Pari passu

What Is Pari Passu?

Pari passu, a Latin phrase meaning "on equal footing" or "with equal step," is a fundamental principle in finance and law stipulating that all parties within a specific class of creditors, obligations, or shares are treated equally, without preference or discrimination⁴⁵, ⁴⁶. This concept is crucial in various financial contexts, including debt financing, bankruptcy proceedings, and the issuance of securities, ensuring fairness and equitable distribution of assets or payments among those with equivalent legal claims. Pari passu is a core tenet within financial regulation and corporate finance.

History and Origin

The pari passu principle originated from equity law, a body of law developed in the English Court of Chancery, which emphasized fairness and conscience. In insolvency law, it ensures the equal distribution of a bankrupt person's or insolvent company's assets among their creditors⁴⁴.

A significant moment highlighting the complexities and interpretations of pari passu clauses in modern finance occurred during Argentina's sovereign debt restructuring following its 2001 default. Holders of defaulted bonds, notably NML Capital, litigated in U.S. courts, arguing that the pari passu clause in their bonds required Argentina to pay them concurrently with or in advance of payments made to holders of restructured exchange bonds. The U.S. Court of Appeals for the Second Circuit broadly interpreted the clause, affirming that Argentina was prohibited from paying its restructured bondholders unless it also paid the holdout creditors in full⁴¹, ⁴², ⁴³. This case spurred international discussion and led the International Monetary Fund (IMF) to propose "modified pari passu clauses" in new international sovereign bonds to clarify that issuers are not required to pay creditors on an equal or ratable basis, thereby aiming to enhance legal certainty and consistency across jurisdictions and address potential "holdout" problems in future debt restructurings.³⁸, ³⁹, ⁴⁰

Key Takeaways

• Pari passu means "on equal footing" or "with equal step" in Latin, signifying equal treatment for parties within a class.
• It is a core principle in financial contexts such as bankruptcy, syndicated loans, and bond issuances.
• The principle ensures that no single creditor or shareholder within the same class receives preferential treatment over others.
• Its application can be complex, particularly in sovereign debt restructurings, leading to varied interpretations and legal disputes.

Interpreting the Pari Passu Principle

The pari passu principle dictates that all claims within a specified class are treated equally in terms of priority and payment³⁷. This means that if a company is liquidating, all creditors in the same seniority level would receive a proportional share of the available assets, rather than one being paid in full before others receive anything. For example, in a bankruptcy scenario, if unsecured creditors are deemed pari passu, they will all receive payments simultaneously and proportionately to their claims, after any secured creditors have been satisfied³⁵, ³⁶.

In corporate finance, the application of pari passu ensures fairness among various stakeholders. For instance, new equity shares issued in a secondary offering are typically pari passu with existing shares, granting all shareholders equal rights to dividends and assets in the event of liquidation³⁴.

Hypothetical Example

Consider a hypothetical company, "Alpha Corp," that faces financial distress and enters liquidation. Alpha Corp has two main types of debt:

• Secured bank loans totaling $5 million.
• Unsecured bonds issued to various investors totaling $10 million.

After selling its assets, Alpha Corp has $7 million available for distribution.

Step 1: Pay Secured Creditors
The $5 million in secured bank loans must be paid first, as secured debt has priority.
Available funds after secured creditors: $7 million - $5 million = $2 million.

Step 2: Apply Pari Passu to Unsecured Creditors
The remaining $2 million must be distributed pari passu among the unsecured bondholders, who are owed $10 million. Since they are on equal footing, each bondholder will receive a proportional share of the remaining funds.

The recovery rate for unsecured bondholders is:
$\text{Recovery Rate} = \frac{\text{Available Funds for Unsecured Creditors}}{\text{Total Unsecured Debt}} = \frac{\$2,000,000}{\$10,000,000} = 0.20 \text{ or } 20\%$

Therefore, each unsecured bondholder will receive 20% of their original claim. If an investor held $100,000 in Alpha Corp's unsecured bonds, they would receive $20,000. This example illustrates how the pari passu principle ensures equitable treatment among creditors of the same class during asset distribution.

Practical Applications

Pari passu clauses are widely applied across various financial and legal domains to ensure fair and equal treatment.

• Lending Agreements: In syndicated loans or other multi-creditor arrangements, pari passu clauses ensure that all lenders within the same tranche of debt have equal rights to collateral and repayment³², ³³. This prevents any single lender from gaining preferential treatment.
• Bond Issuances: Companies and governments often include pari passu clauses in bond indentures. This means that all bonds of a particular class (e.g., all unsecured bonds) rank equally in terms of payment priority and claims on assets³¹.
• Bankruptcy and Insolvency: The pari passu principle is fundamental in insolvency law, guiding the distribution of assets to creditors³⁰. Unless specific legal exceptions or secured claims exist, all unsecured creditors within a class are treated equally and receive a proportionate share of available funds²⁹.
• Corporate Actions: In scenarios like mergers and acquisitions or restructuring, pari passu might dictate how equity holders are treated, ensuring that all shares of a given class maintain equal rights regarding voting, dividends, or liquidation proceeds²⁸.
• Sovereign Debt: As demonstrated by the Argentina debt crisis, pari passu clauses in sovereign bonds have significant implications for international finance and debt restructuring. The interpretation of these clauses can influence how "holdout" creditors are treated versus those who agree to restructuring terms²⁶, ²⁷. The International Monetary Fund (IMF) has been actively involved in discussions and proposed reforms to clarify the meaning and application of these clauses in sovereign debt contracts to prevent future complications and enhance stability in global financial markets.²⁴, ²⁵

Limitations and Criticisms

While the pari passu principle aims to ensure fairness, its application can be complex and has faced criticism, particularly in sovereign debt contexts. One significant limitation is the potential for "holdout" creditors to disrupt debt restructurings. As seen in the Argentina sovereign debt case, a broad interpretation of the pari passu clause allowed a small group of creditors who refused to participate in a debt exchange to demand full payment, effectively hindering the restructuring efforts for the majority of creditors²², ²³. This can create an incentive for bondholders to hold out, complicating future debt workouts and potentially leading to more disorderly outcomes²¹.

Critics argue that an overly rigid application of pari passu can undermine the stability of financial markets by empowering minority creditors to block broadly accepted restructuring plans. This can lead to prolonged litigation, increased costs for the debtor, and a chilling effect on future lending to distressed entities. In response to such challenges, discussions around modifying pari passu clauses and implementing collective action clauses (CACs) in sovereign bonds have gained traction, aiming to ensure that a supermajority of creditors can bind a minority to restructuring terms, thereby mitigating the holdout problem and facilitating more orderly resolutions¹⁸, ¹⁹, ²⁰.

Furthermore, while the principle mandates equal treatment within a class, it does not imply equality across different classes of creditors. Secured creditors, for instance, will almost always have priority over unsecured creditors, even if the unsecured creditors are treated pari passu among themselves¹⁶, ¹⁷. This hierarchical structure of claims can sometimes lead to situations where lower-ranking creditors receive little or no recovery, despite the pari passu principle being applied within their specific class.

Pari Passu vs. Pro Rata

While both pari passu and pro rata relate to proportional distribution, they describe different aspects of financial obligations and claims.

Essentially, pari passu determines who gets treated equally (those in the same class), while pro rata determines how much each of those equally treated parties receives (in proportion to their individual claim or ownership).

FAQs

What does "pari passu" mean in simple terms?

Pari passu is a Latin term that means "on equal footing." In finance, it signifies that two or more parties or obligations within the same group are treated equally without any preference.⁷

Where is the pari passu principle commonly applied?

It is commonly applied in debt agreements, bond issuances, and especially in bankruptcy or insolvency proceedings, where it ensures that creditors of the same class receive proportional treatment.⁶

Does pari passu mean everyone gets paid the same amount?

No, it means everyone in the same class of claims or obligations is treated equally in terms of priority. If there isn't enough to pay everyone in full, the available funds are typically distributed proportionally (pro rata) based on the size of each party's claim.⁴, ⁵

How does pari passu affect shareholders?

For shareholders, if shares are pari passu, it means they have equal rights to dividends, voting, and claims on assets during liquidation, regardless of when they were issued.³

What are "holdout" creditors in the context of pari passu?

"Holdout" creditors are those who refuse to participate in a debt restructuring deal, often relying on a broad interpretation of a pari passu clause to demand full repayment even when other creditors accept reduced terms. This can complicate debt resolution processes.¹, ²