08 May Pari Passu Clauses: An Alternative Interpretation
[Hayk Kupelyants is a PhD candidate at the University of Cambridge]
Pari passu clauses remain perhaps the most nebulous clauses found in sovereign bonds. Among varying wordings, the clause in its simplest form provides that the bonds will rank pari passu (i.e., on equal footing). The clause puzzled many academics and has given rise to legal battles before national courts, for it is undeniable that the state is not subject to a bankruptcy regime where the pari passu treatment is naturally well-fitted.
Two interpretations have been offered to demystify the function of the pari passu in sovereign debt bonds. The first and the most controversial of these constructions argues that the clause requires equal payment to all, even holdout, bondholders. Recently, the Second Circuit Court of Appeal in NML v Argentina has endorsed this interpretation of the pari passu clause. Under this construction of the clause, a sovereign debtor is obliged to pay to all bondholders, even those who held out from the sovereign debt restructuring. The pari passu clause can thus become a powerful tool in the hands of holdout creditors which seek to reclaim the full value of the bonds they hold by claiming that the state is in breach of the pari passu clause by the mere fact of refusing to pay up.
Many academics have argued that this interpretation of the pari passu clause is too far-fetched (at least for the pari passu clauses that do not expressly refer to ‘payment’ in their wording). On its face, pari passu clauses simply require equal (legal) ranking, whereas the payment under bonds is a question of factual performance of the contract and not a question of priorities or ranking.
The second and the conventional interpretation of the pari passu clause argues that the clause merely ensures equal legal ranking and no factual equality in terms of payment. By this, the sovereign debtor would be under no obligation to pay to all bondholders.
Two counter-arguments spring to mind. First, equal legal ranking would presuppose that at the insolvency of the state, creditors would be accorded separate priorities (or divided into separate orders) and the creditors within a single priority/order would be treated equally. However, the state is not subject to any sort of insolvency regime and nor one can think of legal rankings of sovereign bondholders. The pari passu clause, as construed to be limited to legal ranking only, would thus carry no practical sense. The pari passu clause under this interpretation is merely ‘emphatic chest-beating’ or ‘a credibility signal’.
Second, the conventional interpretation of the clause tends to locate the origins of the clause in some historical incidents and claim that the clause has been dragged along for decades by inertia or mistake into modern sovereign bond contracts. With the disappearance of the historical necessities that prompted the insertion of pari passu clauses, the clauses would have no practical application in the modern world. Such historic interpretations reduce the pari passu clause to nothing more than a nonsensical clause.
To a commercial judge, the historical interpretation of the clause that does not purport to answer to the question of its modern meaning may sound too post-modern. This phenomenon might explain the readiness of the US courts in NML v Argentina to agree to the ‘equal payment’ interpretation of the clause which affords at least some sense to a contractual clause found in complex commercial transactions which the sovereign bonds undoubtedly are. Courts are not as a general matter inclined to recognise the unreasonableness of markets in blindly following a clause that does not serve any purpose and bears no contemporary meaning. Courts would feel the need to rationalise a clause that seemingly rational market players constantly include in sovereign bonds and fill the clause with some content.
Consequently, some reasonable interpretation needs to be offered in litigation. This post offers a third and alternative interpretation of the pari passu clause. It is suggested here that the pari passu clause introduces reinforced protection against unfair discrimination in the process of debt restructuring. The sovereign debtor that would propose bond exchange offers, with varying contents, to the bondholders, without a defensible reason, would be acting in breach of the pari passu treatment. To provide a simple example, a state that would solicit a debt reduction of 50% from the group A of bondholders and a reduction of 70% from the group B of bondholders might be acting in breach of the pari passu clause. Equal ‘ranking’ would thus imply ensuring ‘level playing field’.
Discrimination would still have to be unfair to be in breach of the pari passu clause. To cite a few examples, the preference given to domestic banks to preserve the national economy is reasonable and fair, and so is the according of preference to long-term creditors, those creditors inclined to provide further funding and trade creditors over the rest of creditors. By contradistinction, a restructuring that would differentiate between two groups of creditors without a defensible reason is likely to be in breach of the pari passu clause. It is not the ambition of this post to define the standard of ‘fair treatment’ but it is argued that the judicial review under the pari passu clause should be very deferential and the courts should intervene in exceptional circumstances only.
Of course, the extent of coverage of the pari passu clause would depend on the precise wording of the clause. Commonly the pari passu clause requires equal treatment with all other unsecured and unsubordinated obligations of the sovereign debtor which is likely to extend the protection of the clause across all the debt obligations owed by the sovereign debtor.
Questions of unfair treatment of bondholders are brought with some frequency before the English and US courts and one can reasonably assume that the pari passu clause can be construed to deal with the discrimination to the prejudice of the minority when the debt restructuring excludes certain bondholders from the restructuring or treats them unequally. The first historic account of the appearance of the pari passu clause in a 1843 Mexico bond, whatever its weight might be, can also confirm this interpretation of the pari passu clause. Chabot and Gulati chronicle that Mexico might have inserted the clause to forestall the British diplomatic protection in respect of the Mexican public debt that had been discharged in a discriminatory manner. When, following the introduction of the pari passu clause, the British government complained that various British bondholders had not been paid, the Mexican ambassador to the United Kingdom parried that Mexico offered ‘to all creditors’ the same exchange offer.
Contrary to what the Second Circuit decided in NML v Argentina, the pari passu clause, under this alternative interpretation, would not require rateable payment to all creditors. Unless the bondholders have not been presented equal exchange offers at the stage of the restructuring of the bond, they cannot complain of not being paid up. Equally, the proposed interpretation goes further than the traditional interpretation, argued by Argentina in NML v Argentina, by requiring fair treatment as a matter of fact and not merely as a question of legal priorities.
The third, alternative construction proposed here is a more reasonable construction of the clause, it ensures a certain practical meaning to the clause, avoiding the apparent objections to the both interpretations of the clause offered so far. Equally, it is not too intrusive of sovereign debt restructurings and nor it leaves the bondholders empty-handed. It ensures a golden middle for the construction of the clause.