What is the significance of a secured position if the absolute priority rule is typically not followed in a reorganization?

Question

What will be an ideal response?

Answer 1

A corporate debt obligation can be secured or unsecured. In the case of a liquidation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule where senior claimants are paid first. For example, debtholders are paid before stockholders. However, in the case of a reorganization, the absolute priority rule rarely holds. That is, an unsecured creditor may receive distributions for the entire amount of his or her claim and common stockholders may receive something, while a secured creditor may receive only a portion of its claim. The reason is that a reorganization requires approval of all the parties. Consequently, secured creditors are willing to negotiate with both unsecured creditors and stockholders in order to obtain approval of the plan of reorganization.

Even though the absolute priority rule is not typically followed, it is still significant because senior claimants can use it to exercise clout in the reorganization process to insure they get the best possible deal. Even though the amount of cash owed may not be received immediately, the bargaining process can allow for future claims on assets that might make the senior claimants better off than if the assets were just liquidated.