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The absolute priority rule is a rule which insists that a creditor's claim have an absolute priority over a shareholder’s claim. This rule is invoked during the liquidation of assets (assets are converted into cash) of a business entity. This happens especially when an entity files a bankruptcy petition in a bankruptcy court. According to the absolute priority rule, the investors are compensated only after the claims of the creditors are settled to the satisfaction of the bankruptcy court.
The absolute priority rule requires payment in full to a senior class of creditors before any payments can be made to junior interests. The rule only arises when a court confirms a plan over the objections of a class that the plan is not fair and equitable.
The "new value exception" which originated in Case v. Los Angeles Lumber Co., 308 U.S. 106 (1939) is a court-made exception to the absolute priority rule which permits persons to retain an equity interest despite the unpaid claims of senior creditors if they contribute money or money's worth to the reorganized enterprise. Although the exception has been recognized since 1939, it has not often been applied.
The Absolute priority Rule is also invoked for the settlement of estates after the death of the owner.