A preferred creditor (or preferential creditor) is a creditor who is given priority over unsecured creditors when it comes to the distribution of a debtor’s assets during the liquidation or bankruptcy process.
This means that in the event of a company’s insolvency, preferred creditors will receive payment before unsecured creditors and after secured creditors. However, the hierarchy may vary depending on the jurisdiction.
The category of preferred creditors often includes:
- Employees: Outstanding wages and other employee benefits often fall into the preferred category.
- Tax Authorities: Unpaid taxes are often given priority.
- Pension Funds: Unpaid pension contributions may be given preferential status.
- Certain Trade Creditors: In some jurisdictions, certain trade creditors may have preferred status under specific circumstances.
These designations are defined by law and are intended to protect certain groups and societal interests.
It’s important to note that being a preferred creditor doesn’t guarantee that they’ll receive all the money owed to them. If the insolvent company’s assets are not sufficient to cover all debts, the available funds will be distributed proportionally among preferred creditors, and they may still incur a loss.
Example of a Preferred Creditor
Imagine there is a company named “TechCorp Ltd.” that goes into liquidation. TechCorp’s remaining assets, after being sold, total $500,000. The company owes money to several parties, as follows:
- Bank Z (a secured creditor) – Loan amounting to $600,000
- Employee wages (a preferred creditor) – Unpaid wages amounting to $200,000
- Tax Authority (a preferred creditor) – Unpaid taxes amounting to $150,000
- Supplier Q (an unsecured creditor) – Unpaid supplies amounting to $250,000
In this case, the distribution of the liquidation proceeds would happen in the following manner:
Firstly, Bank Z, as a secured creditor, would be paid. However, TechCorp only has $500,000, so Bank Z would receive this amount, leaving a deficit of $100,000.
After the secured creditors are paid, the preferred creditors are next in line. However, as all the liquidation proceeds have been used to pay Bank Z, there would be no funds left to pay the preferred creditors (employee wages and tax authority) or the unsecured creditor (Supplier Q).
In this scenario, being a preferred creditor did not ensure payment for the employees or the tax authority. This is because the available funds were not enough to cover all of the company’s debts, and secured creditors take precedence.
This example shows that while preferred creditors have a higher claim than unsecured creditors, they still rank below secured creditors, and their claim is only as good as the company’s available assets in the event of insolvency.
Remember that this is a simplified example. Actual insolvency procedures can be far more complex and depend heavily on specific laws and regulations in each jurisdiction.