall, the order of priority is the order in which the law entitles different creditors to receive payment under an insolvent liquidation. Secured creditors (with fixed charges and mortgages) receive payment first, followed by the liquidators, preferential creditors, floating charge holders, unsecured creditors and then shareholders last (provided there is anything left). In practice, most insolvencies do not result in liquidation, but the order of priority nonetheless determines the negotiating power a creditor might have against the company and the other creditors. 

If you need help navigating a debt dispute, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.

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