Practical Achievement of Pari Passu Principle

This paper critically appraises to what extent pari passu principle is achieved in practice. Pari passu means “proportionally; at an equal pace; without preference” [1] , often meaning that each creditor will be paid on a pro rata basis in accordance with the level of his financial claim. This principle was first introduced into English law by the Statute of Bankrupts in 1542. The principles as set out in this Act were later underscored by the House of Lords in National Westminster Bank plc v Halesowen Pressworks Ltd [2] . It has been stated that, “Insolvency law has always sought to balance the need to ensure a pari passu distribution between the creditors and accordingly to prevent an individual creditor from obtaining an unfair advantage over the general body of creditors, whilst at the same time avoiding the penalisation of a creditor for acting swiftly to protect his own interests” [3] .

Yet the principle of pari passu being fundamental in insolvency is clearly flawed in its definition. Applications of the pari passu principle are few and far between, indeed “In practice even the most cursory examination of insolvency internationally shows that the pari passu rule is nowhere honoured.” [4] However, a discussion into this principle even at a theoretical level is very misleading. An orthodox definition states that all creditors of a particular type are to be treated similarly post-insolvency, resulting theoretically in them sharing the insolvent’s assets on a pro rata basis Re Smith, Knight & Co, ex p Ashbury [5] . A multi-layered definition “reflects a different layer of priority among creditors and that it is a principle according to which ‘creditors of the same class are treated equally and are paid in proportion to their claim out of the assets of the estate” [6] .

Yet the orthodox definition is undervalued [7] by its miscellaneous exceptions, which derive from combination of history, policy and pragmatism [8] . These include preferential and subordinated creditors [9] . Consequently most commentators have attempted to rescue the principle by utilising the multi-layered approach. It has been stated that: “ it would be a serious misconception to suppose that the pari passu principle operates in a comprehensive way with respect to every species of claim or liability accruing against the insolvency estate, or with respect to the distribution and destination of every item of property comprised within it. Instead, the distributive scheme which is actually established … is essentially one in which the pari passu principle is applied sequentially in relation to certain, discrete groups of claims, ranked into categories according to a fixed system of priorities” [10] . However multi-layered definition has significant problems, which has lead courts to miss-apply it in numerous cases. The fact that “preferential debts rank pari passu among themselves” [11] , even commentators [12] , who accept that preferential debts are a major exception to the principle [13] , are not able to rely on it even in the descriptive sense, because the operation of the preferential claim principle would then paradoxically be a rule and an exception to that rule in the same situation McGrath v Riddell [14] . It could be argued that the system which undermines pari passu actually serves to support it, yet this confusion is open to critique. “Therefore, the attempt to rescue the pari passu principle from its practical irrelevance by saying that it applies sequentially is a categorical failure” [15] .

Further analysis considers how pari passu principle has been treated by the courts. The modern expression of the principle is seen in Farmers’ Mart Ltd v Milne [16] . This case involved an agreement by a trustee that, in return for certain creditors consenting to his acting as trustee, he would permit part of his pay to be set aside to effectively secure those particular creditors a greater proportion of the distribution than the other creditors. The court held that “to allow such action to proceed would be a fraud on the insolvency laws, the object of which was to secure equal distribution of the bankrupt’s assets” [17] . This position is also highlighted in Pritchard v Westminster Bank Ltd [18] , where the court held that “a garnishee order which had the effect of giving the plaintiff preference over all other creditors should not have been made absolute” [19] .

The courts recently held in Re Tain Construction Limited [20] that the traditional established policy of s127 of Insolvency Act (IA)1986, namely to prevent the circumvention of the ’pari passu’ distribution of assets, which is at the foundation of insolvency law, is still applied by the courts in most instances. Section 127 “preserves the insolvent estate; sustains the order of priority of insolvency distribution; and enables the debtor to proceed with its business during the gap period between the presentation of the winding-up petition and the making of winding-up order” [21] . However, commentators agree that such functions are not directly associated with the principle of’ pari passu’ distribution. It is further argued that ‘pari passu’ distribution is not by far at the centre of modern insolvency law. Section 127 provides that in a situation involving a corporate winding up by a court, any and all dispositions of the company’s property which is made after the commencement of the proceedings will be void, unless the court decides otherwise.

Factual review of Tain Construction will now be undertaken to elucidate the current position of pari passu. Tain Construction Limited maintained two bank accounts, namely current and loan accounts. Tain’s effective liability to their bank was secured by personal guarantee from their sole director and shareholder, which was supported by a legal charge over the director’s property. Apart from the bank, Tain’s other main creditor was HM Customs & Excise, who in the event of winding-up presented petition against them for a substantial unpaid VAT liability. They were wound up on 8 September 1997, however until an advertisement of the petition was placed in the Legal Gazette, the bank continued to operate the accounts as usual and by the date of the petition no money was outstanding in respect of either account. Consequently the bank released its legal charge over the property in January 1999 and the liquidator attempted to recover payments made by Tain during this period. The court held, “the basis principle is one of pari passu distribution’. On the facts, there was no real benefit to the creditors generally in relation to the relevant transactions, i.e. the collection of cheques and receipt of payments by the bank by crediting the overdrawn account so as to reduce the overdraft on the two accounts below their amounts at the date of presentation of the petition. There was nothing to justify the departure from the principle of pari passu distribution. Thus no validation order would be forthcoming” [22] . However the court’s view that pari passu underpins s127 had received criticism; stating that “Such a mistaken view of the law is hardly novel. Academics and practitioners alike have for years committed themselves to such irredeemable mistake…In order to make good this claim, it is first necessary to clear the bush of fundamental mis-perceptions about equality and pari passu that have been venerated by bankruptcy scholars and practitioners for far too long.” [23] Preservation of insolvent estate under s127 provision is largely a premise of collectivity, which pari passu fails to explain. Such misconception has raised strong critique with respect to courts practice, where by frequently “throwing pari passu into the laundry list of statutory provisions shows insufficient understanding of the pari passu principle on behalf of courts”.

Further critique surrounding hollowness of the pari passu derives from Ex parte Mackay [24] , that the principle undermines contract and cannot be excluded. Here it was argued that the creditor may not skip his assigned place in the queue, instead of supporting pari passu equality, where places assigned to creditors are all unidistant from the asset pool. Equality distribution is clearly not the premise within bankruptcy, which shows that pari passu can easily be contracted out from. The decision in Re SSSL Realisations [25] with respect to subordination agreements also confirms contracting out of pari passu, which affirms courts misunderstanding with the principles true rationale.

Next consideration will critically examine exceptions of pari passu, starting with false exceptions followed by true exceptions [26] . Pari passu doesn’t apply to secured creditors who have obtained security for their loans. The criticism against failure to achieve equal treatment is that, “Security avoids the effects of pari passu distribution by creating rights that have priority over the unsecured claims” [27] Given that secured creditors, are in most cases the largest creditors of any potential insolvent, this results in a large initial reduction from the funds available to distribute to the unsecured creditors. In relation to creditor security, the institution of security has always been supported on broad efficiency grounds. Arising issues relate generally to questions of fairness, where it has been argued as being fair, based on a ‘bargain’ justification theory, whereby the parties freely bargained the arrangement. Another fairness justification is that relevant parties are given due notice of the security arrangement. Each of these arguments is countered in the sense that inequality of bargaining powers, information asymmetries, and enforcement biases undermine the free-bargaining rationale.

Neither the principle applies to suppliers of goods under agreements reserving title, which increases uncertainties with lending, coupled with legal uncertainties surrounding ROTs. The problems with fairness, is that such arrangements (ROT clauses) are not registrable, thereby misleading unsecured creditors on the insolvency risk they are running. A following uncertainty of the concept is the use of its ‘all-monies’ form, which is used to secure debts beyond the immediate transaction. The effect of the above is that the device shifts insolvency risk to the newest and weakest players in the market. Problems also persist, surrounding arrangements where assets are held on trust for creditors. Conflict with pari passu fairness and consistency, concerns trusts (Quistclose) which are not subject to registration and disclosure requirements associated with security. Further argument that Kayford Trust should constitute preference because the money is taken from a general account and paid into a trust account for the benefit of certain creditors received criticism for directly conflicting pari passu principle. Such false exceptions are clearly inconsistent with rationale of efficiency and fairness of the principle, making it very uncertain due to informational and resourcing disparities.

The Insolvency Rules 1986 (‘IR 86’) state that one major exception is the rights relating to insolvency set-off, these are in many cases broader in their practical effect than those rights that are available outside insolvency. “Set-off applies whenever there have been mutual credits, mutual debts or other mutual dealings, before the onset of liquidation, between the debtor and any of its creditors” [28] . According to Peat v Jones [29] , “The cross-claims need not impeach the debt owed to the insolvent, so long as the requirement of mutuality is satisfied” [30] . These rights of insolvency set-off diminish the pari passu principle, especially if there are mutual credits, debits or other dealings, creditors are permitted to utilise their set-off rights to obtain priority over other creditors [31] . The significance of this point cannot be overstated especially given the fact it operates automatically from the date of any winding up order, and does not require intervention by either party Stein v Blake [32] . The confusion evolves from the fact that this priority is mandated by virtue of r.4.90 IR 1986 [33] as highlighted in National Westminster Bank v Halesowen Presswork & Assemblies ltd [34] . R Mokal describes this situation as, “Parties, in other words, are compelled to breach the pari passu principle” [35] .

Another exception is pre-preferential creditors (s115 IA 86) whom are ranked ahead of all other creditors. They are afforded privileged positions that have claims arising after the date of the winding-up order. Another consideration in this area is the position of utility suppliers (233(2)(a) IA 86), this provides that they, “may make it a condition of the giving of the supply that the liquidator personally guarantees the payment of any charges in respect of the supply”. The final statutory exception to be considered involves “pre-liquidation creditors who can compel payment by virtue of their ability to inflict certain types of harm on the insolvent estate” [36] . This aims to prevent the termination of a contract or the forfeiture of a lease and generally will be a substantial proportion of the insolvent’s estate. This position was explained in Re Levi & Co. Ltd. [37] as follows, “In general, creditors whose continued co-operation is desired by the liquidator may be able to extract payments in respect of pre-insolvency debts” [38] . Such distributive principle was upheld in Khan V Inland Revenue Commissioners [39] by Lord Hoffman, despite being contrary to pari passu. These debts are payable and not provable; they do not rank parri-passu amongst themselves and have to be met in full following the priority ranking in r.4.218 IR 1986, subject to the courts discretion under section 156 IA 1986. The issue which brings difficulty is whether the liquidator has adopted the contract for the purpose of winding up. This strengthens the critical point that the exceptions bring about uncertainty and complexity because the liquidator is left with the discretion of whether or not to adopt pre-liquidation contracts [40] or add cost of environmental clean up liability; therefore creating a thin line between payable and provable. The process of an exception bringing about another exception is criticised as a major source of complexity surrounding pari passu principle.

There is also “an inherent tension between the two fundamental principles of credit and insolvency law, that of the freedom of contract which allows one to bargain for priority and the mandatory pari passu principle.” [41] It is worth mentioning that, “Before a creditor is entitled to claim a preferred position it must be demonstrated that deviation from the inveterate and equitable pari passu principle is warranted.” [42] However, in practice this is a mere formality and the production of a credit agreement will in most cases suffice for such matters. However pari passu shows practical effect when considering the provisions that aim to preserve the insolvent’s estate Hollicourt (Contracts) Ltd. v Bank of Ireland [43] . Section 214 of the IA relates to wrongful trading and offers a good legislative protection to the pari passu principle and unsecured creditors, by ensuring that the pot from which the unsecured creditors receive their distribution from is an accurate reflection of the financial state of the company at the point when insolvency was thought likely by the directors.

Alternatives to pari passu include ranking of debts in chronological order, however such regime fails to address the exceptions and bypassing issues, in addition to the fact that it may dissuade potential creditors from lending, if they know they will rank low in the distributional order. Secondly an ethical ranking of debts aimed to pay unsecured creditors in accordance to their needs, has raised criticism with respect to creditor uncertainty, merely as predicting positions in the payment queue will be nearly impossible. Furthermore, protecting small creditors by ranking debts according to size creates difficulty in correlating the size of the loan with creditor vulnerability. Thus, to adopt various alternatives instead of collective pari passu approach would create much uncertainty.

Whilst it is undeniable that the courts deal with unsecured creditors on a pari passu basis, the exceptions often preclude the operation of this principle. It is unlikely that the system could be changed so as to prevent banks from exerting their status as secured creditors, as this would have a detrimental affect on businesses to either raise money or purchase property. The preferential creditor system is most often used by ex-employees of the insolvent and unlikely to be changed given the detrimental effect on employees. However UK could adopt a more American system for dealing with insolvency. Chapter 11 proceedings allow the insolvent a variety of mechanisms to help restructure their business; this could reduce the need for general insolvency procedures and therefore the ineffectual nature of pari passu. It is argued that instead of several procedures, we should have one rescue procedure like under chapter 11. We should have a rescue procedure scheme with moratorium and minimum court involvement. If company is successfully saved, then the unsecured creditor will hopefully be protected. Two ways to save unsecured creditors is by having an effective rescue procedure and avoiding past transactions. Such critique with respect to past transactions was raised in British International Air Lines Ltd. v. Compagnie Nationale Air France [44] where pre insolvency unequals were “equalised” in insolvency, thereby offending pari passu principle. Also an increase in recovery systems such as administration might alleviate the apparent unfairness of the insolvency system.

The conclusion on the reasoning of Re Tain Construction, shows a total lack of understanding of the section 127 regime in particular and the pari passu principle in general. It doesn’t help that writers persist in pursuing the victory of pari passu through capitulation and in Re Tain Construction the court’s insistence on the relevance of the principle is flatly contradicted by the facts of the case” [45] . Although pari passu principle has significance in insolvency, it is by no means fundamental [46] . Priority rules received strong criticism for frequently leaving nothing for unsecured creditors. Thus the principle is merely a ‘rule of non distribution’, due to its numerous exceptions, and is described as a fall back provision as opposed to a default rule, since it only takes over when it is pointless to employ any other rule.

As a result of economic efficiency and justice, insolvency law inevitably has to make distributional choices, which will be often resolved in favour of one party at the expense of the other. Roy Goode firmly emphasised that, “Uninterested in and uninformed about these conflicts, the pari passu principle simply supplies a blanket to paper over these divergences and imposes an iron-clad idea of equity as equality. As an all-encompassing standard for bankruptcy distribution, the pari passu rule is bankrupt of legitimacy and sclerotic. And it does not lend itself to aggiornamento through Fletcher’s sequential reinterpretation. We must jettison, without the slightest tinge of regret, that hackneyed, and misleading, phrase, ‘the most fundamental principle of insolvency law is that of pari passu distribution” [47] . In relation to why this principle is not more prominent, the simple answer is owing to the vicissitudes of everyday life and the effect of multiple competing parties. It would be hard to see the situation improving markedly in the future, given the essential nature of the root cause.

Bibliography

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(Accessed on 23/03/10)