by Ryan Moeller

When an investment goes south, whether you’re a secured creditor or an unsecured creditor could mean the difference between recouping your investment or walking away empty-handed.

In cases of corporate bankruptcies and liquidations, priorities matter when it comes down to how a distressed company’s assets are distributed.

In matters of priorities, secured creditors reign supreme.

The most recent study on bankruptcy from Yale University law professors found that in the case of businesses with assets worth more than $5 million, secured creditors received 94% of what they are owed. Arturo Bris, Ivo Welch & Ning Zhu, “The Costs of Bankruptcy: Chapter 7 Liquidations vs. Chapter 11 Reorganizations,” Journal of Finance (2005).

Secured creditors are in the driver’s seat due to the principle of absolute priority. Secured lenders agree to lend money only in exchange for corporate assets being pledged against corporate obligations. This lien over the assets of the company ensures that when a company does go under, secured creditors are paid back before any other creditors, including regular bondholders and any other unsecured creditors.

While secured creditors generally receive 94% of what they’re owed, it’s a different story for unsecured creditors who typically receive pennies on the dollar in the best case scenario and nothing in the worst case.

None of this should be surprising since secured creditors have wielded a disproportionate amount of preference and power over their unsecured counterparts dating back to as early as the Roman Empire – likely even earlier. Since the beginnings of English common law, a precursor to our legal system here in the United States, secured creditor status has always been recognized as having priority and being superior to unsecured status.

In fact, according to English legal tradition still followed today, if by agreement between a debtor and a creditor, specific property of the debtor was pledged to secure the creditor’s claim, the fact that such collateral was untouchable by unsecured creditors was not considered unjust or unlawful. English Statute of 13 Elizabeth I.

I point this out to demonstrate that the differences between secured and unsecured creditor status are immense, especially when a company goes south.

Unsecured creditors and shareholders must wait until secured creditors have been adequately compensated before they receive any compensation for the loss of their higher-yielding investments. Because equity owners are last in line, they usually receive little if anything, and because unsecured creditors are only one step above equity owners in the priority ladder, their chances of recouping a portion of their investment are only slightly better, but still not great.

The type of secured creditor who stands to receive the highest portion of a company’s assets (i.e., 100%) is the secured creditor with blanket security over all the assets of the company. Because secured creditors are dependent on the unencumbered (i..e., unsecured) assets of the company for payment, simple math dictates that a company whose entire set of assets are secured will have nothing left to distribute to unsecured creditors and equity owners.

The list of some of the largest corporate liquidations in U.S. bankruptcy history backs up the assertion that secured creditors usually get paid back their entire amounts owed and the unsecured creditors typically receive pennies on the dollar. One recent high profile bankruptcy demonstrating the dichotomy between secured vs. unsecured claims involved the bankruptcy of Omaha-based brick and mortar retailer, Gordman’s, which operated about 100 stores in 22 states.

According to Gordman’s bankruptcy plan, which was finalized at the end of 2017, the secured creditors, including Wells Fargo with the largest claim at $66m, received the full amounts of what they were owed upon the sale of the company’s assets. Unsecured creditors, as predicted, didn’t fare so well and received only 5 cents on the dollar.

The reorganization plan by Lafayette-based oil and gas company PetroQuest Energy, Inc. proposes to pay unsecured creditors less than a penny on the dollar. In the case of Gordman’s and PetroQuest, the unsecured creditors actually fared better than most unsecured creditors in a corporate liquidation wherein more than half the instances unsecured creditors receive nothing.

Nobody invests money in a company expecting it to declare bankruptcy.

However, when you venture outside of the risk-free realm of government-issued securities, you are accepting this added risk to enjoy above-government level returns. It’s just something that needs to be taken into consideration as you diversify your portfolio.

Investors don’t want to see a company fail. However, when a company does go south, every investor will wish they were a secured creditor since secured creditors have the best chances of seeing the value of their initial investments come back to them (94% according to the latest published study).

If you’re interested in secured investment opportunities to protect your creditor status, discover more about our current offerings here.