Pari-Passu
This clause is famous in contracts that create a debt obligation on the party against many creditors.
What is Pari-Passu?
Pari-Passu is a Latin phrase. To break down the meaning, the Pari ablative form of par means 'equal,' and Passu represents 'step.' Therefore, when the term is loosely translated into English, it means "with equal steps."
In the dictionary of financial and legal terms, the clause refers to parity among creditors. This term is generally incorporated in contractual texts to protect the interest of creditors when the debtor has borrowed assets from more than one party.
This clause is famous in contracts that create a debt obligation on the party against many creditors. It ensures that two or more financial assets, debt obligations, etc., are given equal preference. No creditor or investment should be ranked over the others.
It can be used to describe contracts involving various financial instruments like loans, bonds, and wills and to maintain equality among creditors and shareholders. It is also used in the real estate sector for waterfall distributions and at the time of bankruptcy.
Courts of the world, when judging cases about violation of the clause, have made broad interpretations to decide. Nevertheless, there have been mistakes made in the past, due to which there is still certain ambiguity associated with the term.
How does it work?
Pari-Passu is a standard clause used to express equal seniority or rank of any party associated with a financial contract. It is a clause often added in contracts revolving around instruments like loans, bonds, shares, etc.
It allows financial parties to claim equal rights over a financial product. Parties trying to ouster other parties can be stopped through such parity clauses in the contracts. The clause ensures that every party gets equal importance.
In some cases, some parties do have privileges. Following are the instruments and circumstances where the clause is added:
1. Equity Shares
In the case of equity shares, every equity share is equivalent in value to previously issued shares. Therefore, the stakes are equal in rank and are Pari-Passu with each other. Along with equity shares, shareholders are at par with each other.
All the shareholders have parity with each other. This can be established as all the equity shareholders of one company enjoy the same rights and privileges. All shareholders are equivalent. Each has the right to claim dividends, voting rights, etc.
2. Creditors
When the company has more than one creditor, the parity clause becomes standard and imperative so that companies cannot give more or less importance to any specific creditor due to personal bias.
Creditors will be paid before shareholders. Therefore, the clause does not exist between shareholders and creditors. However, each creditor should be given equal significance, and if one creditor's loan is being repaid, then every creditor should be reimbursed.
Not all creditors can be associated with this clause. At the time of bankruptcy, a specific order of repaying Debt is predetermined. Banks are another exception to the list of creditors falling under this clause.
3. Wills and Trusts
The parity clause can also be added to wills and trusts. For example, if a will that states specific criteria for the distribution of wealth does not exist, then this clause can be added so that every named party can be allotted equal wealth.
4. Real Estate
Pari-Passu clauses can also be added to real estate contracts. It is instrumental in Commercial Real Estate (CRE) during windfall distributions. Windfall distributions are the gains earned on an investment property.
The parity clause ensures that the profits are distributed equally among all the investors. This means that neither any investor should be given more importance nor given fewer returns than other investors for any reason whatsoever.
5. Asset Management
This clause is applicable internally in a company as well for all the assets owned by the company. A company having multiple assets cannot afford to pay less attention to a few assets compared to others.
All the assets are given equal weightage. For example, work, attention, and financial resources may be allotted pro rata. However, the management will provide all the assets in the same value bracket with equal importance.
6. Identical Products
Products with similar fundamental properties and pricing are identical. They may have superficial differences but more or less offer the same value to the customers. Therefore, such products are pari-passu to each other.
Pari-Passu and Unsecured Debts
Unsecured Debt refers to debt obligations that require no collateral backing. They are usually between parties with an existing fiduciary relationship, small business people, and local lenders. These are also the reasons behind the high interest charged on unsecured debts.
Due to their nature and characteristics, unsecured debts are not equivalent to other obligations and borrowings. Since there is no collateral backing, the rate of borrowers' default is very high in these cases.
Because of unsecured Debt, the parity bond (also known as Pari-Passu Bond or side-by-side bond) becomes very important. A parity bond refers to all the bonds with equal seniority and claim rights. However, unsecured bonds will still not be considered as necessary as secured bonds.
So, all secured bonds can be considered parity bonds with each other due to the clause. Similarly, all the unsecured bonds will be referred to as parity bonds with each other. Secured bonds will not be compared with unsecured bonds in any case.
Parity bonds are the opposite of senior lien or junior lien bonds (subordinate bonds). An old lien bond holds authority over a junior lien bond. It means an unsecured bond will be considered a junior lien bond, and a secured bond will be considered a senior lien bond.
Example of Pari-Passu
The clauses can be used in different agreements in different sectors. It ensures the protection of the interest of each party involved in any contract. The clause can be added to a contract requiring the involvement of two or more parties.
Following are a few instances:
1. In Real Estate
Suppose the investment is $1 million for a real estate joint venture partnership. If there are 10 investors and each has to contribute, then due to the parity clause, each investor will have to invest $1 million divided by 10, i.e.$100,000. ($1 million/10)
This clause is applicable at any time, not only when the investment is made. It can also be applied to distribute returns equally. For example, every ten investors will receive $20,000 as their portion of the profit if the identical asset is later sold for a $200,000 profit.
The parity provision, in this case, binds all investors. As a result, every investment received the same return.
If not, the division of profits would be pro-rata and equal $200,000*investor investment/total investment.
2. Parity Bonds
Suppose a company has taken a loan of $10,000 and has sanctioned a coupon to the party from whom the amount has been borrowed. The coupon rate is 7%, meaning the bond will pay $700 to the party yearly.
Suppose the company then takes another loan with a coupon rate of 5% ( i.e., the company will have to pay $500 every year to the bondholder) while the previous loan has not been paid in full.
Note both coupons are issued as parity bonds. The parity clause stipulated in both bonds will ensure that no glue is given more importance in any circumstance.
Both will be ranked equally and should be given equal preference at the time of repayment.
Pari-Passu and Sovereign Debt Instruments
For decades sovereign debt cases were looked at as cases that were above the law and could be handled solely by negotiation. However, the world is changing, and with it, its rules. As a result, creditors have managed to be in a better position in such cases.
Cases in the recent past are testimonies to the fact that sovereign immunity is diminishing with time. As a result, the legal perspective has changed towards such cases. But, more importantly, creditors have realized their fighting chance and made these laws enforceable in such cases.
Many have considered the pari-passu clause to be redundant in sovereign debt cases. However, a few cases have brought this clause into the limelight time and again due to the broad interpretation made of the clause.
The first incidence in which the parity clause's meaning was broken down was in 2000 in Elliott Associates LP V Republic of Peru. This was the first time the creditor reached the court's door to seek a decision favoring the creditor based on a clause violation.
Elliott Associates LP was one of the holdout creditors to whom the Republic of Peru had refused to meet its debt obligations. The claimant then gets restraining orders from the courts of each country where the government possessed assets based on violating the pari-passu clause.
The first restraining order from the Brussels Court of Appeals helped Elliott Associates LP prevent the Republic of Peru from clearing its debt obligations towards other parties. According to the initial debt contract, all creditors were on par with each other.
That implied no creditor could be given more importance than Elliott. Therefore, if Peru is repaying any debt obligations, it should meet all its debt obligations or distribute the amount among creditors according to the amounts borrowed from each creditor.
Because of the restraining order, Peru defaulted on its bonds and tried to find an alternative by repaying the other parties through different options. However, Elliott turned it into a hot pursuit and went to every country to get a restraining order from different countries and authorities.
This exhausted all the options Peru had to repay other creditor parties. This series of litigation forced Peru to Repay Elliott. The final settlement was agreed on $58.45 million, and only then could Peru meet its other debt obligations as well.
This was the first time a creditor could have such a stronghold over the debtor in sovereign debt cases. But unfortunately, it happened only because of Belgium's loose interpretation of the clause, which further created a lot of ambiguity and conjecture about it.
Argentine Litigation
The previous case was filed in the Brussels Court of Appeals. However, the court interpreted the meaning of the pari-passu clause based on New York Law. So, when NMT Ltd. V Republic of Argentina was filed, it was assumed that a new interpretation of the clause would be released.
Unfortunately, it did not happen, and the court interpreted the clause along the same lines. The case is now considered a significant missed opportunity to clarify any ambiguity related to the clause. It was embarrassing for Argentina as a gaffe dramatically turned the tables.
NML Ltd brought this litigation as one of the creditors who refused to exchange its old bond with a new bond under the 'most favored creditor clause' (MFCC). Unfortunately, while drafting the MFCC, the word 'settlement' was omitted unintentionally.
To rectify this mistake, Argentina added a 'lock law' to the contract stipulating that the state would not entertain all the holdout creditors who refuted the new offer. Due to this clause, holdout creditors were put at an inferior rank to other creditors.
Argentina mentioned that they were not in a 'legal position' to pay the holdout creditors due to the lock law, which became the basis for the court's judgment that creditors had been discriminated against and the pari-passu clause had been violated.
After the addition of the Lock law, New York could have been open to interpreting the clause in a narrower term. However, they chose against it and continued making broad interpretations of the house, just like Belgium's court.
As New York is the financial hub, this decision has put them at a crossroads. If they continue with this interpretation, a debt repayment structure with the backing of the IMF seems impossible. But, on the other hand, if they disallow such claims, it will be unfair to the creditors.
Conclusion
Pari-passu is a standard clause that protects the rights of any creditors. It ensures that if parity clauses are added to the contracts, no creditor is discriminated against for any reason. It can be used in more cases than just debt collection from debtors.
It is used in real estate gains, wills, trusts, parity bonds, equity shares, identical products, etc. As the meaning (of Equal Footing) suggests, this clause ensures that all parties are treated equally and each party is given equal rights to one another.
Parity clauses can also be added to unsecured debt obligations. However, since unsecured debts have no asset backing, the chances of the debtor defaulting are very high. Therefore, the parity clause comes to the rescue of all the creditors.
It is worth mentioning that although parity means equality, there are cases when even after the clause, some creditors are held above others. For instance, many cases provide banks with a higher rank than other creditors.
Unsecured debt bondholders are in parity with only other unsecured debt bondholders. They will consistently be ranked lower than secured bondholders due to the lack of collateral backing. However, in sovereign debt cases, there is still ambiguity associated with the clause.
Courts are still at a crossroads when the violation of the clause is discussed in sovereign debt cases. Too many laws are considered, due to which providing equal treatment to all creditors can be complicated.
Some economists have believed that the clause is utterly redundant in such cases. Some say better, narrower interpretations can be made.
Anyway, it has helped give the creditors voice in such cases. The earliest example is the Elliott case.
There might be ambiguity and interpretation of the clause regarding sovereign debt cases. However, it is still a handy clause in other matters with less complexity. It protects the rights of creditors to a great extent.
Researched and authored by Priyansh Singal | LinkedIn
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