Sometimes, Lenders like to offer to sell interests in their loans to various participants.  The agreement that governs such sale, and the rights and obligations of the seller and buyer of an interest in the loan, is called a Participation Agreement.

A Lender and a Participant have similar interests in that each wants the borrower to repay the loan and comply with its obligations under the loan.  However, there are sometimes points of contention between the Lender and the Participant.  The article will touch on a few of those points.

By way of background, a Participation Agreement provides for the Lender to sell to the Participant a portion of an existing loan.  For example, if a loan were in the amount of $50 million and a Participant wanted to buy a $20 million participation, then the Participant would be buying a 40 percent participation in the loan.  Such a participation is ordinarily evidenced by a Participation Certificate, which lists the loan, the amount of the loan being purchased by the Participant, the date of the participation and similar information.  In addition to making the participation payment, the Participant also pays to the Lender a one-time participation fee; a monthly servicing fee based on the outstanding principal balance of the loan; and the Participant’s percentage share of any expenses incurred by the Lender in connection with the enforcement of the loan.

The Participation Agreement also provides representations from the Lender to the Participant as to such things as the accuracy of the documentation comprising the loan; that all payments under the loan have been paid to date; and that there is presently no notice of default sent by the Lender.  Other than that, a lender will resist making any additional representations to the Participant.  In particular, the Lender will make clear that the Participant has made its own credit analysis regarding the borrower; and as to the legality and effectiveness of the loan documents, the accuracy of any representations made by the borrower, the adequacy of the collateral, and the existence and priority of security interests. 

Additionally, the Participation Agreement covers how the Lender is to deal with the Borrower, including prohibitions on the Lender changing the interest rate; increasing the principal balance of the loan; extending the maturity of the loan; forgiving principal or interest; releasing collateral; releasing obligors; postponing payment dates; permitting encumbering the property; changing definitions relating to default; permitting transfers of the mortgaged property; and making other material modifications.  If there is default, the Lender is obligated to exercise the same standard of care that it does in its other loan transactions, which would include pursuing remedies as it ordinarily would do.  In that regard, the Lender is required to give the Participant notices as to the status of the loan and, if applicable, the Lender’s exercise of its remedies.

Finally, the Lender will require that the Participant not further grant participation interests in the loan.

While there are numerous issues that can arise in the context of Participation Agreements, below are a few issues that I came across during recent transactions.

The first issue that arose was: what happens if the maturity date of the loan arrives and the Lender wants to extend the maturity date, but the Participant does not?  Since a Participation Agreement ordinarily requires the Participant’s consent to an extension of the term of the loan, the Lender would not have the right to extend unless the Participant consented.  We resolved the situation by allowing the Lender to elect, at the Lender’s option, to either buy out the Participant at par or to proceed with the foreclosure. Thus, the Lender would have the flexibility to either extend the loan or pursue its remedies.

A second issue that arose involved a restriction to which the Lender was subject under the Participation Agreement.  A Participation Agreement would typically provide that the Lender is not allowed to postpone any payment date.  This could present problems for a Lender if the Borrower is seeking a short-term postponement and the Lender does not want to have to go back to the Participant for consent in this situation.  We resolved this issue by providing that the Lender could not agree to an extension beyond 30 days, which gave the Lender the flexibility it sought while protecting the Participant from long payment delays.

A third issue that arose was the Participant’s demand that the Lender retain a certain percentage ownership in the loan and also that the Lender continue to service the loan.  Basically, the Participant wanted to know that it could rely on the Lender’s self-interest in treating the loan as it would have had it not sold participations. 

As far as servicing the loan, a Lender will hesitate to agree to continue to service the loan itself unless it has no potential plans for out-sourcing the servicing.  If a Lender were pressed on this issue, it could agree to service the loan itself unless the Lender was to farm out a certain percentage of its loan portfolio. In a negotiation in which I was involved, the Lender refused to agree to any restriction as to how the loan was serviced.

As far as a Lender keeping a certain percentage of the loan, and thus limiting the percentage of the loan that it could sell to participants, one lender agreed that it would keep at least 51 percent of the loan, unless that Lender decided to sell more than 51 percent of the loan because of regulatory issues, requirements or concerns.  Thus, the Lender, while giving the Participant the assurance that the Lender remained as a majority holder of the loan, protected itself if any regulatory agency pressured the Lender to sell the loan.