Chapter 11, Chapter 7 and Absolute Priority

When a US company can no longer pay its debts, it typically ends up in one of two chapters of the bankruptcy code. Chapter 7 is liquidation: a trustee sells off the company's assets and distributes the cash. Chapter 11 is reorganization: the company keeps operating while a court-supervised process figures out who gets paid what, often converting old debt into new debt or equity in a company that continues as a going concern. Which chapter a company ends up in says a lot about whether its business is worth more alive or dead.

Whichever chapter applies, the distribution of value is supposed to follow absolute priority: senior claims must be paid in full before anyone junior to them receives anything.

Two paths, one queue

Chapter 7 makes sense when a business is worth more broken into pieces than kept together — an unprofitable retailer whose real estate leases and inventory are worth more sold off than operated. Chapter 11 makes sense when the business itself has value as a going concern but the capital structure is simply too indebted for it. A Chapter 11 plan often converts the fulcrum layer of debt into the new equity of the reorganized company, wiping out old equity holders entirely if the business isn't worth enough to reach them.

Worked example

A company enters Chapter 11 with an estimated reorganization value of $600 million. Its claims: $300 million secured debt, $250 million unsecured bonds, $100 million preferred equity, and common equity currently worth nothing on paper.

1. Secured debt is paid first, in full: $300 million, leaving $600 - 300 = 300$ million.
2. Unsecured bonds are next: the full $250 million is available, so they too are paid in full, leaving $300 - 250 = 50$ million.
3. Preferred equity is owed $100 million but only $50 million remains — preferred holders recover $50/100 = 50\%$, and because they were not paid in full, absolute priority says common equity gets nothing: $0.

Here the unsecured bonds were the last class paid in full — they are the fulcrum security: the layer where value runs out and where old claims convert into ownership of the reorganized company.

What this means in practice

In practice, absolute priority is often bent through negotiated settlements: a class that would legally get zero sometimes receives a small recovery anyway (a "gifting" or "tip" payment) in exchange for not contesting the plan and slowing everything down in court. Investors who buy distressed debt spend much of their effort estimating exactly where the fulcrum sits, because that layer is the one whose holders will end up controlling the company once the case is resolved.