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Bankruptcy Law: Liens and Priorities in Bankruptcy

Introduction

The overarching principle in bankruptcy proceedings is the orderly administration of the debtor's estate. In bankruptcy, the debtor's "estate" is made up of all legal and equitable interests in the debtor's property as of the filing of the petition. The interests come in a variety of forms, some more strongly attached to the estate than others. The bankruptcy code provides a structure for dealing with the interests of various creditors by prioritizing them. Still, at times, discerning which rights take precedence over others can be very difficult. Understanding the basics of how debt is generally treated can help both the debtor and creditor develop strategies for handling the debts.

Liens and Priorities

The bankruptcy code sets up a hierarchy of rights which, broadly speaking, prioritizes the distribution of the assets of the estate in the following manner: 1) secured debt; 2) unsecured debt; 3) subordinate debt; and 4) equity.

Secured debt consists of a claim for money coupled with a "lien." A lien is the right of a creditor to seize a specific piece of property as collateral for a loan. The property acts as security for the debt so that if a debtor is unable to pay back the debt, the creditor has the right to take the property. The most commonly recognized lien is a mortgage. The homeowner has borrowed money from the mortgage lender and, in exchange, the mortgage lender has an interest in the homeowner's property as security should the loan not be repaid. There are many types of liens, both voluntary (as in the case of a mortgage) and involuntary (such as one imposed by a court). Bankruptcy laws generally do not distinguish between voluntary and involuntary liens. When either is coupled with a claim, a secured claim is created and that claim takes precedence over others.

After the secured debts are satisfied, unsecured debt is paid. Unsecured creditors do not have collateral to collect if the debtor defaults. From highest priority to least, the bankruptcy code prioritizes certain types of unsecured debt over others as follows:

  1. domestic support obligations as defined by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005;
  2. administrative expenses associated with conducting the bankruptcy;
  3. claims arising after filing for bankruptcy in involuntary cases;
  4. claims for wages earned during the ninety days before filing;
  5. claims for contributions to employee benefit plans;
  6. claims of a farmer against a grain storage facility or a fisherman against a fish processing or storage utility;
  7. claims for deposits for the purchase or rental of real property or personal services that were not delivered;
  8. spouses or children's right to claim alimony, or maintenance, and child support;
  9. government claims for certain taxes;
  10. unsecured claims of a federal depository institution;
  11. claims for death or personal injury resulting from the operation of a motor vehicle or vessel while intoxicated.

Generally, in Chapter 7 bankruptcy, each claim in each one of the priority categories must be paid in full before any payment is made to a category below it. The bankruptcy code puts caps on the amounts that may be paid in many of the categories, but if full payment still cannot be made to each claim in a particular category, then the available assets are distributed proportionately to all the claims within the category.

Next in line, after the above priority categories, are general unsecured claims such as debts to retailers, small loans, credit card debt and, for businesses, trade debt. When an estate is being liquidated, these types of unsecured debt are all treated alike and are rarely paid. However, in reorganization proceedings, they may be prioritized and some may receive a degree of payment.

Next in line is a class of debt simply called "subordinate debt," meaning junior in status to other classes of debt. Claims may be subordinated voluntarily or involuntarily. Sometimes there is a tactical reason behind the subordination of a creditor's claim or the trustee may have forced the claim into subordination because it would be unfair to treat it on par with other unsecured claims. On occasion, a claim is subordinated in order to penalize a creditor for a wrongdoing that damaged the interest of the other creditors.

Equity, or interest, in the estate is last in the pecking order. Equitable interests apply only to corporations, partnerships and the like. It is an interest in the value of the debtor itself as opposed to a particular piece of the debtor's property and, if the corporation's debts exceed its assets, there is no equity in the business. As with claims, there may be priorities in interests, such as preferred stocks; however, the corporation, not the bankruptcy code, creates these priorities.

Before a creditor's claim is recognized in a bankruptcy proceeding, the claim must be filed with the bankruptcy court. The claim will be allowed unless there are any objections from any of the other parties, such as the debtor or another creditor. An objection will likely be made if the amount of the claim is so large that to satisfy it would leave little or nothing for other creditors. The court will then hold a hearing to determine the amount that will be allowed on the claim.

Conclusion

The structure provided by the bankruptcy code is designed to distribute the assets of an estate in a fair and orderly fashion. However, within that framework there are rights to be asserted and protected in order for a creditor to maintain his priority in repayment. An experienced bankruptcy attorney can help you decide what steps can be taken to ensure your place in the priority structure and to improve the odds that the assets of the estate are not drained before your claim can be repaid.

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