22: Insolvency and Financial Distress
22-3 PRIORITY OF CLAIMS
In Australia, the priority of claims in insolvency is given as:
1 Secured creditors (with fixed charge over specific assets)
2 Preferential unsecured (notably employee entitlements, and liquidation expenses)
3 Secured creditors (with floating charge over general assets)
4 Unsecured creditors
5 Subordinated debt
6 Shareholders (with preference shareholders ranking above ordinary shareholders).
This means that, in a liquidation, the secured creditors are paid first when they have a fixed claim over
specific assets of the company, followed by preferential unsecured creditors (such as employees, and
those involved with managing the liquidation) and so on. Those listed ahead of the others are given
priority in their claims.
In a liquidation, it is important to recognise that if any secured creditors have specific assets pledged
as collateral, then they receive the proceeds from the sale of those assets. If these proceeds are inadequate
to meet their claim, the secured creditors become unsecured (or general) creditors for the unrecovered
amount, because specific collateral no longer exists. These and all other unsecured creditors will divide
up, on a pro rata basis, any funds remaining after all prior claims have been satisfied. If the proceeds from
the sale of secured assets are in excess of the claims against them, the excess funds become available to
meet claims of unsecured creditors.
example
Table 22.3 presents the balance sheet of Oxford
Company, a manufacturer of computer drives.
The administrator has liquidated the company’s
assets, obtaining the largest amounts possible. The
administrator obtained $2.1 million for the company’s
current assets and $1.8 million for the company’s
fixed assets; thus the total proceeds from the
liquidation amounted to $3.9 million. It is clear that
the company is legally insolvent, because its liabilities
of $5.5 million exceed the $3.9 million asset sale
proceeds.
The next step is to distribute the proceeds
to the various creditors. The only liability that
is not shown on the balance sheet is $500,000
in expenses for administering the insolvency
proceedings and satisfying unpaid bills incurred
between the time of declaring the insolvency and
the finalisation of the payout schedule.
Table 22.4 shows the distribution of the $3.9
million among the company’s creditors and
illustrates that, once all prior claims on the
proceeds to liquidation have been satisfied, the
unsecured creditors get the remaining funds.
Table 22.5 gives the pro rata distribution of the
$1 million among the unsecured creditors. The
disposition of funds in the Oxford Company
liquidation is shown in Tables 22.4 and 22.5.
Because the claims of the unsecured creditors
have not been fully satisfied, the preferred and
ordinary shareholders receive nothing.