I. INTRODUCTION
A loan participation is a sharing or selling of interests in a loan, used by banks as an important part of lending operations. Participations in loans are sold to: enhance a bank’s liquidity, interest rate risk management, capital and earnings; diversify a bank’s loan portfolio; or serve the credit need of borrowers. When a bank reaches either internal or legal lending limits for certain borrowers, a loan participation allows the bank to continue providing the needed credit to its borrowers. A loan participation results in complex legal relationships with regard to a loan transaction, including, but not limited to the original loan documentation, payments and application of payments, amendment and modification of loan documents and collection activities. The originating lender (lead bank) is concerned with (1) its relationship with the borrower; and (2) its duty to the participating bank in dealing with the borrower.
The legal effect of a loan participation was defined by the Nebraska Supreme Court in Central States Resources Corp. v. First National Bank in Morrill, Nebraska, 243 Neb. 538, 544,501 N.W.2d 271, 276 (1993):
“A participated loan results in the sale of a designated percentage of the loan to the participating bank with the lead bank acting as the participant’s agent to collect and forward the appropriate repayments and to service the loan...”
In this case, the Court noted that legal title to the loan and attendant documents in a participated loan is not transferred in proportionate part to the participants, but remains with the originating lender. Absent agreement to the contrary, the participants must look to the lead bank for satisfaction of the participation amount, since they are not themselves creditors of the borrower and cannot assert claims against the borrower. See also, Northern Bank v. Federal Dep. Ins. Corp., 242 Neb. 591, 598, 496 N.W.2d 459, 465 (1993).
The loan participation is the sale of a portion of the loan and not merely an unsecured loan to the lead bank. The Nebraska Supreme Court has further held that the lead bank holds the loan documents and receives and holds any payments on the loan in “constructive trust” created in favor of the loan participants, with the lead bank as the trustee.
The loan participation relationship may be a source of potential conflict, likely to surface if the participating bank disagrees with the manner in which the lead bank is handling the loan, or if the loan is in default and there are disagreements regarding the lead bank’s collection activities. After default, disputes can also arise as to the original loan documentation and the statements or representation that were made by the lead bank to the participating banks when the participation was created. It may be too late by then to alter the relationship between the participating bank and the originating lender.
In First State Bank v. American National Bank, 808 P.2d 804, (Wyo. 1991) the court held that participating banks are bound by the express terms of participation agreements, including language which disclaims any warranty of collection by the originating bank. Participating banks must become familiar with terms of participation agreements. The Court adopted an OCC Guideline, requiring the participating bank to conduct an independent credit analysis to satisfy itself that the credit is one which it would extend directly.
The Nebraska Supreme Court has held:
“In the final analysis, the terms of the participation agreement govern the relationship between the lead and participating banks” Northern Bank, supra, at 599, 596 N.W.2d at 465. Thus, a participation agreement should be well thought out, carefully considered and negotiated when the participation is drafted.
Negotiating and drafting the form of participation agreement like a see-saw. An originating lender may not want to represent or warrant anything while a participating lender may want representations and warranties of everything. The appropriately drawn document should strike a balance for the relationship to work. Each party should negotiate on a “level playing field” even though the desires or abilities of each are different. Key items should be a part of any participation agreement. Participation documents should be carefully drafted and reviewed by bank counsel.
II. KEY PROVISIONS
The following is a list of key provisions found in a “fair and equitable” participation agreement:
1. Agreement should be structured as a nonrecourse sale of a percentage share in the underlying loan.
2. Collection/servicing powers of the originating lender should be restricted so that the originating lender may not, without the consent of all participants, alter the interest rate, modify the underlying loan transaction, release collateral, etc.
3. Originating lender should be held to the same standard of care it would exercise if it were the sole owner of the loan.
4. Originating lender should represent and warrant that: (a) it has submitted to the participant all financial and other data available; (b) it has submitted true and complete copies of loan documents; (c) it has unencumbered ownership of the loan and authority to sell the participation; and (d) perhaps other representations and warranties. As to “perfection and priority” issues, this is a commonly disputed item between originating and participating lenders and is a subject of negotiation.
5. Originating lender should be obligated to satisfy continuing reporting requirements.
6. Participant should represent and warrant that the agreement has been duly authorized and that the participant has made its independent evaluation of the underlying credit.
7. Agreement should make provisions for a participation certificate, purchase and funding of the participation, and disbursement of loan repayments, the specific mechanism for all of which is negotiable.
8. As a rule, sharing of payments under the participation agreement will bepro rata and should be specified. The agreement should also address the application of payments from borrower on the participated loan and on other obligations of borrower to the originating lender.
9. Participation agreement should containa procedure for resolving disputes between the parties, although the method is negotiable.
10. Written approval of all parties should be requiredbefore any assignments or subparticipations are made - the relationship between the originating and participating lenders is unique.
11. Reasonable expenses incurred incollection, documentation and administration of the loan should be sharedaccording to the parties’ respective shares, and participants should have a right to an accounting.
12. Payments subsequently determined to bepreferential and required to be returned to the borrower should be shared pro rata by all parties.
13. Agreement should contain a provision governing the application of setoff procedures and loan payments not specifically earmarked to the participated loan.
14. Agreement should provide that the agency of the originating lender will terminate upon the insolvency of the origination lender, and all loan documents should then be assigned to participants or a new lead bank should be chosen.
15. Notice provisions andprovisions for amendment should be included in the participation agreement.
16. Agreement should spell out the consequences which flowfrom a participant’s default and from a default by the originating lender or borrower.
17. Agreement should set forth whether theoriginating lender may secure other obligations of the borrower with the same collateral and, if so, the priority of application of sale proceeds of collateral.
III. RESPONSIBILITIES OF THE PARTIES
Participation agreements should be handled with care to minimize the inherent financial risks for both originators and participants. Sound judgment, clear understanding and open and ongoing communication increases the likelihood of success. For example, the originating lender and the participant should both be prepared to disclose any potential conflicts of interest when such conflicts are known or as such conflicts may arise in the course of an agreement. The following is a list of suggested responsibilities of each party to a participation agreement.
A. Participants
1. Participant should obtain, review, and evaluate the same information in participation situations as in any lending transaction to attract a customer so that the inherent risk is known.
2. Participant should make its own assessment of the credit risk and thoroughly analyze the credit quality of the borrower to determine whether the purchase of a loan conforms to the participating lender’s own credit standards.
3. Current and complete information on the underlying borrower should be maintained at all times.
4. Participant should review all underlying loan documents, including filings and appraisals.
5. Participants should consider the general reputation and standing of the originating lender in addition to the expertise of the originating lender in the transaction - in other words, the relationship between the participating lender and the originating lender will be unique and significant.
B. Originating Lenders
1. Originating lenders should provide the participant with complete and current credit information and any other factual information bearing on the continuing creditworthiness of the borrower, as well as copies of all principal loan documents.
2. Where consent of the participants is required under the participation agreement, originating lenders always should obtain the consent in writing from each participant before taking the action for which consent is required.
3. Communication with the participating lender is important when the borrower is in financial difficulty or in default.
4. If the borrower defaults, the originating lender should attempt to reach a consensus with the participating lender on collection activities to be undertaken. This understanding should be memorialized in a written interbank agreement.
IV. PARTICIPANT PROVISIONS
The terms contained in a participation agreement are negotiable. Although the leverage of the participating lender may dictate the terms and conditions of an agreement prepared by the originating lender, the participant should insist upon the following provisions:
1. Transfer of “ownership” language.
2. Limitations on the originating lender’s right to take certain actions adverse to the participating lender’s ownership interest.
3. Termination of the originating lender’s agency relationship upon the occurrence of certain events (insolvency, misappropriation or breach of fiduciary duty).
4. The right of a participating lender to receive payments directly from the borrower.
5. An obligation on the part of the originating lender to provide the participant with updated credit and financial information.
6. Resolution procedures resulting from the inability of the participant and the originating lender to mutually agree as to what actions to take following the borrower’s default.
7. Required notice to and consent on the part of the borrower (as well as other liable parties under the loan).
V. OCC POLICY FOR NATIONAL BANKS
On August 2, 1984, the Comptroller of the Currency (OCC) issued revised Banking Circular 181 (BC - 181, Rev.), entitled “Purchases of Loans in Whole or in Part - Participations,” designed to clarify that it is an unsafe and unsound banking practice for national banks to fail to maintain adequate controls over of the risks inherent in loan participations. The revised policy makes purchasing banks responsible for ensuring that selling banks provide enough information for the purchasers to make sound credit judgments and suggests that “a prudent purchase or participation document would generally include an agreement by the selling or servicing bank to provide available credit information on the obligor (borrower) to the purchasing bank on a continuing basis.” Purchasing banks are required to undertake an independent analysis of credit quality and cannot rely on a credit analysis performed by another financial institution.
Other controls promoted by BC-181, Rev. include: written lending policies and procedures; borrower agreements to provide full credit information to the bank making the loan; agreement by selling bank to provide full credit information to purchasing bank; and written documentation of recourse agreements that outline the rights and obligations of each party.
VI. NEBRASKA DEPARTMENT OF BANKING AND FINANCE
45 NAC 18, a Nebraska Banking Department rule interpreting § 8-141 of the Nebraska Statutes, provides for prior approval for certain “pool participations.” The Department of Banking has also issued Statement of Policy Number 12 regarding “Federal Reserve 23A Participation Loans.”
VII. INTERAGENCY STATEMENT ON SALES OF 100% LOAN PARTICIPATIONS
The case of Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51 (2nd Cir. 1992) prompted the federal banking regulators to issue an “Interagency Statement on Sales of 100% Loan Participations” (4-23-97) to provide guidance for banks with programs that sell off, without recourse, 100% participations of short-term loans originated by the bank. This statement does not apply to other sales of participations or assignments of entire loans, e.g., sales of 100% participation in problem loans from a bank’s portfolio or sales in connection with loan trading activities. The statement, in response to the Banco case, raises safety and soundness considerations and warns of legal, reputation and compliance risks. For programs patterned after sales like those involved in Banco, the statement provides for the adoption of certain policies and procedures.
VIII. SOURCES
Information contained in this article are from the following sources:
Loan Participation Agreements: ABA/RMA Guidelines, The Robert Morris Associates (1987).
Benson, Stanley D., “What Are Loan Participations and How Are They Handled?”, Commercial Lending Newsletter, Robert Morris & Associates (June, 1991).
Schnitzer and Stern, Structuring Loan Participations, Warren Gorham LaMont Publishing (1992).
A Banker’s Guide to Loan Participations, American Bankers Association.
Participation Agreements, Scott Dye and Timothy Haight, Baird, Holm, Omaha.
Comptroller of the Currency (OCC), Banking Circular 181 (Revised).
Interagency Statement on Sales of 100% Loan Participations, 4-23-97