Liquidation policy

We first covered corporate liquidation in the common stock chapter. Here’s the key idea to remember: if a company is forced to liquidate (sell its assets to pay what it owes), payments are made in a specific priority order.

If a company is forced to liquidate its assets, it will pay the liquidation funds in this order:

1. Unpaid wages

2. Unpaid taxes

3. Secured creditors

4. Unsecured creditors

5. Junior unsecured creditors

6. Preferred stockholders

7. Common stockholders

A bondholder is a type of creditor.

After unpaid wages and taxes come secured creditors, which is where collateralized bonds fall. These bonds are backed by collateral (a specific asset). If the issuer fails to make interest or principal payments, that collateral can be sold to help repay the debt.

You may see some variation across sources on how unpaid wages and taxes compare to secured creditors. Secured creditors have first claim on the specific collateral backing their loan. If that collateral is sold and still doesn’t fully repay the loan, then the remaining unpaid balance is paid (if possible) using the general liquidation priority listed above.

Example: Suppose a secured creditor is owed $1,000, and the company also owes $100 in wages and $100 in taxes. If the collateral backing the secured loan is sold for $600, that $600 goes to the secured creditor, reducing the loan balance to $400. Next, the company’s remaining assets are sold for $500. From that $500, $100 goes to unpaid wages, $100 goes to unpaid taxes, and the remaining $300 goes to the secured creditor. The secured creditor is still owed $100.

This wages/taxes vs. secured-creditor detail isn’t heavily tested. Exam questions are more likely to focus on the broader point that creditors (bondholders) are paid before equity holders (stockholders).

Unsecured creditors are next. This is where unsecured bonds - also called full faith and credit bonds - fall. If a bond has no collateral backing the issue, it’s unsecured. Because there’s no collateral and the claim is lower in the liquidation order, unsecured bonds are generally riskier than secured (collateralized) bonds.

After unsecured creditors come junior unsecured creditors, also called subordinated debenture holders. These are debentures that rank below other unsecured debt in liquidation priority. Because they’re paid later, they carry more risk.

After the creditors come the stockholders. Preferred stockholders are paid before common stockholders, and common stockholders are last in line. Stockholders are owners of the company, so if the company goes bankrupt, there’s often little to no money left after debts are paid.