Introduction to Corporate Finance

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.