Priority of claims

When a company cannot pay, the question stops being "what is it worth?" and becomes "who gets the value, in what order?" That order is the priority of claims, and applying it is the waterfall: value flows down a ranked stack, each class paid in full before the next receives anything, until the value runs out. The class where the money runs out, partially paid with everyone below it wiped out, is the fulcrum security, and it is the single most important object in distressed investing, because it is where ownership of the reorganised company transfers from the old equity to the creditors.

The stack (senior to junior), in principle:

1. Super-priority / DIP financing and administrative costs: the costs of the insolvency process itself, and any new money lent to keep the company alive during it (debtor-in-possession financing in the US), which is granted priority ahead of everyone to induce anyone to lend to a bankrupt company at all.
2. Secured creditors: lenders with a lien on specific assets (or all assets). Within this tier, first-lien ranks ahead of second-lien on the same collateral. A secured creditor recovers from their collateral first; any shortfall drops down to rank as unsecured.
3. Senior unsecured creditors: bondholders and lenders with no security, plus trade creditors (in principle).
4. Subordinated / junior creditors: contractually agreed to rank behind senior unsecured.
5. Preferred equity, then 6. common equity: the residual, paid only if every creditor is made whole (rare in a real default).

This ordering is the absolute priority rule (APR): no junior class receives value until every senior class is paid in full. In a US Chapter 11 it can be bent by consent (a senior class may agree to give the equity a small recovery to grease a deal, a "gift"), but it cannot be forced on a dissenting class ("cramdown" enforces APR against holdouts). Verify the current mechanics; they are litigated constantly.

What is subordination, and what do creditors recover?

Two kinds of subordination, and do not confuse them.

• Contractual subordination: a creditor has agreed, in the document, to rank behind another (subordinated notes). The subordination is in the contract.
• Structural subordination: a holding-company creditor is structurally behind the operating-subsidiary creditors, not because they agreed to be, but because the subsidiary's creditors are paid from the subsidiary's assets before any residual dividends up to the holdco where the holdco creditor sits. No contract says so; the structure does. This is why the standalone-vs-consolidated debt gap covered in credit ratios is a recovery issue: holdco bonds with a mountain of opco debt beneath them can recover far less than their headline seniority suggests (the IL&FS holdco creditors' problem exactly).

Recovery rates are empirical and seniority-ordered. Historically (long-run averages across cycles, so check the vintage and market), senior secured bank debt recovers on the order of 60–80%, senior unsecured bonds ~35–45%, and subordinated debt often below 30%; equity, in a genuine default, typically recovers approximately nothing. Recovery is also procyclical (worse in recessions, when more firms default and asset prices are depressed) and sector-specific (asset-heavy businesses with saleable collateral recover more than asset-light ones whose value walks out the door). LGD = 1 − recovery, so these feed straight back into the credit triangle in spreads for credit.

How does the IBC Section 53 waterfall work?

India's statutory waterfall: IBC Section 53. India's Insolvency and Bankruptcy Code, 2016 prescribes a liquidation waterfall in Section 53 (a going-concern resolution under a resolution plan can differ, subject to creditor approval and a minimum for dissenting/operational creditors). The order (simplified, and check against the current Code):

1. Insolvency-resolution-process and liquidation costs;
2. pari passu: (a) workmen's dues for 24 months, and (b) debts of secured creditors who relinquished their security to the common pool;
3. wages/employee dues (other than workmen) for 12 months;
4. financial debts of unsecured creditors;
5. pari passu: (a) government dues (up to 2 years) and (b) the unpaid balance of secured creditors who enforced their security outside the pool;
6. any remaining debts;
7. preference shareholders; then 8. equity.

Note where operational (trade) creditors and government sit: well below financial creditors. That is why, in India, being a financial creditor with security is a materially better place to stand than the textbook stack alone suggests. Worked example 3 runs the whole cascade with numbers.