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American Bankruptcy Institute A M E R I C A N B A N K R U P T C Y I N S T I T U T E JO UIssues and IRnformation for tNhe Insolvency ProfAessional L creditor gets a share determined by the size Baker and Candlestick Maker on their Chapter 11 - of his allowed claim. So if there is enough to c l a i m s . pay 20 percent of all claims in a given class, The bankruptcy priority schedule is, as “ 1 0 1 ” then we pay each creditor in that class 20 we say, explicit in the statute. Oddly enough, percent of his allowed claim. neither of the other rules (neither “pro rata” For example, suppose the debtor owes nor “secured comes first”) is spelled out in $10 to the Butcher, $20 to the Baker and $30 any detail. But there’s no doubt that they are P r i o r i t i e s to the Candlestick Maker—a total of $60. the law. Indeed, that is the point: They are so Contributing Editors: The debtor has $12—just 20 percent of what basic that nobody thought to say so. There Professor John D. Ayer he owes. Under non-bankruptcy law, assets are plenty of Code provisions that recognize University of California at Davis would go first to the fastest, and others these basic rules, at least in a backhanded Chico, Calif. would be left empty-handed. Under the p r o - way. If you find the rule spelled out at all, j d a y e r @ u c d a v i s . e d u r a t a rule of bankruptcy, since we have assets you can discern it from a series of Supreme Michael L. Bernstein equal to 20 percent of all claims, we would Court cases, starting perhaps with Long v. Arnold & Porter LLP; Washington, D.C. pay 20 percent of each claim. So, Butcher B u l l a r d , 117 U.S. 617 (1886), and extending m i c h a e l _ b e r n s t e i n @ a p o r t e r . c o m would get $2, Baker would get $4, and through to Dewsnup v. Timm, 502 U.S. 510 Candlestick Maker would get $6. ( 1 9 9 2 ) . Jonathan Friedland Such is the basic bankruptcy rule. But at As if these facts were not enough, there Kirkland & Ellis LLP; Chicago least four facts conspire to assure it almost are at least two other principles that j f r i e d l a n d @ k i r k l a n d . c o m never works out that way. complicate the distribution scheme. First, in a Editor’s Note: This installment discusses First and most important, in many cases chapter 11 case, the court may confirm a the distribution priority in bankruptcy cases. there are no assets to distribute to creditors. reorganization plan that (within limits) can As you will see, some of the priorities are set This is particularly true in chapter 7. One vary the off-the-rack rules of distribution set forth expressly in the Bankruptcy Code. hundred percent of nothing is nothing. forth so far. Second, the Code also provides Others are less obvious from the statute, but Second, the Bankruptcy Code itself that the judge may, in an appropriate case, equally important. mandates a schedule of priority claims. S e e “subordinate” one claim to another. S e e Code §507; c f . Code §726. We will consider Bankruptcy Code §510. Likewise, case law he priority scheme in bankruptcy these statutory priorities in more detail permits the court (under limited circum- dictates the order in which claims are below. For now, suppose that Butcher has a stances) to “recharacterize” debt as equity— paid. Think of a ladder. The claims T priority claim, and that Baker and which of course has an impact on the priority standing on the highest rung must be paid in Candlestick Maker have non-priority claims s c h e m e . 1 full before any claims on the next rung can (i . e . , Butcher is on a higher rung of the be paid anything. The most senior class of The Priority Scheme ladder). We will pay Butcher $10. That creditors gets paid in full, then the next class, leaves $2 for distribution between Baker and for Unsecured Creditors and so forth, until you come to a class for Candlestick Maker, pro rata. Even where The priorities among unsecured creditors which assets are insufficient to pay everyone there are assets to distribute, in many cases are set forth in Code §507. Note the section in full. the priority claims will eat up the assets number: This means that the priority rules are What happens then? The basic principle before we ever get to the residual non- part of chapter 5, and recall that chapter 5 is one of pro rata distribution among priority class. applies to all kinds of bankruptcy cases, similarly situated creditors. This is supposed But there is more. The most important including liquidating cases under chapter 7 to supplant the “race to the courthouse” that “priority” isn’t even on the priority list. That and reorganization cases under chapter 11. would occur if not for the automatic stay of is, a creditor with a valid and perfected bankruptcy. It sounds simple and fair. But— Administrative Expenses security interest in property of the estate will as with many things in bankruptcy—it’s less Section 507(a)(1) gives a first priority to have first dibs on that property. For simple than it initially appears, and whether “administrative expenses allowed under example, in our case, suppose the asset pool you think it’s fair probably depends on what §503(b).” Section 503(b)(1)(A) in its turn valued at $12 includes a widget, valued at rung of the ladder you find yourself defines “administrative expenses” as “the $9, in which Butcher has a perfected s t a n d i n g . actual, n e c e s s a r y costs and expenses of security interest. Butcher gets the whole $9 For starters, let’s make sure we preserving the estate.” This is, among other value of the widget. There is still $3 of understand what we mean when we talk 1 For a general discussion of recharacterization and some of the other value left in the estate, and Butcher still has pitfalls related to providing additional capital infusions to troubled about pro rata. It’s pretty straightforward: a $1 shortfall unpaid on his claim. Butcher companies, s e e Sprayregen, James H.M., and Friedland, Jonathan P., Pro rata means that when there are not “Doubledowning—Avoid Double Trouble: Structuring Alternatives (on his $1 shortfall) shares pro rata w i t h for Additional Rounds in Troubled Portfolio Companies,” The Journal enough assets to go around, then each of Private Equity, 45-57 (Fall 2002). The American Bankruptcy Institute 44 Canal Center Plaza, Suite 404, Alexandria, VA 22314-1592 • 703 739 0800 things, the place where the lawyers get paid: “superpriorities.” The other is the matter of have only general unsecured claims, but Fees for professionals who represent the priorities “below the list”—residual they jump to the front of the line, getting estate are administrative expenses (but all priorities for liquidating cases under paid in full even though other claims of a subject to court control: see, e.g., C o d e Bankruptcy Code §726. similar rank will probably wait a long time §§327 and 330). And note “necessary,” First, superpriorities: We saw above for any payment, and then receive only italicized above. This is the stuff that that the first priority goes to administrative cents on the dollar. The argument is that litigation is made of. expenses. But not all administrative these “essential trade vendors” are expenses are created equal. For example, a necessary for the debtor’s survival, and they Taxes party who extends post-petition financing to won’t continue to ship to the debtor unless We need to make three quick points a debtor under Bankruptcy Code §364 often they are paid in full. Courts often agree with about the tax priority. First, note that this tax negotiates for a “superpriority” that trumps this argument, although it appears that the priority stands only eighth on the statutory other administrative claims. Also, a claim “essential trade vendor” argument has been priority ladder. But as a practical matter, the for failure of adequate protection has a somewhat overused, and that courts are tax priority is a lot more important than super priority. S e e Bankruptcy Code becoming more skeptical. One example of several of those that precede it. Second, note §507(b) (we will say more about “adequate this is the recent decision of the Seventh that the priority applies only to unsecured protection” in our next installment). And on Circuit in the K m a r t c a s e . tax claims. In plenty of cases, the tax occasion, you will see a court order that collector will have statutory tax lien—a kind purports to create other “superpriorities” Maybe You Own the Asset? of secured claim. Working out the even though not provided for in the Code. One way to obtain “priority” over other relationship between the secured lien claim This can happen, for example, with break- creditors is to establish that you own an and the unsecured priority claim is a up fees payable to outbid prospective estate asset, so that other creditors should bankruptcy subspecialty all its own, but the purchasers in §363 sales.
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