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Difficulty: Very hardGovernment, Municipal, and Corporate Bonds

A corporate issuer undergoes Chapter 7 bankruptcy liquidation. A holder of the company's first mortgage bonds receives a distribution from the liquidation of the specific real estate collateral, but the proceeds cover only 70%70\% of the bond's outstanding principal value. Regarding the remaining 30%30\% unpaid principal balance, which of the following statements correctly describes its standing in the liquidation hierarchy?

  1. It becomes a general unsecured claim, ranking equally with general debentures in the distribution of remaining unpledged assets.Answer
  2. B
    It retains absolute priority over all general debentures and must be fully paid before any general unsecured creditors receive distributions.
  3. C
    It is subordinated to subordinated debentures because the collateral securing the loan was insufficient.
  4. D
    It is completely discharged and canceled, leaving the investor with no legal claim on the remaining unpledged assets.

Answer

The remaining unpaid principal balance becomes a general unsecured claim, ranking equally with general debentures in the distribution of remaining unpledged assets.
In a corporate liquidation, secured creditors have a priority claim only up to the realization value of their specific pledged assets. When pledged collateral is sold and yields less than the total outstanding principal, the remaining unsatisfied portion (deficiency balance) converts into a general unsecured claim. This deficiency claim ranks equally (pari passu) with other general unsecured claims, such as general debentures, and ahead of subordinated debentures and equity holders.

Step-by-Step Solution

1
Identify the initial status of the debt instrument.
The bondholder holds a secured first mortgage bond backed by specific real estate collateral.
Secured bondholders have a primary claim against pledged assets.
2
Evaluate the liquidation proceeds of the pledged collateral.
The real estate proceeds satisfy 70%70\% of the outstanding principal, leaving a 30%30\% unpaid deficiency balance.
Secured status only protects principal up to the net realizable value of the underlying collateral.
3
Determine the priority standing of the collateral deficiency balance.
The unsatisfied 30%30\% balance loses secured status and becomes a general unsecured claim.
Under corporate bankruptcy liquidation hierarchy, any collateral shortfall converts into general unsecured debt, sharing pro-rata with general debentures.

Key Concept

Corporate Debt Liquidation Hierarchy and Secured Collateral Deficiency Claims
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Topics

Government, Municipal, and Corporate Bonds

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