Everything You Need to Know About Pari Passu Clauses in Loans
By Joanne Hue, Last updated: 2022-06-06 (originally published on 2022-02-08)
Know your contract clauses.
When dealing with loan agreements, you may come across the “pari passu” clause. Here we’ll explore its meaning, the context in which it is used, its importance and the related concepts which are important to the term.
What is the meaning of Pari Passu?
It is a Latin phrase which means ‘on equal footing’. Sometimes, it is also named in other words like ‘ranking equally’, ‘with equal force’, ‘hand in hand’, or ‘moving together’.
Generally, the term pari passu refers to those things or situations which are ranked equally. In the context of legal terminology, it means ‘to be equal in right of payment’.
This phrase is commonly found in the various debt instrument agreements. It simply means that all the parties to the agreement will get equal treatment. It implies that more than one party involved in an agreement with one company will be ranked equally.
Who does a Pari Passu Clause apply to?
There are two types of creditors, one is a secured creditor and the other is an unsecured creditor. Pari Passu clauses are relevant to unsecured creditors only where the loan is not secured by any collateral such as a house or a car.
Where a person has lent money to a business, the person is treated as a creditor. This may be understood as providing a loan to the business. Similarly, the employees of a business can also be treated as creditors if they are owed unpaid wages.
What does it mean on the context of a Loan Agreement?
Where a pari passu clause is contained in a loan agreement, it states the wording that all creditors will rank pari passu with each other and any other unsecured payment obligations of the issuer.
Generally, such a clause refers to loans or bonds which means that any debt will be ranked equally with the other obligations of a company. In a loan agreement, the pari passu clause is contained in two ways:
- as a representation and warranty so that the debt owed under the loan agreement is equally ranked and will have equal rights to repayment as the borrower’s other debts or other creditors.
- an undertaking to the effect that the ranking will not be affected and will remain the same in the future.
As mentioned above, the pari passu in loan agreements is related to unsecured creditors or unsecured claims. Where the proceeds from selling the secured asset like a mortgage or asset are not sufficient for repayment to the creditor, this can however, be helpful in securing the loan agreements.
Where a specific class of creditors give priority to other creditors like employees etc, in such cases, the creditor becomes an unsecured creditor and will be ranked equally with other unsecured creditors.
This generally means that if the debtor goes bankrupt and has to liquidate all his assets, the creditors will be able to recover money from the debtor and it will be divided between the creditors on a pro-rata basis. It implies that all the creditors ranked equally will recover their share from the liquidated assets.
What is the importance of a Pari Passu clause?
Where a person or business goes bankrupt, faces financial crisis or is insolvent, a pari passu clause plays an important role. As mentioned above, the creditors with pari passu loans will recover from the businesses or a person facing financial difficulties on a pro-rata basis which means proportionally.
Where the loans are pari passu, all the unsecured creditors will be ranked equally. It implies that when a business or a person will liquidate its assets, all unsecured creditors will be repaid equally or proportionally to each individual creditor’s debt. It means that no creditor will get any preferential treatment.
Why is it important for a lender?
When a company borrows money or takes a loan from a creditor, the creditors would like to know if there are any other creditors in line with those creditors or ranked above them. If such information about creditors has not been revealed or disclosed before they borrow a loan from the creditors, then the company has to repay the loan when asked by the creditors.
Why is it important for a borrower?
The pari passu clause is important for a company as a borrower because it ensures that the clauses are properly drafted and accurate. They also need to ensure that the clauses don’t limit the company’s future borrowings as a borrower.
What is the difference between pari passu and pro rata?
As mentioned above, creditors with pari passu loans will be paid on a pro-rata basis. This means that both terms pari passu and pro-rata are used in conjunction with each other. Although these terms complement each other, they are different in their meaning and are not the same.
Pari passu is a Latin term which means ranked equally whereas, pro-rata means in proportion. Usually in a real estate agreement, pro-rata refers to the proportional distribution of obligations and profits. To take an example for pro-rata, where one person has invested money for 70% of a property and another has contributed 30%, then obligations and profits will be distributed proportionally to each of them.
On the other hand, pari passu means that the creditors are ranked equally. No one is prioritised over the other and both of them will be entitled to get paid on a pro-rata basis.
In short, the difference between the two terms is that pari passu refers to the relationship between investors, and pro-rata refers to distribution of funds between them.
What is a joint pari passu charge?
A joint pari passu charge means that where more than one creditors have lent money to a same debtor, all creditors will rank pari passu with each other in relation to a loan or debt obligation. Such loans are unsecured and each creditor wants to protect their investment. In order to protect themselves, they put a joint pari passu charge on the debtor. It means that all the creditors are equally ranked.
In case the debtor goes bankrupt and prefers to liquidate all its assets, the creditors will get equal distribution of their investments. If there are 4 creditors and the liquidated assets will be distributed between four of them equally.
That’s a wrap, folks.