When a Chapter 11 case is filed (business or personal), the debtor’s schedules will list all of the debts and assets.  Debts are categorized by priority, in the sense that some debts are accorded more favorable treatment than others.  When the debtor’s plan of reorganization is filed, the plan will describe the proposed treatment of the different categories of debt.  In a Chapter 11 disclosure statement and Chapter 11 plan, the different categories of debt will be specified with some particularity.

The two main objectives of the Bankruptcy Code are to give the debtor a fresh start and to distribute equally to unsecured creditors what is available of the debtor’s property in a liquidation,  or to pay each creditor a pro rata share of their debt according to a payment plan under Chapter 11, 12, or 13. Secured creditors either get their collateral or the value of the collateral in cash. If the collateral is worth less than their claim, then the claim is bifurcated into a secured claim covered by the collateral and an unsecured claim for the remaining portion. The secured claim is paid in full while the unsecured claim receives a pro rata share of any payments to unsecured creditors.

We have found that creditors often do not properly understand the nature of their debt and their treatment in the plan of reorganization, and this can on occasion lead to unnecessary disputes over plan confirmation.  The priority of claims and interests carries importance if a “cramdown” type of plan is being proposed.  A debtor must be mindful of the absolute priority rule in these situations.

Under the Bankruptcy Code, claims and interests are entitled to payment in the following ranking of priority:

1.  Secured Claims.  These are claims where the creditor has a lien on some collateral.

2.  Priority Unsecured Claims.  These are given explicit rankings in detail in the Bankruptcy Code (11 U.S.C. 507(a)).  Basically we have here:  expenses of administration, maintenance and support claims, unsecured tax claims of the government, and some other uncommon categories.

3.  Nonpriority Unsecured Claims.  These are general unsecured claims, such as medical bills, deficiencies on repossessions or foreclosures, unsecured lines of credit, payday loans, credit card debts, and private loans.  They are often grouped into subcategories in a plan of reorganization.

4.  Interests of Equity Security Holders.  These are not often encountered, and comprise the interests of shareholders or stockholders.  Examples would be holders of preferred stock or common stock.

There are some claims that have priorities above the priority claims listed above that mostly apply to business debtors. Some higher priorities, called super priorities, are listed elsewhere in the Code. For instance, Section 507(b) gives a higher priority to a secured claimant for any lack of adequate protection given by the trustee or the court so that the debtor or trustee could use the creditor’s property contingent on the promise by the trustee or the court that the creditor will not lose any value from its use. If the adequate protection turns out to inadequate, then the difference will be paid as a super priority claim.

A proper understanding of these categories and their priority is important for both debtors and creditors in a Chapter 11 case.  Each of these categories will have a hierarchy of rights and privileges in a Chapter 11 plan, and voting rights associated with their position. Not understanding the nature of these rights can lead to unnecessary confusion, and may even impact the ability of a creditor to receive any distribution in a plan of reorganization.

Read More:  The Appointment Of A Trustee In A Chapter 11 Case in Kansas City