Liquidation policy

We originally discussed corporate liquidation policies in the common stock chapter, but let’s revisit it. 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

In case you’re wondering, a bondholder is a type of creditor. After unpaid wages and taxes, we have secured creditors, which is where collateralized bonds fall. These securities are backed by a valuable asset that can be liquidated if the issuer fails to make interest or principal payments.

There can be some confusion from the order of unpaid wages & taxes vs. secured creditors, depending on the source of information. Secured creditors have first rights to the collateral backing the loan. If the collateral backing the loan is liquidated and does not cover the loan balance, the liquidation priority above applies.

To demonstrate this, assume a secured creditor is owed $1,000, and $100 of wages plus $100 of taxes are outstanding. If the collateral backing the secured loan is liquidated for $600, all goes to pay back the secured creditor, bringing their loan balance down to $400. Now, the rest of the company’s assets are liquidated for $500. $100 goes to unpaid wages, $100 to unpaid taxes, and the remaining $300 to the secured creditor. This leaves the secured creditor with $100 unpaid.

The order of unpaid wages & taxes vs. secured creditors is not a heavily tested concept. Questions on the priority of creditors (bondholders) vs. equity holders (stockholders) are much more common on the exam.

Unsecured creditors are next, which is where unsecured bonds, also known as full faith and credit bonds, fall. If a bond has no collateral backing its issue, it is unsecured. These securities are riskier than secured (collateralized) bonds due to the lack of backing and the lower priority on the liquidation scale.

After unsecured creditors, we have junior unsecured creditors, also known as subordinated debenture holders. These are the same as regular debentures, except where they fall in liquidation priority. Issuers are sometimes forced to issue subordinated (junior) bonds (don’t worry about why). These bonds are subject to more risk due to the lowered priority.

After the creditors, we have our stockholders. Preferred stockholders come first, with common stockholders falling last on the priority scale. Stockholders are considered company owners that “go down with the ship.” When a company goes bankrupt, there is typically little to no money left for stockholders.