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The pari passu principle refers to the equal treatment of unsecured creditors when a company is insolvent.
In business, it’s not uncommon for things to go wrong. When finances are involved, it’s always good to have guarantees that can make sure all stakeholders are treated fairly.
The pari passu principle gives lenders the knowledge they will be treated equally to others should the company ever face insolvency.
In this article, we’ll explore the pari passu principle further in the context of insolvency and creditors – keep reading to find out more.
What Does Pari Passu Mean?
Pari passu means dividing the assets equally between unsecured creditors when a company becomes insolvent (we’ll go through what this involves below). The term ‘pari passu’ is a latin terms meaning equal footing, where all parties are treated equally and without discrimination.
In the context of business law, this means that creditors that have a claim to an insolvent company’s debts are not subject to preferential treatment among one another.
What Is Insolvency?
Insolvency is a term used to describe the state of a company that is unable to repay their debts in time. There are three common option for companies to take when the have been declared insolvent:
- Voluntary administration – an external person is appointed to manage the company’s affairs
- Receivership – a secured creditor brings in the receiver to sell the companies assets in order to repay the debts
- Liquidation – all the assets belonging to the company are sold off
When Is A Company Insolvent?
In very basic terms, a company becomes insolvent when the money coming into the company is not enough to sustain the company. Therefore, the profits and revenue the company makes (if any) cannot cover the company’s expenses or debts.
As a result, the company is unable to pay their debts in time, landing them in financial trouble. Insolvency can be voluntary or forced.
There are a multitude of ways insolvency can occur, making it difficult to pinpoint an exact reason for companies to face insolvency. However, factors that can contribute to financial troubles eventually resulting in insolvency can include:
- Poor financial management
- An unstable businesses environment
- Entering contract that are detrimental for the company
- Legal proceedings that result in hefty payments
Anyone or a combination of these could lead the company into debt causing them to declare insolvency.
Who Are Creditors?
Creditors are individuals or organisations that have given monetary loans to a company. In the context of insolvency and the pari passu principle, creditors can be divided into two categories:
- Secured creditors
- Unsecured creditors
As we mentioned above, the pari passu principle applies to unsecured creditors.
An unsecured creditor is someone who does not have security for the amount of money they have loaned the company. As a result, when a company faces insolvency, the secured creditors are the ones who have the priority in being paid back.
Once the secured creditors’ debts have been repaid, the remaining assets are distributed equally and at the same time among the unsecured creditors. This is known as the pari passu principle taking effect.
Should I Have A Pari Passu Clause?
A pari passu clause can give lenders additional peace of mind when loaning money to a company as the principle is protected by legislation. In fact, many potential creditors might be wary of signing any loan agreements that do not have a pari passu clause.
Pari passu clauses can be complex concepts, so we recommend getting a legal professional involved so they can help draft a strong pari passu clause that works for both the company and the creditor – contact us today if you need any help.
| Example Baking & Co is a kitchenware company that is being liquidated due to their heavy financial debts. Julian is a creditor to the company, as he once lent them a significant amount of money which, at the time of liquidation, had not been paid back. As there was no security for his loan, Julian falls into the category of an unsecured creditor. However, Julian’s loan agreement contained a pari passu principle. Therefore, once the secured creditors were paid, Julian could rightfully expect to be paid equally and in a timely manner with any other unsecured creditors Baking & Co owed a debt to. |
Key Takeaways
A pari passu clause ensures creditors will be treated equally if the company they are lending money to becomes insolvent. However, a pari passu clause should always be added to a loan contract with the help of a legal professional, as they can be somewhat complex.
To summarise what we’ve discussed:
- The pari passu principle means all unsecured creditors are treated the same when a company becomes insolvent
- This usually means they will be paid equally and at the same time
- Insolvency occurs when a company cannot repay their debts
- A credit is someone that has lent money to a company
- Pari passu clauses can be included in loan contracts to give potential creditors a sense of additional security, should things not go as planned
If you would like a consultation on a pari passu clause, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.
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