Priority of Claims

When a borrower fails, there is rarely enough money for everybody. So the money is not shared out. It is paid down a queue, and the queue is fixed in advance.

Your place in that queue is worth more than the interest rate you negotiated. A lender at the front may be paid in full. A lender two places back may get nothing at all, from exactly the same sale of exactly the same asset.

The workbook sets the queue out in four bands. Secured debt goes first, ranked among itself by how senior its charge is. Unsecured debt comes next, and is paid only once every secured claim is settled in full. Then preference capital. Equity is last, and takes only what is left.

This is why an AIF that lends cares so much about security. It is not buying a rate. It is buying a place in a queue.

Table 6.1 gives the ranking as a numbered list, and the numbering itself is examinable.

1. Secured senior debt has the first and highest claim on the borrower. Within all secured debt, priority is settled on the basis of the seniority of the charge created — first and paramount charge, then second charge, then onwards. Senior debt's first charge is what lets its lenders negotiate better terms and expect a better outcome in a resolution or liquidation.

2. Secured sub-ordinated debt ranks next, and again the order inside that band is decided by seniority of charge. The workbook's definition of sub-ordinate debt is charge-based: all borrowings that rank less than secured debt with first charge, so second or any subsequent charge.

3. Unsecured debt ranks lowest among all debt and is paid out only after claims of all secured debt is satisfied in full. Unsecured means no fixed charge, no floating charge and no lien.

4. Then capital. The table's closing note does the rest: all debt claims, secured or not, have priority over preference capital, which in turn ranks higher than equity capital. Equity has only a residual claim on the company, after preference shareholders have been satisfied in full.

Two refinements sit inside band 1 and band 2. Where several lenders want the same level of charge, one pari passu charge is created over the same pool and none of them outranks the others. Where two same-level charges are separate, the one registered first ranks senior. And a floating charge does not take effect until crystallised; on crystallisation an existing fixed charge on the same assets takes priority over it.

The workbook attaches no figure to any of this. Table 6.1 has no threshold, no minimum security cover and no recovery percentage. The ranking is entirely by rank of charge and by secured-versus-unsecured status. Where the paper does give numbers around debt, they belong to other rules — the 51% that defines a control interest, for instance, is about management control, not about priority.

Chambal Steel Ltd goes into liquidation. Illustrative rupee figures. Its funding stack:

Case A — the plant realises Rs 500 crore.

Bank term loan (first charge)    Rs 320 cr  paid in full      balance Rs 180 cr
AIF NCDs (second charge)         Rs 150 cr  paid in full      balance Rs  30 cr
Unsecured ICDs                   Rs 100 cr  gets Rs 30 cr     = 30% recovery
Preference capital               Rs  60 cr  nothing
Equity                                      nothing

Case B — the plant realises only Rs 400 crore.

Bank term loan (first charge)    Rs 320 cr  paid in full      balance Rs 80 cr
AIF NCDs (second charge)         Rs 150 cr  gets Rs 80 cr     = 53% recovery
Unsecured ICDs                              nothing - all secured debt
                                             is not yet satisfied in full
Preference capital / Equity                  nothing

Rs 100 crore less on the sale costs the bank nothing and costs the AIF Rs 70 crore. Same asset, same default, different place in the queue. That, and not the coupon, is what the AIF was pricing when it accepted a second charge.

Had the AIF instead taken a first charge pari passu with the bank, both would have sat in one pool of Rs 470 crore of claims against Rs 400 crore of realisation, and neither would have been paid ahead of the other.

Chapter 6 (Risk and Return — Investor and Fund Perspective), section 6.2 and Table 6.1, which the workbook titles Primer on Priority of Debt Claims. It is the densest vocabulary block in the paper's debt half, and it is set as ordering questions: which ranks lowest among all debt (unsecured), what decides priority within secured debt (seniority of the charge created), does preference capital rank above or below unsecured debt (below — all debt outranks preference capital).

Chapter 8 then turns the same material into a due diligence question for debt funds: the questionnaire asks for the security structure for all the deals: senior/ junior, security cover, cash escrow, NOC requirements, and for the fund's debt resolution strategy. Chapter 6 also warns that in AIF debt the recovery value of such debt protections are sub-optimal in many situations, and that resolutions bring delay and litigation — a place in the queue is not the same as cash.

• A secured second charge is already sub-ordinate debt in this workbook. XIX-A defines sub-ordinate debt as all borrowings that rank less than secured debt with first charge. The published Subordinated debt page, written from a fixed-income paper, treats senior-versus-subordinated and secured-versus-unsecured as two separate axes. Both are right about their own paper. In XIX-A, answer from the charge.
• Unsecured debt still outranks preference capital. The tempting wrong answer is that a shareholder of any kind beats an unsecured lender. All debt claims come first.
• Equity is residual, and residual means after preference shareholders too — not merely after lenders.
• Priority within a band is by seniority of charge, not by size, age or interest rate.
• XIX-A's table stops at debt, preference capital and equity. The published Residual claim page, from another paper, describes a longer statutory queue that also puts government dues and employees ahead of equity. Do not import that list into a XIX-A answer; answer from Table 6.1.
• Security is not recovery. The same chapter says recovery values on debt protections are often sub-optimal, and that a borrower in distress can make the carrying cost of the debt extremely high.