When a company faces insurmountable financial difficulties and is forced into liquidation (also known as winding up), its assets are sold off to generate funds for distribution to creditors and, potentially, shareholders.
When a company is liquidated, its assets are sold off and the proceeds are distributed to creditors and shareholders according to a strict order of priority. This distribution follows a strict order of priority, dictated by insolvency law, which varies by jurisdiction. Understanding this order is crucial for anyone with a financial stake in the company, from employees and suppliers to lenders and investors.
Hierarchy of claims in liquidation
This article provides a comprehensive overview of the typical order of payout in a company liquidation.
However, it is essential to remember that insolvency laws are jurisdiction-specific, and consulting with a legal professional in the relevant jurisdiction is always recommended for accurate and tailored advice.
1. Costs of Liquidation:
The first priority is covering the expenses directly associated with the liquidation process itself. These costs are essential because without them, the liquidation couldn’t proceed, and no funds would be available for distribution to anyone. Typical costs include:
- Liquidator’s Fees: The liquidator, a qualified insolvency practitioner appointed to manage the process, receives fees for their work.
- Legal and Professional Fees: Legal counsel, accountants, and other professionals involved in the liquidation are paid for their services.
- Asset Realization Costs: Expenses related to preserving, valuing, and selling the company’s assets, such as storage, maintenance, auctioneer fees, and marketing costs.
- Court Fees and Administrative Expenses: Filing fees, court appearances, and other administrative costs associated with the legal proceedings.
2. Secured Creditors:
Secured creditors hold a security interest (a legal right) over specific assets of the company. This means they have a claim on those assets as collateral for a loan or other obligation. They are paid from the proceeds of the sale of the assets they have a security interest in. Common examples include:
- Mortgage Holders: Banks or other financial institutions holding a mortgage on the company’s property.
- Lenders with Security Agreements: Lenders who have a security interest in the company’s inventory, equipment, or other assets.
If the sale of the secured asset does not cover the full amount owed to the secured creditor, the remaining balance becomes an unsecured debt, joining the pool of unsecured creditors.
3. Preferential Creditors:
Preferential creditors have a statutory priority over unsecured creditors, meaning they are paid before them. This category typically includes:
- Employee Claims: This covers outstanding wages, salaries, holiday pay, pension contributions, and other employee entitlements. However, these claims are often subject to limits (e.g., a cap on the amount payable per employee or a time limit on wages earned before the liquidation).
- Government Dues: This includes certain unpaid TAXes, such as Value Added Tax (VAT), payroll taxes, and corporation tax. The specific types of taxes and their priority can vary by jurisdiction.
4. Unsecured Creditors:
Unsecured creditors do not have any security interest in the company’s assets. They are paid after secured and preferential creditors. This group often represents the largest number of creditors and frequently receives little to no recovery in a liquidation. Common examples include:
- Trade Creditors: Suppliers who provided goods or services to the company on credit.
- Customers: Customers who have paid for goods or services that have not yet been delivered.
- Unsecured Lenders: Lenders who provided loans without any collateral.
If funds are available for unsecured creditors, they are typically paid on a pro rata basis. This means each creditor receives a proportionate share of the available funds based on the amount they are owed. For example, if USD$100,000 is available and unsecured creditors are owed a total of USD$500,000, each creditor receives 20 cents for every dollar they are owed.
5. Shareholders:
Shareholders are the last to receive any distribution in a liquidation. They are only entitled to any remaining funds after all creditors have been paid in full. The order of distribution among shareholders is determined by the class of shares they hold:
- Preferred Shareholders: Generally have priority over common shareholders in receiving distributions.
- Common Shareholders: Receive any remaining funds after preferred shareholders have been paid.
Within each class of shares, there may be further distinctions in priority depending on the specific rights attached to different share classes.
Illustrative Example:
Imagine a company with USD$500,000 in assets liquidates. The following claims exist:
- Liquidation costs: USD$50,000
- Secured creditor (bank): Owed $200,000 (secured against equipment sold for USD$200,000)
- Preferential creditors (employee wages and TAXes): USD$100,000
- Unsecured creditors (suppliers): Owed USD$300,000
- Shareholders: Equity investment of USD$100,000
In summary, the order of payout in a liquidation is strictly defined by law. Secured and preferential creditors have priority over unsecured creditors and shareholders. Unsecured creditors often receive little to no recovery. Shareholders are the last to receive any distribution and may receive nothing if insufficient funds remain. Insolvency laws are jurisdiction-specific; professional legal advice is essential for accurate guidance.
NOTE: Understanding the order of payout is crucial for all stakeholders involved in a company liquidation. It provides clarity on the likelihood of recovering outstanding debts or investments and helps manage expectations during this complex process.
