In situations where assets have to be liquidated in order to handle outstanding liabilities, there has to be a clear establishment of who will receive any benefits realized from the sales. This is where the concept of the absolute priority rule comes into play. Basically, the absolute priority rule confirms that any claims by creditors are to be honored and settled before any of the remaining assets from the liquidation are divided among shareholders. Assuring the absolute priority of any claims by creditors help to ensure that debtors who are going through a debt reorganization or even bankruptcy will have a chance of regaining financial health at some time in the future.
The most common application of the absolute priority rule occurs during the liquidation of assets of a business entity that has chosen to file bankruptcy. As the assets are converted into cash, the bankruptcy court will evaluate the creditor claims, then determine the amount of payment each of the creditors will receive, once all assets have been liquidated. This is a process that may take only a few weeks, although it can take years to finally settle the debts. However, the absolute priority rule ensures that creditors will eventually receive at least a partial payment, if not payment in full. During this process, shareholders will receive nothing in the way of financial gain from the sale of the assets. Only after the debts of the company are settled to the satisfaction of the court of jurisdiction will investors begin to see any return.
The absolute priority rule also is often invoked when settling estates after the death of the owner. The executor is charged with the responsibility of settling all outstanding debts out of the resources of the estate. If cash reserves are sufficient to pay off all creditors, then the task is a simple one. If not, other assets would need to be converted into cash and used to settle the debts. At that point, the rest of the estate could be distributed according to the wishes of the deceased.
The absolute priority rule provides some degree of protection to vendors and other types of institutions that extend credit for goods and services to individuals and businesses. A benefit to the consumer is that application of the absolute priority rule helps to pave the way for recovery from a devastating financial situation, as well as create the opportunity to build something new without being hampered by problems associated with a previous venture.