Priority of payments: Overview, definition, and example
What is priority of payments?
Priority of payments refers to the predetermined order in which funds are distributed to creditors, stakeholders, or contractual parties in financial transactions, insolvency proceedings, or structured finance agreements. This hierarchy ensures that payments are made according to legal agreements or contractual obligations, typically prioritizing secured creditors, senior debt holders, or essential expenses before distributing funds to lower-priority claimants.
For example, in a bankruptcy case, secured creditors (such as mortgage lenders) are paid first from the debtor’s assets before unsecured creditors (such as suppliers or credit card companies) receive any remaining funds.
Why is priority of payments important?
Priority of payments is important because it protects financial interests and ensures that funds are allocated fairly and legally. It helps creditors and investors understand their rights in financial transactions and reduces disputes over payment distributions.
For businesses and financial institutions, clear payment priority structures help manage risks, maintain investor confidence, and comply with regulatory requirements. In structured finance agreements, such as collateralized loan obligations (CLOs), priority of payments ensures that higher-tier investors receive their payments before lower-tier participants.
Understanding priority of payments through an example
Imagine a real estate company goes into liquidation, and its assets must be distributed to creditors. The priority of payments is as follows:
- Secured creditors (e.g., mortgage lenders) are paid first from the sale of properties.
- Unpaid employee wages are settled next.
- Tax authorities receive outstanding tax payments.
- Unsecured creditors (e.g., suppliers and contractors) are paid if funds remain.
- Shareholders receive any remaining assets after all debts are settled.
In another scenario, a structured finance transaction such as a mortgage-backed security (MBS) follows a waterfall payment structure. Senior bondholders receive their payments first, while junior bondholders take on more risk and receive payments only after higher-priority debts are satisfied.
An example of a priority of payments clause
Here’s how a priority of payments clause might appear in a loan or structured finance agreement:
“All payments received under this Agreement shall be distributed in the following order of priority: (i) administrative and servicing fees; (ii) principal and interest payments to senior lenders; (iii) payments to subordinated lenders; and (iv) residual distributions to equity holders. No payments shall be made to lower-tier creditors until obligations to higher-tier creditors have been fully satisfied.”
Conclusion
Priority of payments establishes a clear hierarchy for fund distribution in financial agreements, insolvency cases, and structured transactions. It protects creditor rights, ensures compliance with contractual obligations, and minimizes legal disputes over payment allocation. Businesses and investors must understand payment priorities to assess risks and financial recoveries effectively.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.