It is not news that loan participations and syndications grew in popularity over the past several years, largely in response to competitive pressures among banks. In today’s climate, however, co-lending arrangements are being explored not solely out of a desire to earn market share, but as one way to navigate the myriad of economic and regulatory pressures confronting lenders.
Although the external and internal forces promoting and regulating co-lending arrangements have changed somewhat, the underlying goals of lenders in co-lending arrangements have not changed in the new environment. The ability to originate loans within legal lending limits, manage the balance sheets of the banks and diversify risk all remain valid and compelling objectives. As before, however, achieving these objectives requires careful structuring of the co-lending transaction to be sure the transaction qualifies for the treatment the banks seek and to effectively manage and allocate risk among the participants.
Most often, banks need the co-lending arrangement to be characterized as a “sale” (as opposed to a loan, trust, joint venture or other securities transaction) both for accounting purposes and in order to minimize the risks associated with co-lending arrangements. From an accounting perspective, Financial Accounting Standard 140 (FAS 140) establishes rules for FDIC insured financial institutions with respect to the proper accounting treatment of loan participations for both the lead bank and the participating bank(s). Co-lending transactions will be accounted for as “sales” under FAS 140 if the basic criteria of FAS 140 are met, which criteria generally tests whether control has effectively been transferred from the lead bank to the participant(s). Consequently, your participation and syndication agreements must include appropriate transfer, consent and remedy language to be sure that the criteria of FAS 140 are observed.
For example, co-lending agreements must not include recourse rights, such as rights of repurchase or redemption granting a participant a right of recourse against the lead for non-payment of the loan. While recourse against a lead bank for breach of its obligations under a co-lending agreement are appropriate for a variety of reasons, direct rights of recovery against the lead bank triggered by the borrower’s non-payment are not appropriate in a co-lending arrangement in most cases. In fact, even unwritten understandings between a lead bank and participant bank can create problems, if not directly under FAS 140, then pursuant to the risk-based capital treatment of the entities. For example, an informal agreement where the lead bank agrees to buy back the interest of a participant may impact the treatment of the co-lending arrangement and cause the transaction to fail to meet its objectives.
Properly structuring the co-lending agreement also is important to assure the appropriate treatment of the transaction in the context of breach of contract claims among participants. How a court treats the underlying structure of the transaction can have an impact on the extent of the duties owed by a lead bank to the participants. A properly crafted co-lending agreement will clearly define the duties and obligations of the lead bank and participants. Arrangements where these duties are not defined, or defined too broadly, could place the lead bank in the role of agent or trustee for participants and impose heightened fiduciary obligations on the lead bank. This in turn could give rise to claims against the lead bank by participants for damages for the breach of these duties in the event of loss.
You will also want the structure of the transaction and the controlling agreements to address various rights and remedies of the parties in the event of bankruptcy or insolvency, both that of the borrower and of another participant. The selection of a syndication loan as opposed to a participation arrangement will afford participants rights and remedies directly against a borrower. If properly drafted, the participating banks in a syndication will have “creditor” status against the borrower in bankruptcy. You will also want the agreements to explicitly define the remedies available to the participants in the event of a default by the borrower, the insolvency of a participating or lead bank, and the failure of the lead bank or another participant to fund.
As a final note, the Financial Accounting Standards Board continues to evaluate accounting procedures for loan participations and syndications, so future developments should be closely monitored to be sure that co-lending arrangements achieve compliance and meet your goals. Moreover, regulators continue to examine participation arrangements carefully and look to see that internal policies and controls are in place to address diligent credit analysis, review and approvals, record maintenance, monitoring and other controls.
There is no question that the economic and regulatory environment has dramatically impacted how and if deals get done. But effectively structured co-lending arrangements still offer promise to consummate transactions for historically well-performing borrowers that might otherwise be out of reach.