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What Is a Preferred Creditor

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Financial Accounting 1 (Ateneo de Manila University)

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What Is a Preferred Creditor?

A preferred creditor, also known as a "preferential creditor", is an individual or
organization that has priority in being paid the money it is owed if
the debtor declares bankruptcy.

KEY TAKEAWAYS

 A preferred creditor is an individual or organization that has priority in being

paid the money it is owed if the debtor declares bankruptcy.
 The types of creditors that are preferred are defined by law and vary
depending on the jurisdiction.
 Unpaid wages and taxes, as well as environmental and tort damages, are
often the first expenses covered.
 Preferred bondholders and, on occasion, economic development
institutions also have a greater chance of recovering any money owed.
Understanding a Preferred Creditor
Bankrupt entities do not have enough capital to fulfill all of their financial
obligations, meaning that some investors who are owed money will get paid in
part or not at all. Usually, a preferred creditor has the first claim to any funds that
are available from the debtor.1

In bankruptcy cases in most legal systems, the types of creditors with preferential
status are defined by law and commonly include preferred bondholders and
sometimes tax authorities.

A preferred creditor can also be an economic development institution. For

example, the World Bank might have priority to be repaid a loan it made to a
country that experiences a financial crisis, even if this wasn't specified in the
terms of the contract.

The claims of preferred creditors may be covered entirely or up to a certain

percentage.

Types of Preferred Creditor

Preferred creditors can take many different forms or classes, each with a claim
that may take precedence over another claimant depending on the jurisdiction.
They include:

 Employees: Workers at a bankrupt company who are owed pay for work
that has been performed (wages) are the top preferred creditor.

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 Tax and revenue authorities: Government tax authorities, such as

the Internal Revenue Service (IRS) in the United States and HM Revenue
and Customs (HMRC) in the United Kingdom, have the right to be paid for
any tax liability before anyone else—after employees.
 Environmental remediation: When bankrupt companies are adjudged to
have caused environmental damage as a result of their business
operations, the clean-up costs might receive preferential treatment by the
courts.
 Tort victims: Victims of such a "civil wrong" may be given preferred
creditor status in some jurisdictions based on their status as an involuntary
creditor. Since tort victims did not make the choice to become a creditor to
a bankrupt entity, they are generally not penalized.2

Dec. 2020
The date the U.K.'s tax authority, HMRC, returned to preferential creditor status
after an 18-year stint as an unsecured creditor with little hope of recovering any
money owed from insolvent companies entering liquidation.3
Preferred Creditors vs. Unsecured Creditors
An unsecured creditor is essentially an individual or institution that lends money
without obtaining specified assets as collateral. Unsecured creditors are
generally placed into two categories: priority unsecured creditors and general
unsecured creditors.

As their name suggests, unsecured priority creditors are higher in the pecking
order than general unsecured creditors when it comes to claims over
any assets in a bankruptcy filing. That said, when a person or business is unable
to repay their outstanding debts, the resources of economic value they hold are
usually not sufficient enough to reimburse priority unsecured creditors entirely.

In the U.S., the order of creditor and contributory ranking on a debtor's insolvency
is as follows:4

1. Secured claims
2. Administrative expenses and priority claims
3. General unsecured claims
4. Subordinated claims
5. Equity interests

Meanwhile, in the U.K. the creditor order is:4

1. Fixed charge holders

2. Liquidators' fees and expenses
3. Preferred creditors

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4. Floating charge holders

5. Unsecured creditors
6. Interest incurred on all unsecured debts post-liquidation
7. Shareholders

Special Considerations
In general, preferred creditors take precedence over unsecured creditors.
However, in some jurisdictions, as you can see above, preferred creditors are
more likely to get paid than secured creditors whose security is floating, while, at
the same time, taking a back seat to those with a fixed charge.

Banks and other lenders who hold title over business assets usually fall into
the fixed charge category.

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