Liquidation Priority

True or False: In the liquidation of a limited partnership, distributions are made first to partners in proportion to their capital contributions, and only afterward to the partnership's creditors.

1. A.True.Wrong. This reverses the actual priority; creditors are paid before partners receive any return of capital in liquidation.
2. B.False.Correct. Creditors are paid ahead of partners' capital return in the standard liquidation priority.

Why: Liquidation priority follows creditors before owners, the same hierarchy that applies in most business liquidations: the partnership's outside creditors, and partners who are also creditors in that separate capacity, are paid first, followed by partners' return of capital and any remaining profit distributions according to the partnership agreement. Reversing that order would mean partners could effectively be repaid using money still owed to creditors, which is exactly what liquidation priority rules are designed to prevent.

A limited partnership is being liquidated. After paying off all outside creditors, funds remain. The general partner expects to receive her share of what remains before the limited partners recover their capital contributions, reasoning that she managed the program and bore unlimited liability throughout. Is this the standard liquidation priority?

1. A.Yes, general partners are always paid before limited partners in a liquidation, in recognition of their unlimited liability.Wrong. Unlimited liability does not translate into first-priority payment in liquidation; general partners are typically subordinated to limited partners' capital return.
2. B.Yes, but only if the general partner personally guaranteed partnership debt during the program's operation.Wrong. Whether the general partner personally guaranteed debt does not change the standard subordination of the general partner's liquidating distribution to the limited partners' capital return.
3. C.No, all partners, general and limited, are paid simultaneously and proportionally regardless of contribution or class.Wrong. Distributions are not simply pro rata across all partner classes; limited partners' capital return typically has priority over the general partner's liquidating distribution.
4. D.No -- the standard priority typically returns limited partners' capital contributions before the general partner receives a liquidating distribution, subordinating the general partner's interest to the limited partners' return of capital.Correct. Limited partners typically recover their capital contributions before the general partner receives a liquidating distribution, subordinating the general partner's interest.

Why: After outside creditors are paid, the usual liquidation priority calls for limited partners to receive a return of their capital contributions, and often any stated preferred return, before the general partner receives a liquidating distribution. This subordinates the general partner's interest to the limited partners' capital recovery, which is broadly consistent with the general partner's role as the party bearing unlimited liability and receiving compensation for managing the program over its life, rather than being first in line for a return of capital that was never the general partner's own money in the same way.

A corporation is liquidated. Rank the priority of payment among: subordinated debentures, senior secured bonds, general creditors, and preferred stock.

1. A.Senior secured bonds, general creditors, subordinated debentures, preferred stockCorrect. That is the statutory and contractual waterfall.
2. B.Preferred stock, senior secured bonds, general creditors, subordinated debenturesWrong. Equity NEVER precedes creditors.
3. C.Subordinated debentures, senior secured bonds, preferred stock, general creditorsWrong. Subordination pushes those debentures BEHIND other debt, not ahead.
4. D.All claims share pro rata in liquidationWrong-but-tempting. Pro rata sharing occurs only WITHIN a class, not across classes.

Why: Secured claims collect from their collateral first; unsecured creditors and ordinary debentures come next; subordinated debentures contractually stand behind other debt; equity (preferred, then common) takes the residue. Citation: corporate liquidation priority. Takeaway: secured, unsecured, subordinated, preferred, common.

Ellsworth Manufacturing enters bankruptcy. Its capital structure includes a first mortgage bond secured by the plant, an unsecured debenture, a subordinated debenture, and preferred stock. After the secured claim is satisfied from the plant, which of the remaining three is paid FIRST?

1. A.All three share the remaining assets pro rata, because none of them holds specific collateral.Lack of collateral does not equalize claims. Contractual subordination and the debt-before-equity rule both create ranking among unsecured claimants.
2. B.The unsecured debenture, because a subordinated debenture agrees by contract to rank behind other general creditors, and all creditors are paid before preferred stockholders.Correct. Subordination is a contractual demotion below other unsecured creditors, and equity of any kind comes after all debt.
3. C.The subordinated debenture, because subordination refers only to ranking behind the secured bond.Every unsecured claim ranks behind a secured claim on its collateral. Subordination adds a further demotion below the issuer other general creditors.
4. D.Preferred stock, because its fixed dividend makes it the economic equivalent of debt.A fixed payment does not make preferred a creditor claim. Preferred is equity and is paid only after every creditor class.

Why: Two rules stack here. First, all creditors are paid before any equity holder, which puts preferred stock last of the three. Second, a subordinated debenture is one whose holders contractually agreed to stand behind other general creditors, which puts the plain unsecured debenture ahead of it. So the order is unsecured debenture, then subordinated debenture, then preferred stock. Review the liquidation priority material in the debt securities topic.