How does the 'absolute priority rule' function in bankruptcy?

The 'absolute priority rule' in bankruptcy is a fundamental principle that establishes the order in which claims are to be satisfied in a liquidation or a reorganization. This rule dictates that creditors are prioritized according to the seniority of their claims. In essence, it ensures that senior creditors, who have a higher claim on the assets of the distressed entity, are paid in full before any payments are made to junior creditors.

This principle is critical as it upholds the notion of fairness and predictability in bankruptcy proceedings. By adhering to the hierarchy of claims, senior creditors can have more confidence that they will receive compensation for their investments before lower-priority creditors, thus encouraging lending to companies because it reduces the risk associated with credit extensions.

During bankruptcy proceedings, junior creditors, such as unsecured creditors, typically receive a payment only if there are sufficient assets left after senior creditors are paid. This framework helps maintain order and provides a clear process for claims resolution, ultimately supporting a more stable financial environment during and after the restructuring process.