Pari Passu in International Finance

The pari passu clause is a covenant or a warranty that bank loans and bonds ‘rank pari passu’ amid all the other unsecured debt of the borrower or issuer. The clause appears in both corporate and sovereign debt obligations. Pari passu is a Latin phrase whose definition is ‘equal footstep’ or ‘equal footing’. In the legal sense, however, the term is used in the context of ‘proportionally; at an equal pace; without preference’ . As far as the role it plays in finance is concerned, pari passu can refer to loans, bonds and some types of shares which have an equal right of payment or level of seniority.

The negative pledge clause is a basic clause included in a bank unsecured credit agreement and its provision is to restrict the borrower from allocating or allowing the existence of any security over its assets in the first place . Various definitions have been given on the clause . A clear interpretation of the clause explicitly defines it as ‘a negative covenant in a bond indenture in which the issuer agrees not to use any of its assets as security for another debt obligation or other liability if doing so would adversely impact the riskiness of the bond. This protects bondholders and also allows the issuer to pay a lower coupon rate’ . Philip Wood comments on the negative pledge clause stating that it is ‘one of the most fundamentally important covenants in an unsecured term loan agreement’ . It is a companion to the pari passu clause . Intrinsically, the clause has a paramount position in almost every loan agreement, both in international and domestic finance but all in all, negative pledge clause use is worldwide in modern unsecured commercial loan documents.

CHAPTER 1

PARI PASSU CLAUSE

1.1 INTRODUCTION:

The purpose of this chapter is to define the objectives of this study in relation to the pari passu clause . This chapter defines the key terms of the study by providing information on the background of pari passu in International Finance. Additionally, it provides the author’s reasoning behind the idea of this research paper.

1.2 PARI PASSU IN INTERNATIONAL FINANCE:

The rationale of the pari passu covenant is that it is a provision which ‘prevents the borrower from incurring obligations to other creditors that rank legally senior to the debt instrument containing the clause ‘ . Charles Berry, in his article ‘Corporate restructuring and bankruptcy: Pari Passu means what now’ presents a clear history of the clause . The clause came into force in the 19th century and it revolved around the securitization of debt instruments with the intention of affirming that the secured creditors would share ratably in the security.

The Financial Markets Law Committee publicized a report titled ‘Issue 79 ‘ Pari Passu Clauses : Analysis of the role, use and meaning of pari passu clauses in sovereign debt obligations as a matter of English Law’ . The report provides fundamental definitions of the clause which, in effect, is considered to be a standard feature in cross-border unsecured debt obligations found in both loan agreements and securities issues. In a loan agreement pari passu frequently entails that ‘the payment obligations of the borrower under this Agreement rank at least pari passu with all its other present and future obligations’ . On the other hand, in international securities issue, pari passu is most commonly used in the sense of ‘status’ or ‘ranking’ and it provides that ‘the bonds and the coupons are direct, unconditional and unsecured obligations of the issuer and rank, and will rank at least pari passu , without any preference among themselves, with all other outstanding, unsecured and unsubordinated obligations of the issuer, present and future’ . Quintessentially it is a standard clause which is established in international syndicated bank loans as well as bond issues.

Although the basic form of the clause is standard, its rationale varies according to whether the issuer is a corporate or a sovereign borrower. To begin with, in the case of a corporate borrower, the main consideration is the position of the bondholders upon the liquidation of the company upon insolvency. In such an event, the bondholder ought to be placed in an equal position along with all the other holders of unsecured debt which was issued by the corporate issuer. The effectiveness of the clause is feasible only if it ensures that, on insolvency, the assets of the company will be distributed evenly amongst all unsecured lenders.

Notwithstanding the reasoning behind its use, the total effectiveness of the clause is debatable. The FMLC , via their report , introduce a number of situations that come into play, out of which the first and foremost is the fact that most jurisdictions have their own rules as far as the priority of payment of debts in a corporate liquidation is concerned. In essence, these rules take priority over the terms of the bond provisions. As pointed out in the Report , in many jurisdictions, outstanding taxes and wages which are owed to the employees of the company take priority over all other unsecured debts proviso the company is exterminated.

On that note, some jurisdictions give priority to 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. Moreover, in some jurisdictions their rules may provide that unsecured debt ranks as a measure of payment in the event of corporate liquidation in a chronologically ascending order, bearing in mind that precedence is given to the ones created earlier.

Lastly, according to the report , ‘in the Philippines, an unsecured creditor can and, until recently, in Spain could, 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’. Dr. Rodrigo Olivares-Caminal refers to Philippines and Spain characterizing them as ‘exceptional circumstances’ and argues that, unless such circumstances are present and due diligence is accomplished, there is no need to for the pari passu clause to exist. On 1st September 2004, Spain enforced a new bankruptcy law, the Ley Concursal which entails a requirement for all unsecured creditors to be paid on a pro rata basis upon the insolvency of the debtor, regardless of whether their obligations are contained in a public deed or not.

If nothing else, based on the laws of the jurisdiction in question, the clause empowers a bondholder to advance the argument that he or she is not to be isolated or treated differently which is of great importance in future negotiations concerning the pro bono restoration and alteration of the totality of its unsecured debt by an issuer who is financially incapable.

1.3 THE EFFECT OF ELLIOTT:

When it comes down to it, the pari passu clause provides little protection to the individual creditors participating in a syndicate. Relative authority includes the case of Elliott Associates LP v Banco de la Nacion in the Court of Appeals in Brussels which caused uproar in the opinion of professionals on the interpretation of the clause . The Brussels Court of Appeal explains the basis of its ruling by stating that ‘the basic agreement regulating the reimbursement of the Peruvian foreign debt also indicates that the different creditors enjoy a pari passu clause , which has as a result that the debt should be diminished equally towards all creditors in proportion to their claim. From this, one seems to have to conclude that, in case of the payment of interests, no creditor can be excluded from its proportional part’ .

Dr. Olivares-Caminal for one suggests that the case provides a ‘misguided interpretation of the pari passu clause that has opened the door to litigation on incorrect grounds’ . Berry argues that Elliott introduces a new interpretation of the clause which, according to him, is that ‘even prior to bankruptcy, an issuer of debt governed by a pari passu clause could not make any payment to any unsecured creditor without making a pro rata payment to all other creditors of the same class’ .

On the other hand, Professor Andreas F. Lowenfeld , an expert on the Elliott case, is a firm supporter of the interpretation of the clause given in Elliott. He supports that the idea and meaning of the pari passu clause given in is precise and clear. His sincere opinion is that the clause implies exactly what it says; ‘a given debt will rank equally with other debt of the borrower, whether that borrower is an individual, a company, or a sovereign state’ . Moreover his conclusion on the matter is that ‘the pari passu clause in the Guaranty entitles each lender to share equally and ratably with any other holder of External Indebtedness as defined’ the Brady Bonds described above constitute External Indebtedness of the Republic of Peru. Accordingly, if the Republic pays principal or interest to holders of the Brady Bonds or some of them, it is obligated to make a payment of a proportionate amount to all holders of Affected Debt’ including [Elliott]’ . The conclusion drawn from the interpretation put forth by both the Belgian Court in Elliott and Professor Lowenfeld is that equal treatment of creditors of equal rank is required, both in the context of bankruptcy or liquidation and payment to any such creditor made . Berry also makes reference to the FMLC report of the Bank of England which in essence scrutinizes the decision made by the Belgian courts stating that the decision itself was wrong and that it is highly unlikely the courts, if they had the chance to redo their decision making, would decide the same thing again .

Professor Lowenfeld gives his own interpretation of the clause which contained four important elements. To begin with, the clause requires an equal legal ranking of the debt; in Elliott’s case, this implies Peru’s other external debts. A further important element is the fact that equally ranking debt must be paid equally, at least when the debtor vouches in a pari passu clause in order to preserve the equal ranking. This provides originality in the idea that the debtor, who is not bankrupt yet albeit accepting a pari passu covenant, must still pay all of its equally ranking debts in full. There is always a catch though; if this proposition is not acute, then the other propositions will fall away as well. Furthermore, in the event that there is not enough money to pay all equally ranking creditors wholly, then each holder of the aforesaid equally ranking debt is obliged to obtain a ratable share. Last but not least, the above theorems are also carried out against the recipients of non-ratable payments by using the method of injunction. This is the so called ‘ratable payment interpretation of the pari passu clause ‘. All in all, one can easily support the idea that the pari passu clause can in fact only claim equality of rank, not equality of payment.

Look Chan Ho in his article ‘The principle against divestiture and the pari passu fallacy’ distinguishes amongst the two versions of the principle. The first version is the ‘pari passu principle proper’ also known as the ‘orthodox pari passu principle’ . The orthodox version is not a fundamental or sacred principle in any legal system and according to J.H. Dalhuisen ‘for bankruptcy, it is often said that equal distribution is the essence of modern bankruptcy law, but in truth it is equitable (not equal) distribution which in modern times is a matter of statutory definition in terms of ranking and set-off or netting facilities ‘ indeed it is ‘ particularly the ranking or priority that is the essence of modern bankruptcy’.

Pari passu is sometimes confusingly used to refer to the term pro rata . This is represented in s. 175 (2)(a) of the Insolvency Act 1986 that states that ‘preferential claims are to rank equally among themselves and would abate in equal proportions if the company’s assets are insufficient to meet them in full’ . Ho supports that the ‘ratable treatment of preferential claims inter se constitutes the application of this principle, whereas the very existence of preferential claims constitutes an exception to the pari passu principle, properly understood in the orthodox sense’ .

The respective most important English case law is Kensington International Ltd v Republic of the Congo . The FMLC analyzes the case in their report by providing a summary of the case . In Kensington , in 1984, a fund acquired defaulted indebtedness under a loan agreement which was governed by the English law. Eighteen years later the claimant petitioned for a money judgment against the Congo, accompanied by a claim for explicit performance to foreclose Congo from making payments to other creditors. The Counsel for the case alleged that the clause contained in the loan agreement was plainly a sharing clause which compelled Congo to pay the claimant on a pro rata basis once it pays other creditors.

According to the FMLC , the Counsel’s submission in Kensington was based on five important considerations. The first consideration was the literal meaning of the term ‘pari passu ‘. Secondly, the Counsel took into great consideration the significance of the decision making in Bowen v Brecon Railway Company which insinuated that the clause means that the money distributed should be allocated or paid on a pari passu basis. Moreover, the Counsel suggested that is it difficult to ‘accord any sensible meaning to the emphasized words if payments are not to be made pari passu ‘. What is more, the meaning of the term relation to a sovereign borrower differs from the way it is used from the perspective of a corporate borrower. According to the Counsel, when used in a sovereign loan, the clause is essential in the provision of further protection to creditors. The main objective is for the creditors to achieve indemnification for their incompetence to conjure the necessary insolvency procedures against the state. Due to this protection, the state is compelled to pay all creditors on a pro rata basis. Intercontinental authority, such as Merchant Bills Corporation Ltd. v Permanent Nominees Australia Ltd. , Red Mountain Finance , and the most important case of all, Elliott Associates L.P. v Banco de la Nacion .

Francis Beaufort Palmer , a leading 19th century English commentator throws light on the purpose of the clause in a secured debenture. He argued that ‘the object of the above pari passu provision is to place all the debentures on the same level as to security; so that, if the security is to be enforced, whatever is realized from it shall be divided amongst them ratably. But for some such provision the debentures would rank in point of security according to their dates of issue; and, accordingly, the first issued would rank as a first charge, and the next issued as a second charge, and so on ‘ and this would be entirely destructive of the marketable character of the security’ . In essence, Palmer is amongst those who expressed their doubts on the purpose of the clause .

CHAPTER 2

NEGATIVE PLEDGE CLAUSE

2.1 INTRODUCTION:

The purpose of this chapter is to define the objectives of this study in relation to the negative pledge clause . This chapter defines the key terms of the study by providing information on the background of negative pledge in International Finance. Additionally, it provides the author’s reasoning behind the idea of this research paper.

2.2 NEGATIVE PLEDGE IN INTERNATIONAL FINANCE:

In ‘International Loans, Bonds, Guaranteed, Legal Opinions’, Philip Wood outlines the main reason for the negative pledge clause within a loan agreement. Quoting his words, ‘the drafting of a negative pledge clause is important because it will determine exactly what is covered by the negative pledge and what is not covered by it’ . In simple words, the negative pledge clause is a security element. Per Ibrahim Shihata the main purpose of the negative pledge provision is to ensure that present and future properties and assets of the borrower will still be available to satisfy any outstanding claims of the lenders in the event of the borrower defaulting on its payment obligations under the commercial banks’ loan agreement. It is a fact however that terms like ‘lien’ and ‘security interest’ are interpreted by the governing law . The term negative pledge is widely used in International Finance and frequently used in issues of Eurobonds and medium term notes .

Wood also outlines the purposes of the clause . The clause serves as a security element granted by the borrower to another creditor which in effect subdues the bank’s unsecured loan. This is of particular significance in the event that the borrower finds himself in difficult situations. Another purpose of the clause is that it is a security that allocates both the asset and its profits to the secured creditor; thence it provides the secured creditor with extreme power on a work-out or restructuring. Thirdly, it functions as a security which reduces the assets that are available to the unsecured banks provided that financial difficulties are present. In such a case, money is usually required which, due to the heightened risk, is required to be secured.

The rationale of the clause as a general rule lies in its ability to execute a number of assorted functions which hinge upon the scenarios where it is applicable. There are, however, certain limitations affecting the scope and vigor of the clause . To begin with, the negative pledge is not equivalent to security. The reason for this is that the clause does not provide any constraints for other unsecured liabilities which are classified equally with the loan or even aid in the allocation of specific assets to the loan. Furthermore, the basic form of a negative pledge clause usually does not circumscribe transactions that have an analogous effect to security. Moreover, it is merely a contractual restriction; ergo it is weak if the borrower disregards it. Despite the fact that the breach may be an event of default, the third party has the security. When it comes down to it, most international borrowers worship their agreements. A last limitation comprises the breach of a basic negative pledge clause which may give the right to the lender to proceed against a third party that takes security in breach for damages for securing a breach of contract.

All things considered, the reason for including a negative pledge clause in a finance agreement is that it constitutes a distinct way to guarantee the availability of the assets. However, many believe that the role it plays in international finance is more significant and much more special rather than in domestic finance and the reason for this is the predominance of unsecured lending in international finance whereas not so much in domestic finance. This predominance is due to the obstacles relevant to the prevailing and the managing of security on a ‘trans-border basis’.

Old cases, such as Swiss Bank Corporation v Lloyds Bank Ltd and Feuer Leather Corporation v Frank Johnstone & Sons , suggest that the third party must know of any limitations placed in the contract, if he or she is to be held accountable, and they must at least foresee the cause of economic harm. Recent cases on the other have insisted on and imposed the existence of specific intention so as to inflict economic harm. Relevant authoritative study includes Mainstream Properties Ltd. v Young .

Moving on, some agreements provide that in the event that the borrower creates violating security, then the bank is estimated to be evenly and ratably secured on the same asset as it was owed to the other creditor by design. Significantly, in England, the bank could not claim security if the clause provided for the grant of matching security on equivalent assets in any event. This is attributable to the fact that property interest cannot be created over an asset which in its turn cannot be exclusively recognized when the property interest is resolute about attachment.

Questions have been raised regarding the potency of this ‘automatic security clause’. At the outset, as proven in Tailby v Official Receiver , there is the possibility for failure of security in some jurisdictions since the asset is future and has yet to be presently identified. Additionally, in the case that the third party is ignorant of the clause , the million dollar question lies in whether the bank would effectuate a second-ranking security. What is more, security may fail for non-compliance with foreign formalities, as well as lack of publicity. Examples of such failure include the creditor possession, or even control or filing in a public registry. Last but not least, Re Eric Holmes implies that security may possibly fail as an insolvency preference on the grounds that it arises in the suspect period. On this note, it is worth mentioning that the negative pledge clause is incapable of altering the requisite order of priority of debts implemented by many jurisdictions in dealing with corporate insolvency and the covenant is oftentimes accommodated to comment upon.

The International Capital Market Association , via the publication of its article ‘Description of debt as ‘senior’ and the ‘negative pledge’ covenant’, exemplifies that ‘existence of a negative pledge only means that the freedom of the issuer to grant security for its other debt is limited rather than unlimited’ . In other words, the existence of the negative pledge does not imply that the issuer is not allowed to bestow with any security for its other debt at all which, according to ICMA this is something to be expected. Furthermore, another fact that is not implied is that the issuer is not to be allowed to dispose of its assets mainly for the purpose of securitization. Thence, the ICMA propositions that it is best ‘not to rely solely on the indication of the existence of a negative pledge ‘ as well as to ‘analyze carefully the language of the negative pledge , focusing in particular on the entities covered by the prohibition, the definition of security and specification of debt covered by the negative pledge ‘.

There are four types of negative pledges . Initially, we have the ‘strict negative pledge ‘ which consists of the normal agreement not to furnish security to any other creditor. Next, there is the ‘affirmative negative pledge ‘ which, albeit being contradictive in the wording, it does not rule out the creation of security interests over the debtor’s assets as such, but it calls for equal security to be given to the original lender sine qua non . Thirdly, there is the ‘equal security clause ‘ which provides restraint for the borrower to be granted security to subsequent lenders. It additionally gives equal security to the original lender in the event that he breached the first prohibition. The fourth and last type is the ‘automatic security clause’. This type specifies that in the event of a breach of the clause the lender is deemed to be equally and ratably secured on the same asset as the secured creditor it.

By all means a negative pledge is a common place element found in a covenant which is imposed by the lender hindering the borrower from oppressing any of his present or future assets. This ensures that, if something should happen such as the disgrace of the borrower, the lender is endeared available to use any available resources with the intention to proceed against. In any case, a negative pledge clause does not constitute as a security measure. Meanwhile, it is not an unsecured debt either.

2.3 THE WORLD BANK ‘ INTERNATIONAL BANK OF RECONSTRUCTION AND DEVELOPMENT:

The World Bank , otherwise known as the International Bank for Reconstruction and Development (IBRD) provides the basic purpose of the negative pledge clause as the ‘protection of the Bank against the use of governmental resources, or the use of governmental authority to mobilize other resources, to enable other foreign creditors to obtain foreign exchange in preference to the Bank through the creation of liens or priorities on public assets’ . What is more, the Bank’s negative pledge clause entails that in the existence of such a lien or priority interests, then they ‘shall equally and ratably secure the Bank ‘ , unless otherwise agreed upon. In March and November 1993, the Bank enforced changes in the general negative pledge clause policies by introducing ‘country-specific waivers’ that need to satisfy certain conditions of the Bank .

Ibrahim Shihata, via the publication of his book ‘The World Bank legal papers’ aims to bring forward various ‘legal opinions and memoranda which issued during [my] tenure as the World Bank’s General Counsel’ . He has analyzed in great depth the conditions brought forward by the Bank and has provided an insightful analysis of the clause as used by the Bank . More importantly, he provides four key and distinct clarifications on the importance of the clause .

To summarize the key points, the first point is that the clause ‘does not establish any superiority for the Bank over other creditors’ . What is more, any ‘attempts to circumvent the clause should not be seen as acceptable to the Bank ‘ . Thirdly, ‘arguments made by staff in favor of waivers have underestimated the risks to the Bank and overestimated the benefits to the borrowing country’ . Last but not least, ‘it is the Bank’s Board of Executive Directors that has the responsibility to decide the issue, and there is a fiduciary responsibility involved’ .

Through their website , in February 2002 the World Bank has introduced security arrangements, policies, which were drawn up by the World Bank staff but they do not essentially constitute a complete treatment. According to the policies, ‘the general conditions applicable to all IBRD Loan and Guarantee Agreements include a negative pledge provision that limits the creation of security in favor of other creditors over assets of borrowing entity and, where the borrower is not the member country, assets of other member country concerned ‘ . In consequence, the implication of the aforementioned wording is that the clause does not veto the setup of security in favor of other creditors; on the contrary, it aims to prohibit the enactment of pre-eminence for other debts over the debt that is due to the IBRD by requiring that IBRD ratably contribute in security fashioned for other creditors.

Additionally, once the borrower or guarantor is a member, the negative pledge clause refers to any security apropos of public assets which in turn culminates in a preference in the use of foreign exchange for the welfare of external creditors. On the other hand, in the event that the borrower is not a member, the clause addresses any security on any assets of the borrower as security measure for any kind of debt.

What is more, the clause does not relate to the security on a property for the payment of the purchase of the aforesaid property. It does not relate to the security that comes into being in the typical course of banking transactions for a debt that has been maturing for not more than one year after the date on which it was initially induced either. As far as the waiver is concerned, the IBRD has introduced the policy which states that in outstanding cases and always upon demand the IBRD may endow with a waiver with reference to the clause . This waiver has to be recommended to the relevant Managing Director on behalf of the country director. This message is delivered by the Regional Vice President and is afterward presented before the Board for consent. Where the assets which are liable to the security are deemed as having no indispensable influence on the country’s potential to settle the IBRD debt, the Managing Director’s assent is adequate.

Furthermore, the finalization of the security arrangements is an unremarkable condition of whether the Loan and Guarantee Agreements is validated in the event that the IBRD depends upon security. This also occurs in a situation where a member requires security with the intention of securing the borrower’s responsibility to the member relating to the guarantee.

CHAPTER 3

CONCLUSION

Pari passu and negative pledge are two of the three significant covenants partaking in a rescheduling agreement. Negative pledge is a security measure introduced as a means of way to restore full faith and credit as well as a pledge that no forthcoming creditor would be in a position to obtain endemic security unless the Bank were secured pari passu . The negative pledge clause has become an essential distinctive element of the Bank’s loan agreements. It impels the borrower to put no other indebtedness at the forefront of those to the Bank ; per Edward Mason’s words ‘the Borrower will carry out the Project with due diligence’ .

To begin with, the pari passu clause has been ‘mistakenly migrated from a secured private lending to an unsecured sovereign lending’ . Provisions in Philippines or even Spain have allowed the creditor to generate an ex-post right of way. Consequently, the pari passu clause has an underlying principle and has therefore become quite the well-liked proviso in this kind of debt instrument. After that, pari passu clauses remained in unsecured debt instruments because of the certain fears brought forwards. To start with, there are the ‘earmarking revenues or the risk of the sovereign preferring a group of creditors over another ‘ . Whence, in the event that due diligence was carried out by the book, there would be no need for pari passu clauses to exist; except of course in the event that there were limited outstanding conditions.

Moving on, as a contractual provision, the negative pledge clause has its pros and cons. Advantages include the pliability and naturalness of the clause with which it can be integrated into any financial agreement. The negative pledge clause is far from a security interest in the sense that there is no need to comply with local laws in order to form, content or even register which contributes to it being a particular attractive feature in the world of international and ergo multi-jurisdiction finance. On the other hand, the fact that the clause is not a security makes it vulnerable and flawed. If the clause is not fulfilled then the lender has no proprietary entitlement against the assets of the borrower, but he must still depend on several remedies against the borrower. Such remedies consist of an ‘acceleration of the loan, claim for damages, and sometimes specific performance or the use of injunctions and receivership’ and they are simply feasible against a borrower in a ‘sound financial state’ .

There are situations, however, where the negative pledge clause is infringed because of acute financial problems. If that is the case, the use of injunction or receivership is the only useful solutions. The requirement of knowledge of the prohibited transaction prior the assignment of receivers is a hitch for the application of the abovementioned remedies. In principle, the inaptness of the clause along with the affiliated remedies is deemed most pronounced in scenarios where a security interest would be most well-suited; that is to say in case of insolvency or close to insolvency.