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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A hedge fund manager is considering buying the senior secured bonds of a company that has just filed for Chapter 11 protection. Which statement best describes the principle governing how claims are treated in the reorganization plan?

The absolute priority rule states that senior claims must be paid in full before junior claims receive value. Actual reorganization plans can deviate through negotiation, but seniority remains the benchmark for recoveries, so secured and senior creditors generally recover more than junior creditors and equity.

  1. AEquity holders are paid before unsecured creditors if they agree to the plan
  2. BThe absolute priority rule requires senior claims to be paid in full before junior claims receive value, subject to negotiated deviationsCorrect
  3. CAll creditors receive the same recovery percentage regardless of seniority
  4. DJunior creditors are always paid first because they bear the most risk

Explanation

Absolute priority means senior claims are satisfied in full before junior classes receive anything. In practice, plans often deviate through negotiation, but the rule is the benchmark. Equal recovery across classes contradicts the seniority structure.

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