The Pari Passu mechanism, in Latin “of equal level”, appears in several legal disciplines, including Securities & Collateral Laws.
In economic reality, a Borrower is sometimes required to receive finance from an several Banks; whether the first financer isn’t interested in granting an additional credit or it is the Borrower’s will to distribute the credit between deferent financers. In a situation where the liens given to the first Bank constitute a barrier for the second Bank to credit the Borrower, it has a significant effect on raising the additional finance required to the Borrower.
In the Banking Law field, the Pari Passu mechanism details the obligations between several banks granting credit to a certain Borrower, where in principle it includes all the securities taken from the Borrower that will serve the lending Banks on due payment date.
The principle appearance of the Pari Passu term in Banking Law orientation, is frequent in internal agreements made between Banks granting credit, from time to tome, to a Borrower, so that the preference order amongst current liens of each Bank shall be distributed relatively according to the balance of Borrower’s debts to each of the Banks as shall be on due payment date and between the total debts of the Borrower to the Banks on such date.
In other words, the banks agree among themselves that liens registered on their behalf (either permanent lien or floating lien) shall not be exercised by the date of their formation or registration, but relatively to the borrower’s debt to each of the banks on any conclusive date.
The Mechanisms Underlying Logic
The Pari Passu mechanism actually constitutes an equalization of liens level (usually retroactively), enabling each Bank granting credit to the Borrower without damaging the regular course of business and with no need for proper registration of all liens and securities in consideration of the credit grant date – it may be considered as sort of a joint pool of securities that will serve the parties to the agreement and from which they’ll collect their debt by exercising the securities, respectively to the total finance sum they granted to the Borrower.
The partnership in such securities forms a sort of strategic balance in which at any time the Bank is interested in granting an additional amount of credit it will well consider it, knowing the initial risk for lack-return of credit bears on it. The balance expresses in increasing its relative share in the creditor fund (the consideration for the risk). Such balance is conditioned on that the parties to the agreement share their mutual interest in the Borrower and rely on the mutual pool of securities granted by him. Any deviation from that balance undermines the internal rational and logic of the agreement.
Inter-Bank Bona Fide (good faith) Duty
This inner logic is contradicted in a situation which one of the landing banks increases the credit without exposing itself to risk, by receiving an external security. Taking an external security by a party to the agreement undermines the same balance and might cause to an externalization phenomena during grant of credit. Thus, for example, a bank may disperse credit, in a consciously uncontrolled form, or at least in granting credit lightly, knowing that on one hand it increases its part in the secured credit, and on the other hand in a situation of partial lack of return it will exercise, if required, also the external security.
Is it appropriate granting such financier the benefit from the Pari Passu agreement advantages?
Lately Supreme Court resolved that issue (C”A 1974/11 the First International Bank for Israel Ltd vs. the National Bank for Israel Ltd).
On that matter a corporation wished to take over a borrowing company that consumed credits from deferent banks. Several years back the banks signed a Pari Passu agreements in order to settle the borrowers debt, and in that frame it was determined that each bank shall be entitled to grant and renew credits to the borrower secured by liens that are all under the agreement (a lien on the barrowing company stocks, and assets).
One of the banks that financed the borrower, also financed the operation of the corporation that wished to take over the borrower and even the take-over attempt. Under the taking over attempt, instead of granting credit to the taking over corporation, it granted additional credit to that borrower which was in difficulties and on the bridge of insolvency, against taking securities under the Pari Passu agreement and external security in a form of guaranty from that taking over corporation. Thus, it turned out that the borrower consumed an additional credit that financed its take- over.
For purpose of control stock transfer, that bank is required to receive the approval of all banks to-which the stocks equity has been encumbered under the Pari Passu agreement. The additional credit has been granted to the borrower by the bank before the other banks opposed that action and the transfer of stocks.
A year later the borrowing company reached insolvency and Court was required to the question whether that additional credit (used for the take over) is shield under the Pari Passu agreement along with the other credits which are secured at an equal preference level, or rather it should be considered a debt of lower level.
The facts of the case revealed that the bank did not disclose to the other banks (Parties to the Pari Passu agreement) about the means of financing the take-over by the taking-over corporation. Additionally, it was resolved that the other banks were informed that the taking-over corporation shall give an owners loan and not a security for an additional credit to the borrower. Therefore it was resolved that the bank, which was aware to the manner of take-over on the borrower, is obligated of disclosing to the other banks regarding the source of the additional credit granted to the Company. The duty was breached by it, and it must not be allowed to benefit from such breach.
By the non-disclosure, the bank improved its position, inasmuch as the increase of credit relation under the Pari Passu agreement parallel to receipt of external security from the taking over corporation, provided the bank a significant advantage in any respect related to the secured credits it granted the borrower.
The non-discloser about the true nature of the take-over transaction forms stopple which prevents the bank from claiming that the increase of credit is shield under the Pari Passu agreement, in a manner that increases its relative share of credit.
A bank that served as a party to the Pari Passu agreement, is under a duty of discloser to the other banks as part of the good will and fairness obligations, especially when in the Pari Passu agreement there is an explicit obligation of each one of the banks to render other banks with “any information on the borrowing company that is known to it on that date.”
Due to the linkage between the additional credit to the take-over transaction which was financed from the “joint obligo”; due to the purpose and logic of the agreement between the banks; and due to the breach of disclosure and fairness duties of the bank to the other banks regarding the external security, there is no place to grant the additional credit a status of equal credit level and thus should be excluded from the Pari passu agreement.
It seems that there can be no argument on the breach of discloser duty effect, but the question is whether accepting an external security by itself eliminates the agreement’s application on the additional credit granted. If the parties of the agreement have not posed a limitation on taking external securities, why the additional credit ought to be excluded?
Among other reasons, the Court relied on a commercial rational and ruled that if the bank truly believed that there is a business justification for an increase in credit, it ought to do it properly and in the frame of the Pari Passu agreement, alternatively, to grant the taking-over corporation a loan for financing the take-over. Instead, the bank financed the take-over from the borrower’s funds and not by external funding, and that was found wrong.
In conclusion, the rational can be simplified: whoever wishes to equalize the level of the additional credit under the Pari Passu agreement ought to be of equal level also in the securities. On acceptance by the bank of additional security in the form of a guaranty of the ceasing corporation it excluded itself out of the Pari Passu agreement with respect to the additional credit.
Court actually applied an inter-bank duty of good will and fairness regarding how the banks should conduct themselves with each other, and that from signing on a Pari Passu agreement which obligates equal treatment and refraining from exploiting opportunities to improve the securities alignment of one bank over the other.