If a participation agreement is not characterized as a true sale of a participating interest or a true participation but rather as a loan from the participating lender to the originating lender, the participating lender will be exposed to the credit risk of the originating lender. This risk is greater if the originating lender is not an FDIC-insured institution. With the proliferation of non-bank lenders originating loans in the leveraged loan market in recent years, the potential for adverse outcomes has risen, and the LSTA form of participation agreement standard terms and conditions has language that is inconsistent with language upon which a court has recently relied in finding a true sale had occurred.

In the event of the insolvency of a non-bank originating lender, if the participation agreement is found to be a loan rather than a sale, the participating lender would likely be unperfected as the transaction would not be qualify for the automatic perfection provisions under UCC § 9-309(3). The required steps to perfect a security interest in payments under the credit agreement – possession of the loan note or the filing of UCC financing statements against the originating lender – are not typically taken in participation transactions. Accordingly, the participating lender would, in such event, be a general unsecured creditor of the insolvent non-bank originating lender.

The risk of adverse outcomes is less for participating lenders where the originating lender is an FDIC-insured institution because 12 CFR § 360.6(d)(1) of the FDIC Rules and Regulations provides that, in the event of an insolvency of an FDIC-insured originating lender, the FDIC (in its capacity as conservator or receiver) will not reclaim, recover or characterize as property of the originating lender’s estate any financial assets transferred through a participation, provided, that the participation: (1standard terms and conditions has language that is inconsistent with language upon which a court has recently relied in finding a true sale had occurred. constitutes a transfer or assignment of an undivided interest in all or part of a financial interest; (2) qualifies for sale accounting treatment under Financing Accounting Standards No. 166, which requires that the transferred portion must constitute “participating interests” by conveying proportionate ownership rights with equal priority to each participating interest holder, involve no recourse (other than standard representations and warranties) to, or subordination by, any participating interest holder, and does not entitle an participating interest holder to receive cash before any other participating interest holder; and (3) is made without any agreement that the originating lender repurchase the participating interest upon a default of the borrower pursuant to the underlying loan documentation.

The issue of the characterization of a loan participation recently arose in the case of Central Bank and Real Estate Owned, L.L.C. v. Timothy C. Hogan, as Trustee of the Liberty and Liquidating Trust et. al., 891 N.W.2d 197 (Iowa 2017),1 decided by the Iowa Supreme Court. In the Central Bank case, Liberty Bank (“Liberty”) made loans to Iowa Great Lakes Holding, L.L.C. (the “Borrower”), which loans were secured by real and personal property of the Borrower. Liberty entered into participation agreements with five different banks. The participation agreements all provided that Liberty sold, and the participating banks purchased, an undivided participating interest in the loan, and that Liberty held the loan documents in “trust” for the participating banks. The participation agreements also addressed the potential insolvency of Liberty and specified that in the event that Liberty became insolvent, Liberty would be required to surrender possession of the records evidencing the loan and legal title to the same would revert to the participating banks. The Borrower defaulted on the loans extended by Liberty, and the collateral supporting the loan was surrendered to Liberty as part of the foreclosure process. Following the foreclosure, Liberty sold certain of its assets, including “loans,” to Central Bank (“Central”), and conveyed certain real property which had served as collateral for Liberty’s loan to the Borrower to an affiliate of Central via quitclaim deed. Central sought a ruling in Iowa state district court that it owned the real property free and clear of any interest of the participating banks. The court ruled against Central, reasoning that the participation agreements transferred “all legal and equitable title in [Liberty’s] share of the loan and collateral” to the participating banks. Central appealed this ruling and the Iowa Supreme Court upheld the ruling of the district court.

The conclusion of the Iowa Supreme Court was based on the presence of the following language in the participation agreements: (1) express terminology of a sale (i.e. the originating lender “hereby sells to [participating lender] and the [participating lender] hereby purchases from the [originating lender] a participation interest”), (2) reference to an “undivided interest” held by the participating lender in the underlying loan documents, and (3) trust language (i.e. the originating lender shall “hold the [note and loan documents] in trust for the undivided interest of the [participating lenders]”). In addition, the court noted that the participation agreements did not include any provisions which mitigated the credit risk of ownership (e.g. a buyback requirement in the event of a borrower default or a marked difference in interest rates). The court’s focus on the establishment of a trust relationship is of particular note.

When purchasing a participation in a loan, we would recommend negotiating certain changes to the LSTA form of participation agreement standard terms and conditions (June 9, 2017) set forth below:

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