A Negative Pledge as an Alternative Solution to Achieve the Pari Passu Pro-Rata Parte Principle

One of the main objectives of bankruptcy law is to ensure the distribution of bankrupt assets from debtors to creditors [22]. The distribution of assets follows the principle of pari passu pro-rata parte, which means dividing bankrupt assets to creditors without collateral based on the consideration of how much the creditor claims [23]. The asset settlement process in a bankrupt company is not exactly clear and does not follow bankruptcy law principles. The principle of pari passu pro-rata parte emphasizes the distribution of debtor’s assets to pay creditors’ debts following proportional procedures [24, 25].

Law concentrates on loans with collateral, which means that the financial perspective of bankrupt company’s assets allocation is not taken into account. The main issue from the law perspective is that for each creditor to have a fair and equal position. From a legal standpoint, the transfer of the assets of insolvent enterprises appears fair, but from an economic standpoint, it is not [26, 27].

The pari passu pro-rata parte principle is an essential clause in the credit agreement. The pari passu clause is standard in international contracts, especially for unsecured debt obligations [28, 29]. To understand the pari passu clause, the meaning of this term is from Latin, namely the phrase ’pari passu’ [30]. Pari passu means ‘with equal step’ (in the same position), and it comes from the word pari, ablative of pars, which means ‘equal,’ and the word passu, ablative of passus, which means ‘step’ or stages [31, 32]. The Supreme Court held that ‘if the agent becomes insolvent, a proprietary claim would effectively give the principal priority over the agent’s unsecured creditors, whereas the principal would rank pari passu, i.e., equally, with other unsecured creditors if he only has a claim for compensation’ [33]. Thus, pari passu means being in the same condition in the same situation and having an equal position. This clause is generally included in debt agreements to protect the lender or creditor from being in a subordinated loan position [34].

With a pari passu position, no creditor has a higher rank than the others. All creditors have the same place [35, 36]. This arrangement in a credit agreement includes equal status between creditors who have guarantees or separatist creditors and does not include concurrent creditors in a pari passu position.

The principle of pari passu pro-rata parte is regulated in Article 1131 and Article 1132 of the Indonesian Civil Code [37, 38]. This principle stipulates that all creditors have the same rights over the debtor’s assets unless there are valid reasons for priority based on the criteria or position of the creditor [39].

The Pro-rata parte regulates the rights of each creditor in obtaining collateral and in voting on matters concerning the debtor. Pro-rata parte is not defined as a one-man-one-vote system, but it is based on the composition of the loan value given to the debtor. The principle of pari passu pro-rata parte is regulated in Article 189 Paragraphs (4) and (5), as well as in the explanation of Article 176 letter (1) of the Indonesia Bankruptcy Law [40].

The pro-rata principle regulates the distribution of creditors’ portions. This principle stipulates that creditors have the same position on guarantees provided by debtors based on their respective loan portions. Each creditor will get an equal share according to the amount of the loan. If Bank A has a loan to a debtor of IDR 5 billion and a total of IDR 100 billion, then the portion of Bank A is 5/100, which is 5%. The 5% portion is the portion of voting rights in deciding on the debtor’s assets. This portion is the rights of the creditor on the executed guarantee if the debtor defaults.

The application of the pari passu principle creates confusion for other creditor [41]. The pari passu principle can only be applied if all creditors agree, and it is stated in a Master Credit Agreement (MCA) [42]. Without an MCA, this pari passu principle cannot be applied between creditors. Without an MCA arrangement, each secured creditor would have collateral rights. This is regulated in the Law of the Republic of Indonesia on Bankruptcy and Suspension of Debt Payment Obligations. The principle of pari passu holds that the position of creditors is the same. In recording the debt of a bankrupt company, the creditors have several functions, namely preference, separatist, and concurrent.

Merchandise suppliers are unsecured creditors. The position of creditors, which is regulated by the pari passu and the pro-rata parte principles, becomes an issue in a default. The role of creditors becomes a sensitive issue when calculating debt restructuring and bankruptcy [43].

Separatist creditors are secured creditors. Separatist creditors hold the right to guarantee material goods, and these creditors can sell the collateral that is guaranteed to them. Separatist creditors can directly sell and auction their collateral [44]. A bank usually is an example of a separatist creditor. Banks as creditors holding material security rights can execute the collateral if the debtor defaults on one’s obligations. Banks’ legal protection is the right to enforce the collateral following Article 55 of the Indonesia Bankruptcy and Suspension of Debt Payment Obligations Law (PKPU Law) [45].

Separatist creditors have mortgage rights and apply parate executies or the right to carry out executions as if there was no bankruptcy [46]. Separatist creditors in executing collateral cannot be hindered by a period of suspension because the position of the separatist creditor is separate from other creditors, and the collateral object is not included in the bankruptcy law [47].

Creditors have the right to have their loans repaid. This has been regulated in the credit agreement that the debtor is obliged to return the loan following the agreed period in the loan agreement. If the debtor defaults, then the creditor has the right to confiscate the collateral. The creditor has the right to sell the collateral to cover the debtor’s obligations [48].

Third-party legal protection is provided by appearing as a concurrent creditor by submitting a third-party loan to the curator in a verification meeting [49]. The suspension of debt payment obligations only applies to concurrent creditors [50]. Creditors want a fast settlement of debt, and the debtor can pay off all debts. The debtor wants a debt settlement that provides legal protection with all debtors able to obtain a refund of the receivables [51].

Many researchers and writers have changed their minds about the pari passu clause. In a market where many businesses have more advanced knowledge, pari passu clauses are considered to have no clear purpose and can result in ineffectiveness for decades [52]. The British Supreme Court has affirmed that the parties must not bind themselves to the distribution of assets to a company based on the pari passu principle [53].

In addition, many of the rules in bankruptcy law contradict the norms and principles of bankruptcy. This creates loopholes for parties who want to take advantage of the condition of bankruptcy with bad intentions [54]. The Bankruptcy Law stipulates that the right to sell, especially mortgage rights owned by creditors, can be suspended if the debtor is in a state of bankruptcy. This is different from the Mortgage Law, which gives creditors the right to execute collateral objects to pay off debtors’ debts [55, 56].

Although the pari passu pro-rata principle is ideally fair and equal in the legal perspective, in practice the principle cannot stand by itself when dealing with distribution of bankrupt assets. There is a need to find for another solution to support the legal principles, and one way is through loan agreements and negative pledge.

A loan agreement is also known as a pro-rata parte clause, which is related to pari passu. The pro-rata parte clause deals more with regulating collateral goods. When all creditors are equally based on pari passu, then the creditors have the same position, namely pro-rata parte, in obtaining collateral rights [57]. Loan agreements fall under the regime of contract law and therefore should be regulated under the Indonesian Civil Code. The agreement should fulfill requirements to be considered valid, which are: consent, capacity of the parties, objects, and legal cause, where the first two are subjective elements and the remaining are objective elements [58].

Some agreements require a negative pledge. A negative pledge is a clause in a deal that does not allow debtors to pledge their assets to any individual party [59]. In essence, a negative pledge is an agreement where the debtor is not allowed to create a security interest over the agreed or all of his asset. The economics explanation of the negative pledge is to prevent the debtor from creating uncertainties to the creditors’ end. As an illustration, say that A lend B some 1 million USD. Under a general loan agreement, A will request a security in the form of asset that allows A to have execution right in case of default. However, instead of adopting the traditional method mentioned, A will take B’s negative pledge, where B agrees not to put any of his asset as a security for other loan agreements.

A study in 2014 by Komara explains how negative pledge is a collateral model adopted from the practice in other countries outside of Indonesia [60]. Nonetheless, the implementation of negative pledge is actually facilitated in article 1338 of the Indonesian Civil Code, Freedom of Contract. Here, parties involved in the contract have the right to make an agreement that also includes the negative pledge clause. Although there are no regulations that specifically talks about negative pledge, the implementation of negative pledge can be seen often in Indonesia. We can also see the implementation of negative pledge in Indonesia from the research done by Utama, Hariyanto, and Hawin, which discusses the case of PT. Bank Mandiri [61].

PT. Bank Mandiri is one of the biggest government-owned banks in Indonesia, the bank also bears the responsibility to support and facilitate the economic growth in Indonesia. Most of the time, when businesses suffer from insolvency and even result in bankruptcy, banks as one of the companies’ loan providers, have to bear a big loss. However, as a prominent government bank, PT. Bank Mandiri must have an innovative and creative solution to provide financial assistance to business owners across Indonesia, one of which is through implementing negative pledge. The research results show that the Master Credit Agreement (MCA) regulates how banks provide companies with loan possibilities but still manage to follow the prudential principles in banking.

Furthermore, in another research done in 2017 by Putri discusses how negative pledge is often used as an alternative for World Bank when providing loans to countries by which the loan-recipient countries will not be able to provide collateral [62]. The practice by World Bank is clearly different in the business world, but Indonesian banks often use negative pledge as an alternative for providing loans. The research found that a government-owned bank, namely, Bank XYZ provide loans without personal guarantee or collaterals but under the condition of negative pledge as a covenant. The negative pledge is made under the bank’s Master Credit Agreement (MCA) and Security Sharing Agreement (SSA) regulations. Negative pledge is considered as a general collateral which is regulated in the Indonesian Civil Code article 1131, 1132 jo. 1320 - 1337, article 8(1) of the Indonesian Law of Banking bill no. 10 year 1998, and Bank Indonesia Decree of Director no. 27/162/KEP/DIR year 1995.

Several companies propose negative pledge clauses not to provide separate collateral agreements to certain creditors. All debtor assets are pledged to all creditors on a pari passu basis. The execution of debtor assets in a state of default will follow the principle of pari passu pro-rata parte. All creditors have the same position towards the debtor’s assets based on the pari passu principle in a negative pledge. However, the calculation of rights to assets is based on the pro-rata parte principle. The position of the debtor is not distinguished between separatist and concurrent. Thus, the negative pledge is related to the pari passu pro-rata parte principle. The clauses will be related to the principle of balance (equality) and the principle of justice (principle of fairness).

The negative pledge clause is not fully effective in protecting creditors in obtaining the right to collateral. Others can use the “priority principle” [63]. For the negative pledge to work, the priority principle must be removed.

The determination of the right of execution of the collateral by the creditor is based on the position of the company’s debt. This theory is based on the accounting theory. The accounting theory holds that short-term debt is above long-term debt. Debt is placed above the capital. The placement of the Chart of Account (COA) records determines the priority in the order of payments. The accounting theory does not consider the collateral effect.

The position between creditors is based on the order of COA in the accounting theory. Under normal circumstances, creditor priority applies. In a state of default, all creditor’s debts become due and can be collected so that the creditor’s position becomes equal. Workers have positions as preferred creditors with privileges that prioritize payments from other creditors in the event of bankruptcy [64]. Workers’ wages are categorized as preferred creditors according to the regulations. Tax payable also is classified as preferred creditors [65, 66].

From the aforementioned discussion, it seems that there is a disharmony regarding the regulations. Regulations are silent in the possibility of using negative pledge in a loan agreement. The lack of regulatory framework on the field will invite court’s decision in providing legal certainty of the use. The decision may be in the form of analogy (argumentum per analogiam) [67], depending on how the existing regulation might fit the use of negative pledge. On the other hand, banks, by regulation, are required to comply with the precautionary principles that under Indonesian Banking Law is translated into the 5 Cs: Character, Capacity, Condition, Collateral and Capital [68]. This is to ensure that banks do not end up with too much of non-performing loan [69].

Creditors will always suspect debtors. The debtor will not disclose the precise information to the creditor. Debtors who provide valid details to creditors will not receive financing. There are two hypotheses of this research:

Hypotheses 1:

The relationship between creditors and debtors will not achieve a fair and an equal relationship

Hypotheses 2:

The relationship between creditor and creditor will not achieve a fair and an equal relationship.

4.1 Legal perspective

The notion of loan-agreement itself has self-explain that it is a form of an agreement. Indonesian law categorizes loan-agreement as a named agreement, as it is one of the forms of agreement recognized by default under the civil code. As an agreement, it is regulated under Article 1320 of the Civil Code where an agreement is constituted if it fulfills four elements: consent, capacity of the parties, objects and legal cause. Banking regulation, however, puts a higher standard of legal cause element as Indonesian banking law requires a loan agreement from a financial institution to fulfill 5C principles. The five Cs are: Character, Capacity, Condition, Collateral and Capital. Collateral is essential under Indonesian banking regulation and, although some exceptions may be applied, without collateral, banks are not allowed to pass a loan. This is to ensure legal certainty of the creditors, especially taking into account that principle-agent theory might highlight the different incentives between the bank owners and the loan officers. Legal theories in general requires certainty on both creditor and debtor’s end. With certainty as the ultimate aim, negative pledge turns to be an instrument that provide certainties to the creditor.

In essence, these two forms are way of the judges in adjudicate a case without any strict regulation. A negative pledge is an agreement where the debtor is not allowed to create a security interest over a specific or all assets. Negative pledge falls under the contract law regime where trust plays a huge role in its application. Negative pledge essentially disregards the collateral element of the banking principle, where the loan will be securitized by the debtors’ promise not to encumber specific or any asset under his possession. Assuming perfect information between the debtor and creditor, negative pledge offers a more efficient alternative in a loan agreement then a loan with security as it will result in less hassle of administrative process in securitizing, and allowing debtors to retain the assets, which result in leaving debtor with more available business decision. Under Indonesian law, however, negative pledge is not per se recognized. This invites present practicalities to be a question of interpretation. In any submitted case before the court, the judge is required to interpret the approporiation of negative pledge under Indonesian Law as they are not allowed to reject a case. The judges may find the law in the form of either intepreting the law or constructing the law.

The writer will first argue on whether in understading the negative pledge, the judge need to use legal construction or interpretation. Legal construction is an approach used by the judges in adjudicate a case, yet the case is both unprecedented and constitutively regulated. In this situation, the judge would need to ‘construct’ the law, creating a judge-made law that is not a product of legislative body, but purely from judicial body. However, another situation where the case does not perfectly match the existing regulation, but in principle, the case is normatively resembled from the existing law. In this kind of case, legal construction might not be efficient since a new law is not necessarily required. Therefore, taking the context, principles and analogy from other case or the existing constitutive regulation might be a wiser decision for the judge. Apart form the efficiency, such approach will also provide future certainty as the interpretation of the judge might enlight the written law in more detail with a proper precedent basis.

Retracting back to whether negative pledge is a practical case that require interpretation or construction, the writer argues that a legal interpretation through analogical approach is a more likely approach to be used. There are some reasons for the writer to reach this conclusion. First, the determination of the approach is based on the existence of regulation. While we do not have any regulation that normatively recognize negative pledge, we have securities law and security is the embodiement of trust that the debtor would be able to pay the loan. Second, Indonesian banking regulation clearly adopts the banking precautionary principle. This is to ensure that bank does not end up with a too high non-performing loan, which in a larger scale might disrupt the national economy.

Negative pledge essentially allows one to receive a loan without any asset collateral, as the collateral offered is merely in a non-asset form, the promise that the asset will not be used as a security for other loan. From the perspective of economics, with the assumption of clear calculation of risk, negative pledge is a more efficient option than collateral. The legal theory would agree this principle. While the regulatory framework provides a clear guideline on collateral and encumberement, Indonesian banking law does not regulate collateral as an absolute requirement. This norm itself has opened a door for interpretation. Third, the negative pledge, as a part of a loan agreement, remains within the scope of contract law regime. The freedom-of-contract principle is therefore applicable and both parties should be left to be the ones to decide whether the negative pledge is acceptable or not, not the judicial body. A negative construction that disallows negative pledge would be quite patrilineal that might result in unknown economics efficiency in the society. Therefore, interpretation within the scope of legal and economic theory that support the existence of negative pledge is a desired approach by the society. Present normative laws are suffice to accommodate the possibility of applying negative pledge, and construction is not required.

As mentioned before that from a legal perspective, the distribution of bankrupt assets may seem fair and equal. However, through economic and financial perspective the same conclusion may not be reached. Therefore, there is a need to incorporate both standpoints in order to have a better understanding of the issue.

4.2 Economic and financial perspective

Looking through the relationship between debtors and creditors, debtors obtain loans from creditors by providing collateral. Creditors need collateral to reduce credit risk. This collateral can be executed if the debtor defaults. Arrangements regarding execution procedures at the time of default are stated in the credit agreement.

Creditors will ask for the highest possible collateral coverage. The higher the coverage ratio, the more the creditors believe that the loan will be secure. Creditors ignore other information and focus on the collateral value obtained. The debtor will try to provide minimum collateral. Small collateral will allow the debtor to get additional loans. Additional loans can use the remaining assets that have not been pledged as collateral. As a result, creditors suspect that the coverage ratio is not the same between creditors.

Creditors who just made the last loan will get a worse collateral asset. However, creditors still need debtors. A bank needs debtor as consumers. The comparison of collateral coverage and type of collateral per creditors is described in Figure 1. Each creditor provides different loan facilities with different collateral and different collateral ratios. This creates problems of justice and balance.

The leverage ratio is a comparison between debt and capital. The comparison of collateral coverage is the ratio of total assets divided by total debt. This collateral coverage is related to the leverage ratio. The explanation of this calculation is in Table 1.

The covenant regarding collateral coverage reflects the ratio of total assets to total debt. Total assets are total debt plus equity. This covenant clause has a calculation basis. The covenant concerning leverage ratio and collateral coverage is referred to as total assets and equity and leverage ratio.

In a credit agreement, the covenant regarding leverage ratio is related to collateral coverage. The debtor’s leverage ratio is 10x, so the maximum collateral coverage ratio is 110%. If the debtor’s leverage ratio is 10x, the collateral coverage ratio is unlikely to reach 120%. A collateral coverage ratio of 120% can only provide a leverage ratio of 4x. This is explained in Table 1.

Table 1. Calculation of leverage and collateral coverage

The leverage ratio is a comparison between total debt or liabilities to equity. In addition, the collateral coverage ratio is the ratio of total assets to total debt. Total assets are the sum of total debt and equity. This is illustrated in Figure 2.

However, creditors do not believe that they can get good assets by obtaining a high collateral coverage ratio. Creditors tend to ask for a lot of collateral with a high level of collateral coverage. The debtor may not be able to provide a high collateral coverage ratio. The number of liabilities and equity limits the number of creditor assets. Thus, the debtor may not offer a lot of collateral and with a small number of assets. Creditors try to get a high collateral coverage ratio. If the debtor gives it, the debtor is likely to make a double or triple pledge on the same asset. Creditors and Debtors have different positions. The creditor is the master, and the debtor is the agent. Between agents and masters have different views. This is in line with Agency Theory.

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Figure 1. Comparative of collateral coverage and collateral type

A double pledge or triple pledge is a fraud or violation of the credit agreement. The same asset is given as collateral to more than one creditor. This violation may lead to default for failing to provide guarantees to creditors. Creditor collateral must be free from guarantees to parties other than following the laws and regulations regarding guarantees.

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Figure 2. Leverage ratio

In reality, cases of double pledges or triple pledges still occur in the real world. These cases have increased creditors’ distrust of debtors. The cost of granting credit is getting higher because of the higher risk. The collateral value determines the cost of credit. High credit costs result in high production costs. High production costs become a burden on society.

Creditors want to get the same position as other creditors according to the type of loan. Creditors like to have rights to the company’s assets following a loan, especially at the time of default. This is in line with the pari passu pro rata parte principle.

The principle of a negative pledge will provide a solution to achieve the pari passu pro-rata parte principle. Debtors do not pledge certain assets to certain creditors. All debtor assets become collateral to creditors. All creditors have equal rights to the debtor’s assets, including current, fixed, and other assets.

4.3 Agreements in negative pledge

As previously discussed, negative pledge is presently not directly regulated. However, there are two regimes of law that indirectly regulate negative pledge, which are contract and banking law. From the contract law point of view, a negative pledge is part of the loan agreement provisions and therefore shall be deemed as a valid clause as long as it fulfills the element of an agreement. Both parties in the loan agreement should have agreed that negative pledge is accepted as a collateral for creditor, which is a fulfillment of the element of consensus. Capability, on the other hand, is a subjective element and depend on the parties. As long as the individuals are not minor and is not under any form of guardianship, then they are capable. The third elements, the specific object clause, is clearly fulfilled as the loan agreement would specify the details of the agreement. The last element, the legal cause, however, would be a more debatable element. The non-existence of direct regulation of negative pledge invite a deeper analysis, mainly on economics point of view, that turns to be the main discussion of this section.

The negative pledge requires the abolition of the creditor’s special rights. Creditors must waive priority principle rights, net-off rights, and other preferential rights. Creditors have the same position as at the time of bankruptcy. All debtor assets become collateral to all creditors. Debtors do not differentiate between secured and unsecured creditors or between trade payable and loan payable. The schematic system is depicted in Figure 3. All creditors have collateral for company assets and creditor rights are based on the same loan amount and loan ratio. So that there are no creditors who are exaggerated in the ratio and type of loan. Each creditor knows the position of the other creditors.

Covenants for all creditors are the same. All creditors have the same covenants, such as leverage, collateral coverage, shareholding, dividend payouts, positive covenants, negative covenants, and affirmative covenants. A credit agreement is the same for all creditors. Creditors will know the number of existing creditors and the amount of a loan. Creditors allow new credit facilities as long as the leverage ratio is below the specified amount stated in the credit agreement.

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Figure 3. Negative pledge

This credit agreement is known as a Master Credit Agreement (MCA). Every creditor who wants to provide a loan will sign this agreement. Each new creditor entering it will sign this agreement. The debtor will notify the new creditor of the existing creditors.

Debtors offer MCA to all creditors. If the debtor already has a loan, then all the agreements are combined into one. The contents of this agreement incorporate all covenants and clauses contained in all contracts. After this merger, each new creditor will co-sign the MCA. This clause opens the entry of new creditors with an obligation to notify the existing creditors. The debtor only informs them and does not require consent. New creditors will also get a list of the existing creditors and the loan amount. Thus, all creditors have the same position in the agreement. Creditors will not suspect each other. MCA regulates credit agreements. MCA complies with the pari passu principle.

In addition to the MCA, creditors will sign a negative pledge agreement or Security Sharing Agreement (SSA). This SSA will stipulate that all debtor assets are collateral for all creditors in the MCA. Creditors have collateral but do not have specific collateral. Collateral in SSA is a mutual guarantee. Creditor supervision is the responsibility of all creditors. Figure 4 describes the SSA scheme.

The debtor agrees to the collateral. This agreement is called the Security Sharing Agreement (SSA). All debtor assets become one pool of assets that are pledged as collateral. All creditors are entitled to this pool of assets—the distribution of rights based on the portion of the loan that has been used. SSA complies with the pro-rata parte principle. Creditors may appoint a trustee as the manager of the MCA and SSA.

MCA and SSA are forms of implementation of the negative pledge principle. MCA and SSA also comply with the pari passu pro-rata parte principle. Creditors must leave certain privileges and rights to the collateral. Creditors have confidence that they are on the same level as other creditors.

With MCA and SSA, debtors and creditors will be more efficient in the loan agreement process. Credit and guarantee agreements already exist, so there are no additional fees for making agreements. Old and new creditors have confidence and trust in the debtor.

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Figure 4. Security sharing agreement

The concept of MCA and SSA is common after debtors and creditors agree on a restructuring proposal. The restructuring proposal is signed by the creditors who agree to the debt restructuring with the debtor. The concept of MCA and SSA is moved to an earlier stage and is beneficial to all parties before bankruptcy occurs.

Debtors who have good performance and a good reputation can start offering negative pledges to creditors. The principle of the negative pledge will save the cost and time of debtors and creditors. Not all creditors can accept this negative pledge principle. Debtors rather than creditors offer standard clauses. A violation of the law regarding standard clauses does not apply here.

The implementation of a negative pledge must follow the regulations of the financial authorities in each country. Some financial rules require explicit guarantees for lending. Creditors, especially banks, will find it challenging to meet these requirements.

This implementation can be in the form of a combination of particular collateral to creditors and negative pledges. This implementation is a transition period before fulfilling the 100% negative pledge. The mixture can be 50% special or collateral to creditors, and 50% is a negative pledge. This combination is only for the value of the guarantee. The contents of the agreement remain the same as the MCA. The interests of creditors are guaranteed by the contents of the MCA credit agreement. Covenants governing debtors stay the same between creditors under the MCA. This scenario can still achieve the pari passu pro rata parte principle. The difference only occurs in the collateral owned by 50%.