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Pari-passu is a Latin term that means “ranking equally and without preference.” Applied in a legal context, pari-passu means that multiple parties to a contract, claim, or obligation are treated the same, “ranking equally and without preference.”
Uses and Applications of the Pari-Passu Principle
The term pari-passu is popular in the lending and credit space. More specifically, it is a financing agreement that allows multiple creditors to obtain a secured loan with equal claims on an asset.
Also, pari-passu is an important concept in bankruptcy proceedings. Upon reaching a verdict, under the principle, a court would regard all creditors as equals. Thus, a trustee of the insolvent company would pay the creditors based on the pari-passu principle, and creditors of the company would receive equal portions of the liquidation in accordance with the amount of each creditor’s claim and the covenants attached to their claims (also known as pro-rata). Additionally, the creditors would be paid at the same time.
Pari-passu can also apply to the management of assets or securities. The principle would apply to the management of assets or securities in the sense that the assets or securities would be managed with equal preference or a preference weighted on the value or amount invested in either the asset or securities.
The principle of pari-passu can also be applied in clauses or covenants of debt instruments like bonds. Companies issue bonds as a part of debt financing to raise capital; pari-passu would be implemented in bonds to ensure that each bond is equal.
Pari-passu can be applied to all bonds issued by the company; however, they can also apply the pari-passu principle to specific tranches of debt to hold that within each tranche, the principle holds. It may be problematic if the pari-passu principle is held across multiple tranches.
Pari-Passu and Financial Instruments
Pari-passu can be applied to a myriad of financial instruments or contractual relationships. Firstly, it can be applied to equity. Though there are multiple classes of equities, within each class, the pari-passu principle holds.
With common voting shares, each share is equal in the sense that they hold a voting right and are equal in case of a liquidation. With preferred shares, each share is equal in the sense that they each hold an equal preference with dividend distributions and a preference (ahead of common shares) in the case of a liquidation.
Regarding common shares, they are equal in liquidation; however, it is important to notice that the pari-passu principle does not span across different classes of equities as the different classes come with different risk characteristics, attributes, and costs.
With regard to debt, it is important to understand that the pari-passu principle does not undermine the priority of payout in a liquidation. It does not negate the principle that certain creditors should be paid ahead of others. For example, in the event of a liquidation, senior secured debt holders would get paid before junior secured debt holders, and junior secured debt holders would get paid before unsecured debt holders.
Yet, the pari-passu principle can apply within each tranche of debt. For example, within the tranche of senior secured debt holders, the principle can apply to those creditors within that tranche.
Assume a company wants to raise capital through issue stocks and bonds. The company issues common shares and two bonds which sit within the same tranche of debt, with the same seniority, and rights of payment. However, they are different in terms of yield, coupon rates, maturity, and payment periodicity.
After raising the capital, the company becomes insolvent and must liquidate. According to the pari-passu rule, since the two bonds are within the same tranche, hold the same rights of payments, and are equally senior to each other, the pari-passu principle holds. However, the principle would not hold between the bonds and the stock since the bonds would hold a priority of payment to the stock.
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