Comment on the following statement: "An investor who purchases the mortgage bonds of a corporation knows that should the corporation become bankrupt,

Question

mortgage bondholders will be paid in full before the common stockholders receive any proceeds."

Answer 1

When a company is liquidated, creditors receive distributions based on the absolute priorityrule to the extent that assets are available. The absolute priority rule is the principle thatsenior creditors are paid in full before junior creditors are paid anything. For secured creditorsand unsecured creditors, the absolute priority rule guarantees their seniority to equityholders.

In liquidations, the absolute priority rule generally holds. In contrast, there is a goodbody of literature that argues that strict absolute priority has not been upheld by the courtsor the Securities and Exchange Commission (SEC).Studies of actual reorganizations under Chapter 11 have found that the violationof absolute priority is the rule rather the exception.Consequently, although investors in the debt of a corporation may feel that they havepriority over the equity owners and priority over other classes of debtors, the actual outcomeof a bankruptcy may be far different from what the terms of the debt agreement state.