Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which statement regarding the bankruptcy process is CORRECT?

1. In a Chapter 7 bankruptcy, a reorganization occurs to enable the firm to continue as a going concern after bankruptcy.

2. Holders of senior collateralized debt are paid, then non-collateralized debt holders, followed by junior debt holders and shareholders.

3. In a Chapter 11 bankruptcy, liquidation occurs with proceeds from asset sales distributed to stakeholders.

4. Holders of senior secured debt are paid, then junior debt holders, then unsecured debt holders, preferred shareholders, and common shareholders.

The correct answer is: Holders of senior secured debt are paid, then junior debt holders, then unsecured debt holders, preferred shareholders, and common shareholders.

In a bankruptcy process, the order of payment to creditors is influenced by the legal priority assigned to different classes of debt holders and stakeholders. The statement regarding the hierarchy of payment during bankruptcy proceedings accurately reflects this priority. When a firm is involved in bankruptcy, particularly during Chapter 7 (liquidation) or Chapter 11 (reorganization), creditors are paid in a specific sequence based on their claims. Senior secured debt holders have the highest priority because these debts are backed by collateral, which provides a level of security in case of default. Following them are junior debt holders, who do not have the same level of claim to the company’s assets but are paid before any equity holders. After all creditors are settled, the remaining amounts, if any, are distributed to preferred shareholders before common shareholders. This hierarchy of payments is critical for understanding the risks associated with investment in different classes of debt and equity. The structure ensures that those most exposed to default risk are compensated first, thereby protecting the interests of creditors who hold positions of greater security.