Junior securities are financial instruments that hold a lower priority in payment relative to other types of investments. In simpler terms, junior security holders are the last to be paid out when a company undergoes bankruptcy or liquidation. Consequently, there’s a significant risk that some, or even all, junior security holders might not be compensated after a company liquidates its remaining assets.
Key Takeaways
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Junior securities stand lower on the priority scale for asset and income claims compared to senior securities.
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Common shares are identified as junior securities, whereas bonds are mostly considered senior securities.
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Any residual cash post-senior security payout is distributed among junior security holders.
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In regular circumstances, junior security holders anticipate greater returns versus senior issues.
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Increased risk accompanies junior securities as holders might potentially receive only partial or even no restitution in default scenarios.
Understanding Junior Securities
Upon a company’s declaration of bankruptcy or liquidation, every stakeholder aims to recuperate the maximum possible portion of their investment. There exists an established hierarchy in the repayment sequence, distinguishing senior securities, which are viewed as the safest investments, from junior securities.
Examples of senior securities include bonds, debentures, bank loans, and preferred shares. Junior securities, such as common stock, get repaid only after these safer financial instruments. Consequently, the corporation’s capital structure decides the repayment order, where creditors holding secured debts are paid first from the proceeds derived from the company’s assets.
Senior securities receive the initial payment, after which the remaining cash is divided among junior security holders. Due to the risk-reward profile disparity among securities—corporate bondholders attract lower returns and therefore assume lower risk compared to shareholders who face indefinite profit potential—a senior status is justified for safer securities.
The Absolute Priority principle details this repayment ordering method during a bankruptcy process as per Section 1129(b)(2) of the U.S. Bankruptcy Code. Hence, it is popularly known as the liquidation preference principle.
Example of a Junior Security
Consider a scenario where you own XYZ Industries, a manufacturing firm. To set up your business, you secured $1 million from shareholders and acquired a $500,000 mortgage for buying real estate to set up your factory. Annually, you organized a $500,000 line of credit from the bank to manage your operational needs.
Upon inspection of your balance sheet, you realize a maximum usage of your line of credit and an outstanding $350,000 mortgage balance remains. Post ongoing liquidation of your assets, you generate a total of $900,000.
You need to allocate the funds to clear your top-priority debts first, which include the bank-provided mortgage and line of credit. From the total $900,000, pay off $350,000 of the mortgage and $500,000 of the line of credit. The remaining $50,000 is distributed among your investors, who fall last in line due to their junior securitized common shares.
Ideally, while this specific incidence results in a drastic 95% loss for the investors, there resides an investment advantage since success scenarios border on infinite ROI potential. This encapsulates the assumed risk confronting the business stakeholders during investment.
Related Terms: senior securities, common stock, debentures, preferred shares, secured debt, capital structure.
References
- The Free Dictionary. “Junior security”.
- Securities and Exchange Commission. “Bankruptcy: What Happens When Public Companies Go Bankrupt”.
- Investing Answers. “Junior Security”.
- CFI. “Junior Security”.
- Thomson Reuters Practical Law. “Absolute Priority Rule”.
- Cornell Law School. “11 U.S. Code § 1129 - Confirmation of plan”.
