In sovereign loan agreements there are several critical legal clauses that can impact how debt is treated in the case of a debt restructuring. Some of these terms do not receive much attention in the drafting process, but may have a significant impact in the event of default, restructuring or vulture fund litigation. The ALSF is starting a new series where it will focus on one particular clause each month with the goal of educating our readers on how this term fits into the larger picture of the debt agreement.
The first clause that we will look at is the “pari passu” clause. Pari passu is a Latin phrase that means “with an equal step” or “on equal footing.” This clause is related to the seniority of the underlying debt. In general, a pari passu clause is intended to rank all creditors equally in the event of a default or restructuring. It requires the issuer to treat all senior assets equally without any display of preference. The conventional use of this clause is to ensure that the borrower does not take on any obligations that rank legally senior to the debt instrument taking the clause.
Here is a typical pari passu clause in a cross-border agreement:
The Notes rank, and will rank, pari passu in right of payment with all other present and future unsecured and unsubordinated External Indebtedness of the Issuer.
On its own, the clause seems harmless and plays a key role in commercial debt agreements. However, in the sovereign context, its role is less clear and the subject of debate among legal scholars.
These clauses take on particular importance in the context of commercial creditor actions against sovereign debtors and vulture fund litigation. In an enforcement action initiated by Elliot Associates, L.P., a New York based hedge fund, against the Republic of Peru, a Belgian court interpreted the clause to mean that the debt must be paid pro rata among all creditors.
This interpretation by a Belgian court on an issue of New York law has provided a tool for vulture fund creditors. Following the ruling in the Elliot case, Argentina, Democratic Republic of Congo, the Republic of Congo, and Nicaragua all faced claims brought on the interpretation that the pari passu clauses in the sovereign debt agreements required that the creditors be paid on a pro rata basis. This interpretation gave holdout creditors in debt exchanges (a common tool for restructuring sovereign debt) a powerful legal argument that potentially prevents governments from successfully restructuring their debt.
The practical implications of a “boiler plate” legal clause can be far reaching as seen in the context of the pari passu clauses. Next month, we will look at Collective Action Clauses to see how they can assist governments in preventing holdout creditors from delaying the debt restructuring process.
 Buchheit, L. and Pam, J., Georgetown L. Rev. Working Paper, The Pari Passu Clause in Sovereign Debt Instruments, 2003.