Loan participations have been a valuable tool in commercial lending for years. This is true primarily because they allow banks to participate in transactions that would otherwise present too much risk for them alone, or allow them to purchase or sell an interest in a transaction necessary to comply with their legal lending limit. Loan participations also allow banks the opportunity to diversify their loan portfolio with transactions, or within lending markets, in which they have minimal experience or expertise.
Prior to late 2007, when the most recent recession began, loan participations were used regularly. However, since that time, and continuing with the adoption of FASB 140, which took effect as of November 15, 2009, many banks have shied away from using loan participations. Properly managed, loan participations still have value in today’s lending marketplace and appear to be regaining popularity. With that in mind, it is important to understand not only what banks cannot do within the scope of a loan participation, but also understand what they should do to protect their interests.
THE DON’Ts OF LOAN PARTICIPATIONS
Although FASB 140, as amended by FASB 166, is merely an accounting standard, its adoption has had the largest impact on what banks can no longer do with respect to loan participations. Specifically, FASB 140, as amended by FASB 166, requires loan participations to (i) be based on a pro-rata ownership interest in the loan; (ii) require all cash derived from the loan to be shared based on pro-rata ownership, except for cash stemming from services rendered (i.e. an origination fee or a servicing fee); and, (iii) be non-recourse. In the event a loan participation fails to meet these requirements, it may not invalidate the participation agreement; however, the participation likely will not be treated as a sale of a portion of the loan. Rather it will most likely be treated as a direct loan from the participating bank to the borrower. In such case, certain unintended consequences such as exceeding a bank’s legal lending limit and other regulatory compliance violations may occur.
Loan participations prior to 2009 commonly included Last-In-First-Out (LIFO), First-In-Last-Out (FILO), or other accounting variations which were loan participation structures utilized by lead banks to facilitate the sale of loan participations. However, those types of accounting variations and structures do not comply with the current requirement that loan participation ownership be structured on a pro-rata basis.
Additionally, prior to 2009, loan participations also regularly allowed the lead bank to retain non-service based fees, such as non-usage fees on revolving lines of credit, pre-payment penalties and late fees, just to name a few. Retention of those types of fees clearly violates the current requirement that all cash derived from the participated loan be shared based on pro-rata ownership. It is important to note that service based fees need not be shared based on pro-rata ownership. Thus, the lead bank may still retain service based fees, such as loan origination fees, loan renewal fees and loan servicing fees.
Lastly, some loan participation agreements previously contained mandatory sale or buy-back provisions in favor of participant banks. These provisions ranged from mandatory buy-out of a participant by the lead bank upon the occurrence of an event of default by the borrower, to at-will repurchase. Depending on the specific language, these types of provisions allowed lead lenders better control of the particular lending relationship with the borrower or were an incentive for a participant bank purchasing an interest in a loan. These types of provisions are now contrary to the requirement that sales of participating interests be non-recourse and a true sale. Although, it is important to recognize that a lead lender may still buy back a participating interest from a participant bank, they just cannot have a required sale/buy-back in the loan participation agreement.
THE DOs OF LOAN PARTICIPATIONS
In addition to the issues that lenders should avoid in loan participations as noted above, which are primarily driven by the changes to the applicable FASB standards, lenders should ensure that the terms and conditions of their loan participation agreements guard against the unfortunate consequences experienced by both lead and participant banks during the most recent recession.
First, many lead banks and participant banks alike experienced a great deal of frustration with loans participated to more multiple participants. Previously, many lead banks used the same form of participation agreement to govern loans participated to multiple participants as they did for loans participated to a single participant. Unfortunately, loans participated to multiple parties present their own unique issues and should be documented accordingly. Specifically, many loan participation agreement forms allow the lead bank to take certain actions without the consent of participants and require participant consent for other actions. Although these types of consent provisions were sufficient for loans participated to a singular participant, they proved problematic for multi-participant loans because, when read together, such consent provisions are sometimes interpreted as requiring unanimous approval by all participants. This type of unintended interpretation allowed participants owning just a small percentage of a loan to veto any action decisions by the remainder of the lending group. For this reason, it is strongly recommended that when contemplating a loan to be participated by multiple parties, a master loan participation agreement is utilized, rather than individual loan participation agreements for each participant to ensure proper and unambiguous voting requirements for any given loan administration or collection action.
Second, as recently experienced by many lenders, the dynamics of loan participations change significantly when either the lead lender or a participant has been closed by the FDIC, and the applicable interest in the participated loan is assigned to an acquiring bank. The insertion of a participant bank with loss-share remedies with the FDIC substantially alters how that party may act within the scope of the loan participation. Particularly troubling for the other parties to the participated loan were collateral liquidation scenarios that were favorable for all of the parties without loss-share, but not deemed as favorable to a party with loss-share. With respect to this issue, there are a few noteworthy considerations. A loan participation agreement cannot divest a lead lender or a participant of its ownership because of a FDIC take-over. Such a provision would violate the requirement that loan participations be sold without recourse. However a provision can be included in the participation agreement to contemplate that the servicing responsibilities are to be transferred to one of the participant banks upon the closure of the lead bank by the FDIC. New ownership of the lead bank’s rights may have a different servicing philosophy. Common differences of opinion among the lead banks and participants involve issues such as what constitutes an event of default, when to call an event of default, enforcement of non-monetary loan covenants, whether to utilize a loan workout or forbearance agreement, collateral liquidation strategies, and an assortment of other issues. These are just a few of the many issues that should be carefully considered by the lead bank and participants when the parties are negotiating the participation agreement. Participation agreements are not “one size fits all” documents. In fact, the majority of participation agreements should be customized to fit the transaction and the specific lead and participant banks.
Another issue that arose frequently during the recession involved the ownership of foreclosed or surrendered collateral which caused lead, and participant, banks to ask how such collateral should be carried by the banks following liquidation or surrender in light of the fact the “loan” no longer exists. In reality, such collateral should be treated as OREO or OPPO. Depending on the nature of the asset, a limited liability company is the most favored ownership entity structure for this scenario and will continue to be, especially with the changes to the limited liability company rules set to take effect as of August 1, 2015. Placing OREO or OPPO participated assets into a limited liability company can significantly limit both the lead and participant banks’ exposure to non-contractual liability, with the banks each obtaining an ownership interest in the entity equal to their pro-rata share in the participated loan. This is particularly important where the assets involve businesses which are, and will continue to be, open to the public after the asset foreclosed or surrendered. It is important to note that lead and participant Minnesota banking corporations must obtain approval from the Minnesota Department of Commerce prior to the formation of such entities. The participation agreement should include a provision that contemplates the formation of such an entity and, to the extent possible, proposed drafts the entity’s formation documents should be negotiated and prepared simultaneously with the participation agreement.
In the last decade, there have been significant changes to both the relationship of parties to a participated loan and the language of loan participation agreements. Although significant, these changes have not altered the fact that banks can continue to utilize participated loans as a valuable part of their businesses, but doing so within the parameters of today’s requirements and in light of prior experiences.