What is the Absolute Priority Rule?

Absolute priority is the rule that secured claims are paid in full before junior claims when a corporation liquidates. To extend the concept further, equity holders are only paid after all creditors, since equity is considered to be the residual value of the business. This rule is applied in a Chapter 7 bankruptcy, where the bankrupt entity is to be liquidated. In this situation, you need to determine how much of the firm’s net assets will be distributed to each claimant. When the business is instead reorganized in a Chapter 11 filing (so that it will continue in operation after exiting bankruptcy), the absolute priority rule is not so rigidly followed, as noted in the following situations:

Employee retention. Employees may be offered shares in the company as a retention bonus; otherwise, there is an increased risk of turnover among key employees, which damages the value of the business.
Shareholder cooperation. Some shareholders may actively support the operations of the debtor, or are in a position to delay the acceptance of a bankruptcy plan through legal challenges. If so, creditors may allow shareholders to retain some of their ownership in the business in return for their cooperation in supporting the entity.

In these cases, a violation of the absolute priority rule is validated, as long as the class of unsecured creditors votes to support the bankruptcy plan. If the absolute priority rule is broken in an egregious manner (such as by paying out more to shareholders than to unsecured creditors), then expect one or more of the classes of creditors to challenge the issue in court.