Bankruptcy is often viewed as having camaraderie with the debtor only,
since bankruptcy clearly aims at liberating a debtor from the clutches of enormous debts. But, what we seldom care to take into account is that bankruptcy is creditor-friendly as well.
Bankruptcy indeed gives a fresh start to the debtors but it also ensures that the creditors receive their payments as much as possible. Unsecured creditors paid off either with the proceeds fetched from liquidation of the debtor’s assets, or with a pro rata portion of their debts as per a court devised payment plan. Secured creditors are either given their collateral or the value of the collateral in cash. If the collateral value is less than the claim of the secured creditor, then the claim is further split into a secured claim and an unsecured claim. The secured claim is covered by the collateral and is paid in full, while the unsecured claim is distributed on pro rata basis.
However, claims of some creditors get priority over those of other creditors in a bankruptcy case. Such priorities, commonly called “priority claims” are applicable to Chapter 7, 11, 12 and 13.
The priority order
As per the Federal Bankruptcy Code, the “priority claims” are divided into the following 10 categories with decreasing order of priority:
1. Domestic support obligations: These are claims for support that is to be given to the spouse, former spouse, child, or child’s representative. Any claims by a governmental unit that has extended support for the debtor’s family obligations, come within this category but with a lower priority.
2. Administrative expenses: These are expenses required to administer the bankruptcy case itself. Originally, administrative expenses had the highest priority. But with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the Domestic Support Obligations was lifted to the highest priority level. Nevertheless, this category has a de facto priority over Domestic Support Obligations, because such expenses are deducted from the bankruptcy estate, before they are paid to DSO recipients. The courts allow the top priority for administrative expenses as no trustee will oversee a bankruptcy case for nothing.
3. Claims in an involuntary bankruptcy petition under Chapter 7 or Chapter 11: Such claims arise between the filing of the involuntary petition by the debtor’s creditors and issuance of the relief order by the court. These claims need to be prioritized, or else creditors would not deal with the debtor in a situation where the debtor has not declared bankruptcy and the court has not yet ruled in the creditors’ favor.
4. Employee wages: Employee wages up to $10,950 per worker, for the 180 day period prior to either the bankruptcy filing or when the business ceased to operate (whichever is earlier).
5. Unpaid contributions to employee benefit plans during the 180-day period prior to bankruptcy filing.
6. Claims by a grain producers by a fisherman for grain/fish, for up to $5400 per grain-producer/fisherman.
7. Consumer layaway plan deposits up to $2,425 each.
8. Taxes outside of bankruptcy: Normally taxes have a higher priority, when they are outside the purview of bankruptcy. Therefore, creditors prefer to file an involuntary bankruptcy petition against the debtor, so that they can receive more priority in bankruptcy than they would outside it.
9. Debtor’s obligation to a Federal depository institution in order to preserve the capital of the institution.
10. Claims for death or personal injury from a motor vehicle that occurred while the debtor was driving it and was intoxicated.
Every category of priority creditors must be paid in full before the next category of creditors can receive their payment. Normally, unsecured creditors receive lowest priority. If there is not enough money left to pay a priority category in full, then all the members of that category receive a pro rata share of the leftover.
What are the exceptions to the pro rata disbursement?
There are 2 exceptions to the pro rata distribution within a priority category:
• In case of domestic support obligations, individual claimants have priority over governmental claims.
• If a Chapter 11 case is converted to a Chapter 7 case, then the administrative expenses of the Chapter 7 case will have priority over the replaced Chapter 11 expenses.
Can the priority order be changed?
State laws can neither modify the priority of claims nor can disregard the priority order. Even, the courts are not empowered to modify the order, under normal circumstances. However, there are some specific types of payments which are granted a de facto priority by the courts. These are usually prioritized in order to achieve some legal solutions, such as resolving conflicting legal objectives, paying the trustee to oversee the bankruptcy case, and so on.