Relevance of Principle of Pari Passu in Contemporary World

Meaning of Pari Passu

The principle of Pari Passu is applied in insolvency processes, including administration, liquidation, and bankruptcy proceedings. It states that at the time of insolvency, all the unsecured creditors shall be placed at equal footing with each other and there shall not be any preference in the priority of payments to creditors.  This principle works complementary with the principle of pro-rata, which states that the creditors will be paid in proportion to their respectful debts provided to the debtor.

To clarify, the principle of pari passu does not attempt to promote equal payments rather equality of creditors to receive repayment of their debts. The major object of the principle is to strike a balance between the interests of different creditors at the time of insolvency to not allow any creditor to gain an unfair advantage over the debt of others.

In the international financial sector, the principle of pari passu is of most significance for the recovery of corporate credits. The English Law, incorporating the principle of pari passu as earlier as 1542, in the Statute of Bankrupts. In most Common law countries, this principle is regarded as the fundamental policy of insolvency laws. Its application in an agreement or contract implies that a debt shall be treated the same as other debts irrespective of their dates of origin.

Other than a pari passu clause which is between lender and borrower, there also be can pari passu agreement which is between the lenders, to bar any lender from having preference at the time of repayment of the debt during insolvency. The clause is feasible only if it ensures that, on insolvency, the assets of the company will be distributed evenly amongst all unsecured lenders.

Also Read: Doctrine of Ultra Vires Company Law

Exceptions to the principle of Pari Passu

There are certain exceptions to this principle, wherein pari passu does not apply:

  1. If according to insolvency proceedings or application of the law, certain debt is to be paid before the other debts.
  2. In many countries, the outstanding taxes, salaries, and wages of the employees of the company take priority over all other unsecured debts.
  3. In some countries, priority is given to the depositors with banks or other financial institutions, as well as to the holders of insurance policies provided that the company’s failure led to its bankruptcy.
  4. In the Philippines and until recently in Spain, an unsecured creditor can by publicizing the relevant agreement in the prescribed manner before a public official and by paying a documentary tax, achieve priority over unsecured creditors who do not publicize their agreement and, possible, also over other unsecured creditors whose agreements are subsequently formalized. (Spain in 2004 repealed this rule and adopted the pari passu principle)
  5. If the law enables the creditors to keep particular assets out of the estate of the insolvent company. Such assets can be separated from the total estate and will not be available for pari passu distribution.

There is a new emerging and much-debated development, application of the pari passu principle to sovereign debts. Although the significance of the clause is most applicable in corporate credit however it has been recently started to be used in sovereign borrowings. Sovereign borrowing is lending between states.

In sovereign lending contracts, a pari passu clause acts as a restrain on the sovereign’s ability to incur debt obligations that could subordinate the right of payment of the other debt. There are certain controversies in the operation of sovereign debt, pari passu clauses, as in a corporate debt the company or individual may go insolvent, and however, a state cannot go insolvent. These questions have been attempted to be cleared through various judicial pronouncements of different countries.

The Indian Law also contains the provision which incorporates the principle of pari passu such as section 73 of CPC, which provides for rateable distribution of payment of money among the decree-holders on an equitable plane.

The principle of Anti-Deprivation is also another doctrine that operates complementary to the principle of pari passu. It states that any agreement or arrangement will be void, which has the effect to remove an asset from the estate of insolvent that would otherwise be capable of realization for the benefit of the insolvent’s creditors.

Relevance of The Principle of Pari Passu

As it is understood, the principle of pari passu signifies that at the time of insolvency, all the unsecured creditors shall be placed at equal footing to any such other creditor, and there shall be no priority in any creditor for the repayment. The payment to each unsecured creditor shall be on a pro-rata basis, which is payment is made proportionally according to the debt of each creditor.

In the contemporary world, the relevance of the principle of pari passu has been questioned. Whether the applicability of this principle, still fundamental to the insolvency proceedings?

It would be incorrect to state that the principle of pari passu has lost its relevance with the emergence of newer principles and laws. It is true that with time and advancement in the paradigm of law, there has been the emergence of many counter principles of this doctrine, which have the effect of circumventing the principle of pari passu; however, the main principle has not been rendered inactive. Certain counter-principles, developments, or contractual advancements, limiting the ambit of pari passu are discussed below:

  • One of the major, set back to the applicability of pari passu was the development of the concept of sovereign debt, which are credits given by states to one another. There have been various attempts to inculcate the principle of pari passu in such lending but the state is different from a corporate entity. When states are in a situation where they are not able to fulfill their debt obligations, unlike corporate entities, they cannot be declared insolvent.
  • Therefore, the major applicability requirement of the principle that is the presence of insolvency proceedings is absent in sovereign debts. Sovereign states are free to enact, certain legal provisions which would have the effect of preferential ranking to their creditors. Therefore, the essence of the principle of pari passu is not applicable in sovereign debts, which in turn limits the scope of principle to international or domestic corporate lending only.
  • In the modern lending/credit model, creditors aim at securing their debts through the security of the debtor. This makes a different class of creditors, which are secured creditors, and have a right at the time of insolvency proceedings, to utilize the asset of the company over which their debt is charged. Usually, the potential of secured creditors are large, and this reduces the total asset of the company, for distribution to unsecured creditors. Only when all the secured creditors have realized their debts, then the unsecured creditors can utilize the remaining assets of the company in proportion to their debts. Pari passu principle does not apply to secured creditors, which successively affect the right of unsecured creditors.
  • Over time, the principle of the ROT clause, i.e. Retention of the Title clause has gained much importance, in contracts for the supply of goods. In this clause, a provision is contained in the contract which entitles the seller to retain the legal ownership of the goods until certain obligations are fulfilled by the buyers which are usually regarding payment of the purchase price. This presupposes that on the insolvency of the buyer it is inevitable that there would be the default of payment, as the title of good is with the creditor. The ROT clause has the effect of escaping the principle of pari passu.
  • In certain contracts, some creditors have ranked ahead or above other creditors, which are called pre-preferential creditors. They have priority of claim, at the event of liquidation proceedings. They are therefore outside the scope of pari passu, as even being unsecured creditors they have priority of repayment.
  • The principle of pari passu has also been struck at its unfettered importance, by the laws of different states, governing the insolvency proceedings. Many countries have formulated laws that enable priority of payment of debts in a corporate liquidation. This has consequently affected the ranking of claims based on insolvency regulations and mandatory provisions of law. These exceptions created by law, take priority over the principle of pari passu.
  • The principle of debt subordination is when one creditor through agreement contracts his debt at a lower footing than the debt of some other creditor or creditors. Debt subordination refers to a transaction where one subordinated or junior creditor agrees not to be paid by a debtor until another creditor of the debtor has been paid. This is usually done through, creditors agreeing to arrange themselves in ranking order and thus contracting out of the pari passu rule.
  • The development of the ‘Direct Payment Clause’ has effected in nullifying the applicability of the pari passu principle. These creditors form a different category of creditors who may gain a preference over other creditors. The creditors with direct payment clauses, in the event of the insolvency of the company, monies that would usually go to the company can be paid directly to specific creditors, without the consent of or consultation with the general body of creditors by virtue of the contract terms under which they operate.
  • In the Principle of ‘Ring-Fenced Fund’, a trust gives rise to a ring-fenced fund. This means that if money is lent to a company on trust, the property under the trust will remain separate from the personal property of the trustee. This implies that the debtor does not hold the beneficial ownership of the assets under the trust. Hence, in the event of the insolvency of the trustee who is the borrower, his creditors will not have recourse to the assets held on trust.

Many other such principles have limited the application of the principle of pari passu, however, its relevance has not been lost in the contemporary world. As part of some of these exceptions to the principle, its importance is still the same, in the protection of interest of unsecured creditors in insolvency proceedings.

 

This article is written by Miss. Divyanshi Maheshwari, a 4th year, BA LLB student with specialization in Energy Laws, UPES, Dehradun

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