The order of priority of claims in liquidation is firmly established in legal precedent. As depicted in Table 18.9 of the textbook, common shareholders are last in priority. Yet, in bankruptcy negotiations, creditors (who have a relatively high priority) often give up their debt in exchange for shares of common stock, whose claim on liquidation proceeds are last on the list. Why might they do this? Do you believe it is a good idea? Explain.
TABLE 18.9 Order of Priority of Claims in Liquidation of a Failed Firm
1. The expenses of administering the bankruptcy proceedings.
2. Any unpaid interim expenses incurred in the ordinary course of business between filing the bankruptcy petition and formal action by the court in an involuntary proceeding. (This step is not applicable in a voluntary bankruptcy.)
3. Wages of not more than $4,650 per worker that have been earned by workers in the 90-day period immediately preceding the commencement of bankruptcy proceedings.
4. Unpaid employee benefit plan contributions that were to be paid in the 180-day period preceding the filing of bankruptcy or the termination of business, whichever occurred first. For any employee, the sum of this claim plus eligible unpaid wages (item 3) cannot exceed $4,650.
5. Claims of farmers or fishermen in a grain-storage or fish-storage facility, not to exceed $4,650 for each producer.
6. Unsecured customer deposits, not to exceed $2,100 each, resulting from purchasing or leasing a good or service from the failed firm.
7. Taxes legally due and owed by the bankrupt firm to the federal government, state government, or any other governmental subdivision.
8. Claims of secured creditors, who receive the proceeds from the sale of collateral held, regardless of the preceding priorities. If the proceeds from the liquidation of the collateral are insufficient to satisfy the secured creditors’ claims, the secured creditors become unsecured creditors for the unpaid amount.
9. Claims of unsecured creditors. The claims of unsecured, or general, creditors and unsatisfied portions of secured creditors’ claims (item 8) are all treated equally.
10. Preferred stockholders, who receive an amount up to the par, or stated, value of their preferred stock.
11. Common stockholders, who receive any remaining funds, which are distributed on an equal per-share basis. If different classes of common stock are outstanding, priorities may exist.