Customer bankruptcies are inevitable. In 2012 alone, there were over 40,000 business bankruptcies filed with the United States Bankruptcy Courts. Thus, lenders must be proactive to prevent a bankruptcy from becoming a major write off.

Managing risk is a balancing act, but no matter how good you are at it, there will always be instances where the scale tips and the borrower must liquidate its assets to settle its debts. A good lender knows how to prepare for this worst-case scenario by securing the best spot in the asset distribution line.

The United States Courts Bankruptcy Code outlines how a business’s assets are distributed or secured after it files bankruptcy.  At the front of the line are the secured creditors, or those who established a security interest with the debtor at the time of credit extension. At the back of the line are the unsecured creditors.

Knowing the differences between the two groups and how the asset distribution process works gives creditors the best chance to avoid walking away from a bankruptcy empty-handed.

In almost all cases, the senior secured lender (e.g., the bank or asset-based lender) will get paid before any other creditor because the lender is in a first position in the line of UCC1s filed. The lenders will typically be paid in full or paid the debtor’s remaining cash.

There is a common misconception that lenders receive preferential treatment during a liquidation, when in fact they must get in line like any other secured creditor. The difference is that the lender typically secures the front spot in line because it is the entity that extends the initial capital loan for the business. Lenders will have the customer sign a security agreement when the loan is granted before any other creditor has the opportunity to become secured, putting the lender at the front of the line to get paid. They do not receive preferential treatment; they are simply the first to extend credit and secure their interest. If there are other lenders with a UCC1 filing before the secured lender, then the two lenders will need to have an inter-creditor agreement in place which will detail who is in first on the assets of the borrower.

After the lender has been paid in full, the remaining secured creditors are next in line. A secured creditor is a creditor that has obtained some form of security interest through a blanket UCC-1, a purchase money security interest filling, or a consignment filing. Payment distribution priority is determined by who filed a UCC-1 first. Creditors who file closer to the lender’s original UCC-1 filing will get paid before those who become secured closer to the bankruptcy filing.

The first step in becoming a secured creditor is to create a security agreement and include it as part of the credit application process. The security agreement defines the transaction terms and creates a secured interest. After obtaining a signed security agreement from the customer, a finance statement must be filed with the appropriate Secretary of State office in the form of a UCC-1 filling. The UCC-1 filing will perfect your security and establish priority rights over future secured creditors.

Secured creditors can also choose to file a purchase money security interest, which gives them priority on reclaiming the physical goods they sold to their customer. In case of bankruptcy, the creditor will be able to take back their goods from the customer to satisfy a portion of the debt. Purchase money security interest filings are an exception to the “bank gets paid first” rule, as creditors will be able to obtain their goods before the trustee liquidates the assets.

If there is any money left after the secured creditors are paid, the remainder goes to the unsecured creditors (e.g., vendors).  Unlike secured creditors, payment distribution priority for unclaimed creditors is not based on your spot in line, but rather whether or not you have a priority claim. The United States Courts Bankruptcy Code Chapter 11 Section 507 defines ten claim types in which unsecured creditors receive priority over unsecured creditors who are not considered priority claims. If there is any money left after priority unsecured creditors receive their payment, it is split in equal amounts among the rest of the unsecured creditors. However, those who do not file a proof of claim after the bankruptcy filing are not eligible to receive any assets.

Now the picture is clear why a secured lender is so adamant about having a UCC1 filing in a first position on a borrower’s assets. It all about getting paid out when things don’t go as planned.