The term 'Pari passu' principle means 'on equal footing (with equal step), proportionately'. The principle of pari passu is frequently used in bankruptcy and insolvency law proceedings to ensure that all creditors (people or companies to whom money is owed) are treated fairly and equally. It aids in preventing certain creditors from receiving preferential treatment over others. These certain creditors are:
- Secured creditors: Has acquired a security interest in the business' assets (banks or lenders)
- Unsecured creditors: Has not acquired security interest in the business's assets (trade creditors and suppliers). The pari passu principle only applies to an unsecured creditor.
It also ensures that all creditors are treated fairly in the distribution of the debtor's assets. If the company's debts are pari passu, they are all ranked equally. This also results in the company paying the same amount to each creditor in the event of insolvency. The pari passu clause is typically framed in the loan agreement as:
- A representation and warranty. This ensures that the loan agreement debt ranks equally with the borrower's debt in the event of insolvency; and
- An undertaking that the ranking will remain in the long term
The Importance of the Pari Passu Rule
The principle of pari passu is important in the context of liquidation and bankruptcy proceedings. This is because it helps ensure that all creditors are treated fairly and equitably. It establishes a legal framework for the distribution of the assets equally. Additionally, it helps to prevent certain creditors from receiving preferential treatment over others.
What is Insolvency?
Insolvency is a legal term that describes a situation where an individual or entity is unable to pay their debts. This can happen to both individuals and organisations, including corporations, partnerships, and sole proprietorships. When a person or company becomes insolvent, they may be unable to meet their financial obligations. They may also need to consider options such as:
- Restructuring their debt
- Filing for bankruptcy; or
- Negotiating with creditors to settle their debts.
Insolvency is a distinct concept from bankruptcy, which is a legal process used by insolvent individuals or organisations to obtain relief from their debts through a court-supervised process. Insolvency is typically a precursor to bankruptcy, but not all insolvent individuals or organisations file for bankruptcy. Here are three common options for companies to take if they have been declared insolvent:
- Voluntary administration: An external person is hired to manage the company's affairs.
- Receivership: A secured creditor appoints a receiver to sell the assets of the company in order to repay the outstanding debts.
- Liquidation: All of the company's assets are sold off.
Read: Pre Insolvency Advice From Corporate Lawyers
What Pari Passu Means For Individuals and Businesses?
Section 108 of the Bankruptcy Act 1966 states that all debts proved in bankruptcy rank equally. If the bankrupt's property proceeds are insufficient to meet them in full, they must be paid proportionately.
Section 555 of the Corporations Act 2001 states that all debts and claims proved in a winding up rank equally. Winding up refers to the closing of a business which may include selling off assets and paying off creditors. If the proceeds of the bankrupt's property are insufficient to meet them in full, they will be paid proportionately.
Circumstances Where Pari Passu Can Occur
The pari passu principle can apply to lending arrangements, particularly in situations where multiple lenders have provided financing to the same borrower. In this context, the principle requires that all lenders with the same legal priority or ranking are distributed equally and receive their proportional share of the borrower's assets or funds.
For example, if a group of lenders provides financing to a borrower, the lenders may agree to share the borrower's assets or funds on a pari passu basis. This means that all lenders with the same legal priority or ranking would be entitled to receive an equal share of the borrower's assets or funds. However, they must base it on the amount of their outstanding loan.
The pari passu principle is often applied during bankruptcy proceedings. For example, secured creditors with the same priority or ranking would be entitled to receive a proportional share of the debtor's assets based on the amount of their security interest. Similarly, unsecured creditors with the same legal priority or ranking would be entitled to receive a proportional share of the debtor's assets.
However, they must base it on the amount of their claim. The pari passu helps to ensure that the distribution of the debtor's assets is done in a fair and equitable manner. It also helps to promote stability and confidence in the bankruptcy process.
3. Asset Management
The principle can also apply to asset management, particularly for managers who are responsible for managing assets on behalf of multiple investors. For example, a fund manager may manage assets on behalf of multiple investors, each of whom has invested a certain amount of capital into the fund.
Under the pari passu principle, all investors with the same legal priority or ranking would be entitled to receive an equal share of the returns generated by the fund. However, they must base it on the amount of their investment.
4. Debt Covenants
Debt covenants are restrictions imposed on lending agreements by lenders to limit the borrower's actions. In other words, debt covenants are agreements between a company and its lenders that require the company to follow certain rules established by the lenders. The pari passu principle can be relevant in situations where there are multiple creditors with similar types of debt.
This may include bonds or loans that have the same priority level in the payment hierarchy. In such cases, debt covenants may require that payments be made on a pro-rata or equal basis to all creditors with the same priority level. This ensures that the creditors' rights are protected and are all treated fairly.
Importance of Seeking Legal Advice
Individuals or companies who borrow money or obtain credit may, in certain circumstances, fail to repay it to creditors. Failure to pay the debt on time or in accordance with the terms of the agreement can result in legal consequences. This may include:
- Heavy penalties
- Interest charges
- Creditors or lenders taking legal action
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.