What is ‘Liquidation’
In finance and economics, liquidation is an event that usually occurs when a company is insolvent, meaning it cannot pay its obligations as and when they come due. The company’s operations are brought to an end, and its assets are divvied up among creditors and shareholders, according to the priority of their claims. Chapter 7 of the U.S. Bankruptcy Code governs liquidation proceedings; solvent companies can also file for Chapter 7, but this is uncommon. Not all bankruptcies involve liquidation; Chapter 11, for example, involves rehabilitating the bankrupt entity and restructuring its debts.
BREAKING DOWN ‘Liquidation’
Liquidation is the process of bringing a business to an end and distributing its assets to claimants. Once the process is complete, the business is dissolved. This is not the same as its debts being discharged, as happens when an individual files for Chapter 7. The debts still exist in theory, at least until the statute of limitations has expired, but there is no debtor to pay them, so they must be written off in practice.
Assets are distributed based on the priority of various parties’ claims, with a trustee appointed by the Department of Justice overseeing the process. The most senior claims belong to secured creditors, who have collateral on loans to the business. These lenders will seize the collateral and sell it—often at a significant discount, due to the short time frames involved. If that does not cover the debt, they will recoup the balance from the company’s remaining liquid assets, if any.
Next in line are unsecured creditors>. These include bondholders, the government (if it is owed taxes) and employees (if they are owed unpaid wages or other obligations). Finally, shareholders receive any remaining assets, in the unlikely event that there are any. In such cases, investors in preferred stock have priority over holders of common stock.
Liquidation can also refer to the process of selling off inventory, usually at steep discounts. It is not necessary to file for bankruptcy to liquidate inventory.
Trading: Liquidating A Position
Liquidation can also refer to the act of exiting a securities position. In the simplest terms, this means selling the position for cash; another approach is to take an equal but opposite position in the same security, for example, by shorting the same number of shares that make up a long position in a stock. A broker may forcibly liquidate a trader’s positions if the trader’s portfolio has fallen below the margin requirement or she has demonstrated a reckless approach to risk-taking.