Priority of Liens

Priority of Liens refers to the legal pecking order that determines which Creditors get paid first from the proceeds of a foreclosure or Bankruptcy. Think of it as a queue for repayment. When a company or individual defaults on their debts, the Assets they pledged as Collateral are typically sold off. The priority of liens dictates the sequence in which the lenders (lienholders) receive their money from the sale. A creditor with a higher priority lien gets paid in full before a creditor with a lower priority lien sees a single penny. This order is usually established by the timing of when the Lien was recorded—first in time, first in right. For investors, particularly those buying company debt like Corporate Bonds, understanding this hierarchy is absolutely critical. It directly impacts the risk of an investment; a higher position in the line means a greater chance of recovering your capital if the company stumbles.

In a word: Risk. The legendary investor Warren Buffett has two famous rules: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Understanding the priority of liens is a fundamental part of obeying these rules when investing in a company's debt. It helps you assess the margin of safety on your investment. A loan or bond with a high-priority lien is safer because it's first in line to be repaid from the company's most valuable assets. Because it's less risky, it typically offers a lower Yield. Conversely, a debt instrument with a low-priority lien (or no lien at all) is much riskier. You're further back in the repayment queue, and if the asset sale doesn't raise enough cash, you could lose your entire investment. To compensate for this higher risk, these investments must offer a much higher potential return. A value investor scrutinizes a company's Capital Structure to see exactly where they would stand if the worst were to happen.

Imagine a company’s capital structure as a pyramid. Those at the top get paid first from secured assets, while those at the bottom get the leftovers, if any.

These are the lenders at the front of the line because their loans are backed by specific collateral, like real estate, equipment, or inventory. They have a formal lien on these assets.

• First-Lien Debt: The absolute top of the food chain. These lenders have the first claim on the collateral. If the company defaults, the proceeds from selling that specific asset go to them first until they are paid in full.
• Second-Lien Debt: These lenders are next in line for the same collateral. They only get paid from the proceeds after the first-lien debt holders have been completely satisfied. It's riskier, so it carries a higher Interest Rate.

Unsecured Creditors have lent money to the company without securing the loan against a specific asset. They are paid from the company's general assets after all secured creditors have been paid from the collateral they had claims on.

• Senior Unsecured Debt: This is a common category for many corporate bonds. They have a higher claim on the company's unpledged assets than other unsecured creditors.
• Subordinated Debt: The name says it all. This debt is “subordinate,” or junior, to senior debt. These lenders contractually agree to be paid back only after the senior debtholders are made whole. The risk is high, but so is the potential reward.

Right at the bottom of the pyramid are the owners of the company—the Shareholders.

• Preferred Stock Holders: They have a higher claim than common stockholders but are still behind every single debtholder.
• Common Stock Holders: As the ultimate owners, they are dead last. In a bankruptcy, common stockholders are rarely left with anything. This is the price of unlimited upside potential—you also accept the risk of total loss.

Let's say “The Bankrupt Bistro Inc.” goes out of business. It sells all its kitchen equipment and restaurant property for $150,000. Here's a list of who the Bistro owes money to:

• Bank A: $100,000 first-lien loan (secured by the equipment and property).
• Bank B: $75,000 second-lien loan (also secured by the same assets).
• Food Suppliers: $50,000 in senior unsecured bonds.
• Equity Investors: $25,000 originally invested for common stock.

Here is how the payout unfolds, according to the priority of liens:

1. Step 1: The $150,000 from the asset sale is collected.
2. Step 2: Bank A, the first-lien holder, is at the front of the line. It gets its full $100,000.
3. Step 3: Now there is $50,000 left ($150,000 - $100,000). Bank B, the second-lien holder, is next. Its claim is for $75,000, but there's only $50,000 available. Bank B gets all $50,000 and has to write off the remaining $25,000 as a loss.
4. Step 4: The money has run out. The Food Suppliers (senior unsecured) and the Equity Investors get $0. Their investments are wiped out.

This simple example powerfully illustrates why knowing your place in the queue is everything.

When you're analyzing a company's debt, don't be dazzled by a high yield alone. Ask the crucial question: Where do I stand in the priority of liens? Your position in the repayment line is one of the most important factors determining the true risk of your investment. A juicy yield might be tempting, but it's worthless if the company defaults and creditors ahead of you absorb all the assets. Always check the fine print to understand what collateral, if any, is backing your investment and who else is in line ahead of you.