What Is a Junior Security?
Let me explain what a junior security is. It's a type of security that ranks lower in priority than others. In simple terms, if you're holding a junior security, you're subordinate to holders of senior securities. This means you only get paid after they do if the company goes bankrupt or gets liquidated. There's a real chance you might not get repaid at all, or only partially, once the leftover cash is distributed.
Key Takeaways
- Junior securities have a lower priority of claim on assets or income compared to senior securities.
- Common shares are forms of junior securities whereas bonds are deemed senior securities.
- After senior securities are paid, any leftover cash is divided among junior security holders.
- In normal circumstances, junior security holders enjoy a greater reward than other, more senior issues.
- Junior security holders carry greater risk because they may either receive some or none of their investment back in the case of default.
Understanding Junior Securities
When a company declares bankruptcy or is liquidated, every stakeholder wants to recover as much of their investment as possible. But there are strict rules that dictate the order of repayment based on security seniority. You need to know that some securities are senior and others are junior, and this order is fixed.
Junior securities, like common stock, sit lower on the repayment ladder. Senior securities are at the top and are the safest, so their holders get paid first. Think of bonds, debentures, bank loans, and preferred shares as common senior securities.
The repayment process hinges on the company's capital structure. In bankruptcy, secured and unsecured creditors come before stockholders. Bondholders and secured lenders usually get paid first, and only then does any remaining cash go to junior holders. Sometimes, some common shareholders might get a bit back, but others could get nothing.
This prioritization exists because not all securities have the same risk-reward balance. For example, corporate bondholders might get a 3.5% interest rate in today's market, while shareholders could see unlimited upside and dividends. Bondholders accept lower returns, so they get lower risk through priority in default scenarios. That's why they're ahead of shareholders if things go wrong.
Important Note on Absolute Priority
The system for ordering repayments in bankruptcy follows the principle of Absolute Priority, outlined in Section 1129(b)(2) of the U.S. Bankruptcy Code. It's also known as the liquidation preference principle, ensuring a structured and fair distribution.
Example of a Junior Security
Let me walk you through a hypothetical example to illustrate how junior securities function. Suppose you own a manufacturing company called XYZ Industries. To start it, you raised $1 million from shareholders and took a $500,000 mortgage for factory real estate. You also got a $500,000 line of credit for working capital.
Now, looking at your balance sheet, you've maxed out the line of credit and have $350,000 left on the mortgage. After selling all equipment and assets, you raise $900,000.
You have to pay senior creditors first—the bank for the mortgage and line of credit. From the $900,000, $350,000 covers the mortgage, and $500,000 goes to the line of credit. That leaves $50,000 for your shareholders, who hold common shares as junior securities and are last in line.
This means a 95% loss for shareholders, which is tough, but remember: if the business succeeded, their ROI could have been unlimited. That's the risk they took when investing.
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