assignment participation loan

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As the secondaries market continues to grow and increase in complexity, we have noticed an uptick in interest among our clients in selling (and buying) loan participations. Participation arrangements can be a powerful tool for institutions on either side of the transaction – sellers can free up capital on their balance sheet, pare back funding obligations and reduce exposure to certain borrowers or industries, and buyers can get the economic benefit of a loan without having to manage a direct relationship with the borrower or comply with (typically more stringent) restrictions and consent requirements for direct assignments. Plus, while the transaction is undoubtedly complex, both parties can leverage the Loan Syndications and Trading Association’s form documentation to keep attention focused on those provisions most important to their institution and the specific transaction. Done right, a bespoke participation arrangement lets everyone leave the field a winner (trophies optional).

Below we discuss broadly the participation structure and its benefits, typical principal documentation and some key considerations and commonly-negotiated provisions.

Participation Structure and Its Benefits

For the uninitiated, a participation is best understood in contrast with an assignment. Both are mechanisms by which a lender of record under a loan agreement ( i.e. , the entity that is actually party to the contract as a lender) can transfer all or part of its interest in a funded or unfunded loan to a third party. However, unlike with an assignment (where the assignee steps fully into the shoes of the assignor as lender of record, and assumes direct contractual privity with the borrower and legal and beneficial ownership of the loan), the seller of a participation interest retains title to the loan and direct contractual privity with the borrower ( i.e. , the participant does not become a lender of record under the loan agreement) along with certain rights and obligations, and the buyer of a participation interest assumes the economic benefits and risks. The contractual relationship for a participation is just between the seller and buyer – the borrower is not typically involved, and indeed is often not even aware of the transaction.

Among the benefits to sellers of loan participations, perhaps the most obvious is the cash received from the buyer upon settlement. Loan participations in the non-distressed secondaries space are often purchased for prices at or near par ( i.e. , 100% of the principal amount of the debt participated), and that cash lands immediately on the seller’s balance sheet. For unfunded loans, because the participation agreement obligates the participant to fund (or reimburse, depending on timing) future draws through the seller, a seller also benefits by shifting much of the responsibility to fund future draws to the participant (noting, of course, that this introduces new credit risk with respect to the buyer). In addition, regulated lenders are not typically required to hold capital against participated loans. Sellers can also realize value by retaining some of the economics of the loan they’re selling a participation interest in. We see many participations where sellers retain some or all upfront fees paid by the borrower in respect of the loan, and a number where the buyer takes a haircut on the interest payments that are passed through to them, with the seller retaining the difference (noting that, if a seller is not passing along all or substantially all of the rights and obligations under the loan, the parties should carefully consider with counsel whether the sale would still be considered a true participation under New York law – if it wouldn’t, buyer may be at risk of being considered a mere contractual counterparty of seller subject to seller’s credit risk). Taken together, sellers can use participation arrangements to put cash on their balance sheets, reduce exposure to certain borrowers or industries and decrease regulatory capital obligations in compliance with internal or external requirements.

On the buyer’s side of the transaction, buyers benefit from being able to realize some or all of the economic benefits of a loan without incurring origination expenses, the bulk of ongoing administration expenses or the legal expense associated with preparing the underlying loan documentation (subject, of course, to indemnities, etc., that can flow through to a participant,  e.g. , agent expenses). From a credit perspective, depending on buyer’s internal comfort level, a buyer can draft to varying degrees behind the seller’s credit analysis and diligence of the borrower. In addition, since participants are typically not disclosed to a borrower, a buyer can generally keep its status as participant confidential.

Buyers and sellers alike benefit from not needing to seek consents and pay assignment or other fees that might be required in the case of a direct assignment.

Typical Principal Documentation

Sellers and their counsel typically hold the pen when documenting participation arrangements. While drafting parties can and do use their own forms, it often makes sense to leverage the Loan Syndication and Trading Association’s (LSTA) standard form participation agreement for par/near-par ( i.e. , non-distressed) trades as a starting point – even for bespoke, heavily-negotiated participations. The LSTA’s form participation agreement was developed to facilitate efficient documentation of transactions in the high-volume secondary market (where participations are often used as a backup settlement option for debt trades that can’t settle by assignment), and accordingly generally tracks market-standard terms and mechanics for participation arrangements. The LSTA form splits the participation agreement into two documents: (i) a longer set of standard terms and conditions (often referred to as STCs, and available  here  for LSTA members), which contains a baseline set of market-standard provisions, and (ii) a relatively short form agreement setting forth the transaction-specific terms of the participation (often referred to as the TSTs, and available  here  for LSTA members), which incorporates the STCs by reference and lets parties toggle on or off (often via checkbox), or otherwise supplement or modify, the various provisions of the STCs. The LSTA’s bifurcated documentation pulls all the transaction-specific information, business terms and frequently negotiated provisions into a more manageable document.

Of course, there are a number of points in the LSTA forms that counsel will typically want to smooth out when using them outside of the more commoditized secondary loan trading market ( e.g. , the need for trade confirmations and funding memoranda, delayed compensation, etc.). Nevertheless, starting with LSTA forms helps both buyer and seller cut down on legal expense, and focuses attention on the terms and provisions that are of particular importance to the parties and the specific deal. These efficiencies can also facilitate innovation.

Key Considerations and Commonly-Negotiated Provisions

Elevation . Buyer’s rights to request “elevation” of its participation ( i.e. , to seek to become a direct lender under the loan agreement) is often the subject of negotiation. Under the STCs, a buyer can always elevate if seller goes into bankruptcy. Otherwise, it’s up to the parties – in some transactions buyers are free to elevate at any time. In others, elevations triggers are heavily tailored, and can include conditions tied to seller’s credit rating, the amount of seller’s loans or commitments under the facility, disputes over collateral value (particularly for participations in NAV loans) or the occurrence of certain events (or failures by seller to take certain actions) under the loan documents.

Voting . The voting provisions in the participation agreement govern whether, when and to what extent, the buyer can direct seller’s votes as a lender under the loan documents. Participation provisions in loan agreements will sometimes limit a seller’s ability to grant voting control to a participant beyond the typical suite of “sacred” provisions ( e.g. , facility size, interest rates, payment dates, term, etc.). Otherwise, the parties can and do tailor the allocation of control to their liking – from no buyer voting rights at all to full buyer voting rights and everything in between. Buyers will often push for control over at least the “sacred” provisions in the loan documents. Sometimes buyers request decision-making power over waivers of certain events of default, facility subordination or other provisions important to the buyer’s credit analysis or institutional concerns. If the underlying loan agreement does include limitations on the seller’s ability to grant voting control, parties will typically clarify in the participation agreement that any voting rights allocated to buyer are allocated only to the extent it would not violate the loan agreement.

Sub-participations . One standard provision of the STCs we frequently see negotiated is the requirement that seller consent to a requested sub-participation by buyer “not be unreasonably withheld or delayed.” Often, sellers will request that that language be deleted. Buyers, in turn, will request some exceptions ( e.g. , permitting sub-participations to affiliates, if seller’s hold on the facility drops below some specified amount, etc.).

Loan agreement diligence .  Buyers and sellers should take care to consider the terms of the underlying loan documentation when documenting participation arrangements. Loan agreements in the secondaries market do not always include the detailed assignment and participation provisions lenders might expect in a loan agreement drafted with an eye towards syndication – indeed, it’s not infrequent that we see loan agreements that are silent on the subject. Sometimes there will be credit agreement provisions that necessitate representations from buyer or seller ( e.g. , a representation that buyer is not an affiliate of the borrower, not on a disqualified institution list or not otherwise an ineligible buyer) or explicitly require that seller maintain a participant register for tax purposes. While uncommon, credit agreements occasionally include borrower or other consent requirements for lender participations (and often the consequence for failing to obtain that consent is that the transaction is void). Additional complexities are introduced when participating in a bilateral loan – in the event a buyer wants to elevate its participation interest, significant revisions to the loan documents may be required to accommodate a multi-lender structure. Often specifically tailored provisions are required in the participation agreement to address a given loan agreement.

The above is just a sampling of bespoke provisions.

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Assignment, novation or sub-participation of loans             

Transfers of loan portfolios between lending institutions have always been commonplace in the financial market.  A number of factors may come into play – some lenders may wish to lower their risks and proportion of bad debts in their balance sheets; some may undergo restructuring or divest their investment portfolios elsewhere, to name a few.  The real estate market in particular has been affected by the announcement of the “three red lines” policy by the People’s Bank of China in 2020 which led to a surge of transfers, or attempted transfers, of non-performing loans.  Other contributing factors include the continuous effects of the Sino-US trade war and the Covid-19 pandemic.

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Transferability of Loans

The legal analysis regarding the transferability of loans can be complex.  The loan agreement should be examined with a view to identifying any restrictions on transferability of the loan between lenders, such as prior consent of the debtor and, in some cases, whether such consent may be withheld.  Other general restrictions may apply given that most banks have internal confidentiality rules and data protection requirements, the latter of which may also be subject to governmental regulations.  Certain jurisdictions may restrict the transfer of loans relating to specific types of receivables – mortgage or consumer loans being prime examples.  It is imperative to conduct proper due diligence on the documentation and underlying assets in order to be satisfied with the transferability of the relevant loans.  This may be complicated further if there are multiple projects, facility lines or debtors.  It is indeed common to see a partial transfer of loans to an incoming lender or groups of lenders.

Methods of Transfer

The transfer of loans may be carried out in different ways and often involves assignment, novation or sub-participation.

A typical assignment amounts to the transfer of the rights of the lender (assignor) under the loan documentation to another lender (assignee), whereby the assignee takes on the assignor’s rights, such as the right to receive payment of principal and interest on the loan.  The assignor is still required to perform any obligations under the loan documentation.  Therefore, there is no need to terminate the loan documentation and, unless the loan documentation stipulates otherwise, there is no need to obtain the debtor’s consent, but notice of the assignment must be served on the debtor.  However, many debtors are in fact involved in the negotiation stage, where the parties would also take the opportunity to vary the terms of the facility and security arrangement.

Novation of a loan requires that the debtor, the existing lender (transferor) and the incoming lender (transferee) enter into new documentation which provides that the rights and obligations of the transferor will be novated to the transferee.  The transferee replaces the transferor in the loan facility and the transferor is completely discharged from all of its rights and obligations.  This method of transfer does require the prior consent of the relevant debtor.

Sub-participation is often used where a lender, whilst wishing to share the risks of certain loans, nonetheless prefers to maintain the status quo.  There is no change to the loan documentation – the lender simply sells all or part of the loan portfolio to another lender or lenders.  From the debtor’s perspective, nothing has changed and, in principle, there is no need to obtain the debtor’s consent or serve notice on the debtor.  This method of transfer is sometimes preferred if the existing lender is keen to maintain a business relationship with the debtor, or where seeking consent from the debtor or notifying the debtor of any transfer is not feasible or desirable.  In any case, there would be no change to the balance sheet treatment of the existing lender.

Offshore Security Arrangements

The transfer of a loan in a cross-border transaction often involves an offshore security package.  A potential purchaser will need to conduct due diligence on the risks relating to such security.  From a legal perspective, the security documents require close scrutiny to confirm their legality, validity and enforceability, including the nature and status of the assets involved.  Apart from transferability generally, the documents would reveal whether any consent is required.  A lender should seek full analysis on the risks relating to enforcement of security, which may well be complicated by the involvement of various jurisdictions for potential enforcement actions.

A key aspect to the enforcement consideration is whether a particular jurisdiction requires that any particular steps be taken to perfect a security interest relating to the loan portfolio (if the concept of perfection applies at all) and, if so, whether any applicable filing or registration has been made to perfect the security interest and, more importantly, whether there exists any prior or subsequent competing security interest over all or part of the same assets.  For example, security interests may be registered in public records of the security provider maintained by the companies registry in Bermuda or the British Virgin Islands for the purpose of obtaining priority over competing interests under the applicable law.  The internal register of charges of the security provider registered in the Cayman Islands, Bermuda or the British Virgin Islands should also be examined as part of the due diligence process.  Particular care should be taken where the relevant assets require additional filings under the laws of the relevant jurisdictions, notable examples of such assets being real property, vessels and aircraft.  Suites of documents held in escrow pending a potential default under the loan documentation should also be checked as they would be used by the lender or security agent to facilitate enforcement of security when the debtor defaults on the loan.

Due Diligence and Beyond

Legal due diligence on the loan documentation and security package is an integral part of the assessment undertaken by a lender of the risks of purchasing certain loan portfolios, regardless of whether the transfer is to be made by way of an assignment, novation or sub-participation.  Whilst the choice of method of transfer is often a commercial decision, enforceability of security interests over underlying assets is the primary consideration in reviewing sufficiency of the security package in any proposed loan transfer.

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Loan participations vs. syndications: What’s the deal?

Posted on Jun 29, 2021 by Bob Laffler, CPA  | Tags: Accounting , Auditing

Loan participations and loan syndications are terms often interchanged to describe a lending arrangement involving more than one lender; however, for accounting and reporting purposes, these are two different types of transactions with unique considerations and issues. We often get questions from participants in our classroom Banking Industry Fundamentals training programs and have dedicated time to this subject in our eLearning series available on the Revolution, our online learning platform.

While both loan participations and syndications involve multiple lenders, the way each is structured results in different accounting issues, including derecognition under ASC 860 and recognition of fees under ASC 606 and/or ASC 310.

Loan Participations:

In a loan participation, the originating bank enters into several lending arrangements. The first transaction is the loan origination to the borrower. This transaction will follow the normal accounting for loans under ASC 310. The unloading of a portion of the loan to participating banks represents a “transfer of a financial asset” (i.e. the loan, or a portion of the loan) and must be assessed for derecognition under ASC 860. This analysis involves determining if the participating loan represents a “participating interest” under ASC 860 and further whether control over the participating loan has been relinquished by the originating bank.

Loan Syndications:

In a loan syndication, the bank with the “relationship” with the borrower likely does not want to assume the risk of issuing such a large loan. As a result, rather than underwrite the entire loan and look to participate it out to other banks, the lead bank acts as a “syndicate”, matching the borrower up with multiple lenders, each of which underwrites and originates its own loan to the borrower. As a result, there are multiple loans issued by numerous banks to the one borrower.

Loan syndications do not involve any “transfers of financial assets” as each loan in a syndication is between a respective originating bank and the borrower. As a result, ASC 860 and the analysis of derecognition is not an issue. However, there are some issues for the lead syndicate bank involving revenue recognition related to the fees it collects from the borrower. Some of these fees may represent “syndication fees” for arranging the deal, as well as typical lenders fees for the loan it has underwritten itself. Also, these arrangements may involve the lead syndicate servicing the series of loans on behalf of the syndicate banks. For these loans, other than its own originated loan, the lead syndicate will need to recognize a servicing asset (or liability) in accordance with ASC 860.

How do you tell the difference?

As it is illustrated above, these two arrangements (a loan participation and syndication) have unique terms even though they achieve the same economic result. Therefore, the only way to know whether you are dealing with a participation or syndication is the READ the loan agreements! Careful consideration should be given to the legal underwriters and parties to the contract, contractual terms of the instruments, and other conditions to make a final analysis.

Often it is a legal determination that will dictate whether it is a loan participation or syndication. Once this determination is made, it’s on to the accounting analysis!

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Assignment, Novation Or Sub-Participation Of Loans

Contributor.

Transfers of loan portfolios between lending institutions have always been commonplace in the financial market. A number of factors may come into play – some lenders may wish to lower their risks and proportion of bad debts in their balance sheets; some may undergo restructuring or divest their investment portfolios elsewhere, to name a few. The real estate market in particular has been affected by the announcement of the "three red lines" policy by the People's Bank of China in 2020 which led to a surge of transfers, or attempted transfers, of non-performing loans. Other contributing factors include the continuous effects of the Sino-US trade war and the Covid-19 pandemic.

TRANSFERABILITY OF LOANS

The legal analysis regarding the transferability of loans can be complex.  The loan agreement should be examined with a view to identifying any restrictions on transferability of the loan between lenders, such as prior consent of the debtor and, in some cases, whether such consent may be withheld.  Other general restrictions may apply given that most banks have internal confidentiality rules and data protection requirements, the latter of which may also be subject to governmental regulations.  Certain jurisdictions may restrict the transfer of loans relating to specific types of receivables – mortgage or consumer loans being prime examples.  It is imperative to conduct proper due diligence on the documentation and underlying assets in order to be satisfied with the transferability of the relevant loans.  This may be complicated further if there are multiple projects, facility lines or debtors.  It is indeed common to see a partial transfer of loans to an incoming lender or groups of lenders.

METHODS OF TRANSFER

The transfer of loans may be carried out in different ways and often involves assignment, novation or sub-participation.

A typical assignment amounts to the transfer of the rights of the lender (assignor) under the loan documentation to another lender (assignee), whereby the assignee takes on the assignor's rights, such as the right to receive payment of principal and interest on the loan.  The assignor is still required to perform any obligations under the loan documentation.  Therefore, there is no need to terminate the loan documentation and, unless the loan documentation stipulates otherwise, there is no need to obtain the debtor's consent, but notice of the assignment must be served on the debtor.  However, many debtors are in fact involved in the negotiation stage, where the parties would also take the opportunity to vary the terms of the facility and security arrangement.

Novation of a loan requires that the debtor, the existing lender (transferor) and the incoming lender (transferee) enter into new documentation which provides that the rights and obligations of the transferor will be novated to the transferee.  The transferee replaces the transferor in the loan facility and the transferor is completely discharged from all of its rights and obligations.  This method of transfer does require the prior consent of the relevant debtor.

Sub-participation is often used where a lender, whilst wishing to share the risks of certain loans, nonetheless prefers to maintain the status quo.  There is no change to the loan documentation – the lender simply sells all or part of the loan portfolio to another lender or lenders.  From the debtor's perspective, nothing has changed and, in principle, there is no need to obtain the debtor's consent or serve notice on the debtor.  This method of transfer is sometimes preferred if the existing lender is keen to maintain a business relationship with the debtor, or where seeking consent from the debtor or notifying the debtor of any transfer is not feasible or desirable.  In any case, there would be no change to the balance sheet treatment of the existing lender.

OFFSHORE SECURITY ARRANGEMENTS

The transfer of a loan in a cross-border transaction often involves an offshore security package.  A potential purchaser will need to conduct due diligence on the risks relating to such security.  From a legal perspective, the security documents require close scrutiny to confirm their legality, validity and enforceability, including the nature and status of the assets involved.  Apart from transferability generally, the documents would reveal whether any consent is required.  A lender should seek full analysis on the risks relating to enforcement of security, which may well be complicated by the involvement of various jurisdictions for potential enforcement actions.

A key aspect to the enforcement consideration is whether a particular jurisdiction requires that any particular steps be taken to perfect a security interest relating to the loan portfolio (if the concept of perfection applies at all) and, if so, whether any applicable filing or registration has been made to perfect the security interest and, more importantly, whether there exists any prior or subsequent competing security interest over all or part of the same assets.  For example, security interests may be registered in public records of the security provider maintained by the companies registry in Bermuda or the British Virgin Islands for the purpose of obtaining priority over competing interests under the applicable law.  The internal register of charges of the security provider registered in the Cayman Islands, Bermuda or the British Virgin Islands should also be examined as part of the due diligence process.  Particular care should be taken where the relevant assets require additional filings under the laws of the relevant jurisdictions, notable examples of such assets being real property, vessels and aircraft.  Suites of documents held in escrow pending a potential default under the loan documentation should also be checked as they would be used by the lender or security agent to facilitate enforcement of security when the debtor defaults on the loan.

DUE DILIGENCE AND BEYOND

Legal due diligence on the loan documentation and security package is an integral part of the assessment undertaken by a lender of the risks of purchasing certain loan portfolios, regardless of whether the transfer is to be made by way of an assignment, novation or sub-participation.  Whilst the choice of method of transfer is often a commercial decision, enforceability of security interests over underlying assets is the primary consideration in reviewing sufficiency of the security package in any proposed loan transfer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Insights & Analysis

Top ten issues to consider when dealing with loan participations, insights douglas j. schneller · john j. hanley · july 24, 2018.

Rimon Partners,  John Hanley  and  Douglas Schneller , have an important update titled “Top Ten Issues to Consider When Dealing with Loan Participations”.

Loan participations can be an effective way for lenders to reduce their exposure to a borrower’s credit and manage their loan portfolios and liquidity, and for investors to acquire an interest in a loan without becoming a lender of record under the loan agreement. Although loan participations are customarily used in the loan market, they differ from assignments (i.e. outright sales) in several important ways.

Before delving into the issues, what do we mean by a participation interest in a loan? Although discussed in more detail below, generally a participation refers to a situation in which the lender of record, or Grantor, retains legal (or nominal) title to the loan while simultaneously conveying to the investor, or Participant, the economic interest in the underlying loan.

There can be several reasons why parties might use a participation arrangement rather than an outright assignment. From the Participant’s perspective, it may not satisfy requirements under the Loan Agreement to become a lender of record. In certain jurisdictions there can be licensing requirements to engage in lending activities, which the Grantor may satisfy but the Participant might not. Sometimes the Participant may want its investment to be confidential and unknown to the Borrower, Administrative Agent or other parties in the credit facility. And, finally, the Grantor may wish to remain nominally a lender under the Loan Agreement – for example, to continue to receive syndicate information – while offloading some or all of its credit exposure.

Click  here  to view the full article.

John  J. Hanley  focuses his practice on first and second lien financings; private placements of debt and equity securities; and the purchase and sale of loans, securities, trade claims and other illiquid assets. His clients include business development companies, specialty lenders, investment banks, hedge funds, actively managed CLOs, special purpose vehicles, and other financial institutions.

Douglas Schneller  handles a broad range of complex transactional matters involving bank finance and lending; restructuring, bankruptcy and insolvency; inter-creditor and subordination arrangements, including for mezzanine, leveraged, multi-lien and unitranche financings; claims analysis and reconciliation; and purchases and sales of par and distressed assets such as bank loans, notes, accounts receivable, trade claims, bankruptcy claims, and equity interests.

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How are assignment and participation treated?

An “ assignment ” under New York law is the legal term used to refer to the transfer of rights, such as the right to receive payments on a loan , while “delegation” is the legal term used to refer to the transfer of obligations, such as the obligation to make loans .  However, “assignment” as commonly used in the US refers to the transfer of both rights and obligations of the assignor/ seller under a credit agreement, such that the assignee/buyer comes into privity of contract with the borrower .

An “ assignment ” as used under English law is the transfer from a lender to another party of the rights to interest and principal – not any obligations – for amounts already drawn down and owing to the lender.  Only the benefit of an agreement may be assigned, with any commitment to provide funds to the borrower remaining with the existing lender.  The transferee (buyer) assumes the rights of the transferor (seller) and enters into a direct relationship with the parties to the loan agreement – the borrower, the agent and the other lenders .

Where a US participation transfers the beneficial and economic ownership of a loan, under English law the loan remains with the originating lender and an unsecured debtor-creditor relationship is created between the participants and the grantor.  Therefore, a US participation is effectively a true sale , where an LMA-style participation if refinancing for the loan originator and grantor.  However, both US and UK participations create a new contract between the original lender and the loan buyer, while leaving the contract between the borrower and the original lender unchanged.

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When is a Loan Participation a Sale, When is it a Loan and Why Does it Matter?

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.

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Loan Agreement: Assignment and Participation Clauses | Practical Law

Loan Agreement: Assignment and Participation Clauses

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MBA Article – Dos and Don’ts of Loan Participations

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.

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Assignments and Participations of Loans

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• Title 7 —Agriculture
• Subtitle B —Regulations of the Department of Agriculture
• Chapter L —Rural Business-Cooperative Service, Rural Housing Service, and Rural Utilities Service, Department of Agriculture
• Part 5001 —Guaranteed Loans
• Subpart E —Loan and Guarantee Provisions
• Loan Provisions

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5 U.S.C. 301 ; 7 U.S.C. 1926(a) ; 7 U.S.C. 1932(a) ; and 7 U.S.C. 8107 .

85 FR 42518 , July 14, 2020, unless otherwise noted.

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§ 5001.408 Participation or assignment of guaranteed loan.

( a ) General. The lender may obtain participation in the loan or assign all or part of the guaranteed portion of the guaranteed loan on the secondary market subject to the conditions specified in paragraphs (a)(1) through (5) of this section or retain the entire guaranteed loan.

( 1 ) Participation. The lender may obtain participation in the loan under its normal operating procedures; however, the lender must retain title to and possession of the promissory note(s) and retain the lender's interest in the collateral.

( 2 ) Assignment. Any assignment by the lender of the guaranteed portion of the loan must be accomplished in accordance with the conditions in the lender's agreement and the provisions of this section. The holders and the borrower have no rights or obligations to one another. The holders and the borrower have no rights or obligations to one another.

( 3 ) Minimum retention by the lender. Minimum retention at all times must be from the unguaranteed portion of the loan and cannot be participated to another person.

( i ) The lender must hold a minimum of 7.5 percent of the total loan amount.

( ii ) The lender must retain its security interest in the collateral and retain the servicing responsibilities for the guaranteed loan.

( iii ) The Agency can approve a reduction of the minimum retention requirement below the applicable percentage on a case-by-case basis when the lender establishes to the Agency's satisfaction that reduction of the minimum retention percentage is necessary to meet compliance with the lender's regulatory authority.

( 4 ) Prohibition. The lender must not assign or participate any amount of the guaranteed or non-guaranteed portion of the loan to the borrower, borrower's officers, directors, stockholders, other owners, or to members of their immediate families, or to a parent company, an affiliate, or a subsidiary of the borrower.

( 5 ) Secondary market. The lender must properly close their loan and fully disburse loan funds of a promissory note for the purposes intended prior to assignment of the guaranteed portion of the promissory note(s) on the secondary market. The lender can assign all or part of the guaranteed portion of the loan only if the loan is not in default.

( b ) Lender's servicing fee to holder. The assignment guarantee agreement must clearly state the guarantee portion of loan as a percentage and corresponding dollar amount of the guaranteed portion of the guaranteed loan it represents and the lender's servicing fee. The lender cannot charge the Agency a servicing fee and servicing fees are not eligible expenses for loss claim.

( c ) Distribution of proceeds. The lender must apply all loan payments and collateral proceeds received, after payment of liquidation expenses, to the guaranteed and unguaranteed portions of the loan on a pro rata basis.

( d ) Promissory note(s). A loan note guarantee is issued to the lender for a specific promissory note(s) executed between the lender and the borrower. The lender must retain title to and possession of the guaranteed promissory note(s), retain the lender's interest in the collateral, and retain the servicing responsibilities for the guaranteed loan. The lender is prohibited from issuing any additional promissory notes at a later date for the same guaranteed loan.

( 1 ) The lender may assign all or part of the guaranteed portion of the loan, including interest strips, to one or more holders by using an assignment guarantee agreement for each holder. The lender must complete and execute the assignment guarantee agreement and return it to the Agency for execution prior to holder execution.

( 2 ) The lender or holder may request a certificate of incumbency and signature from the Agency.

( 3 ) A holder, upon written notice to the lender and the Agency, may reassign the unpaid guaranteed portion of the loan, in full, assigned under the assignment guarantee agreement. Holders can only reassign the complete block they have received and cannot subdivide or further split their interest in the guaranteed portion of a loan or retain an interest strip.

( 4 ) Upon notification and completion of the assignment through the use of the assignment guarantee agreement, the assignee succeeds to all rights and obligations of the holder thereunder. Subsequent assignments require notice to the lender and Agency using any format, including that used by the Securities Industry and Financial Markets Association (formerly known as the Bond Market Association), together with the transfer of the original assignment guarantee agreement.

( 5 ) The Agency will not execute a new assignment guarantee agreement to affect a subsequent reassignment.

( 6 ) The Agency will not reissue a duplicate assignment guarantee agreement unless:

( i ) The original was lost, stolen, destroyed, mutilated, or defaced; and

( ii ) The reissue is made in accordance with § 5001.459 .

( e ) Rights and liabilities. When a guaranteed portion of a loan is assigned to a holder using an assignment guarantee agreement, the holder succeeds to all rights of the lender under the loan note guarantee to the extent of the portion purchased. The full, legal interest in the promissory note must remain with the lender, and the lender remains bound to all obligations under the loan note guarantee, lender's agreement, and Agency regulations applicable to the guarantee.

( 1 ) A guarantee and right to require purchase in accordance with § 5001.511 will be directly enforceable by a Holder notwithstanding any fraud or misrepresentation by the lender or any unenforceability of the loan guarantee by the lender, except for fraud or misrepresentation of which the holder had actual knowledge at the time it became the holder or in which the holder participates or condones.

( 2 ) The lender must not represent a conditional commitment of guarantee as a loan guarantee.

( 3 ) The lender must reimburse the Agency for any payments the Agency makes to a holder on the lender's behalf under the loan note guarantee, given the lender would not be entitled to the payments had they retained the entire interest in the loan.

[ 85 FR 42518 , July 14, 2020, as amended at 85 FR 62197 , Oct. 2, 2020; 86 FR 70358 , Dec. 10, 2021]

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Loan Participation Note (LPN): What it is, How it Works, Example

James Chen, CMT is an expert trader, investment adviser, and global market strategist.

What Is a Loan Participation Note?

A loan participation note (LPN) is a fixed-income security that permits investors to buy portions of an outstanding loan or package of loans. LPN holders participate on a pro-rata basis in collecting interest and principal payments, and are similarly exposed to a proportional risk of default.

Banks, credit unions, or other financial institutions often enter into loan participation agreements with local businesses and may offer loan participation notes as a type of short-term investment or bridge financing.

Key Takeaways

• A loan participation note (LPN) allows investors to purchase a claim to a portion of an outstanding loan issued by another lender.
• With an LPN, the lead bank underwrites and issues the loan, while participant investors subsequently purchase a pro-rata amount.
• LPNs are popular with credit unions, which use participation agreements to foster greater economic participation and community building through sharing risk & reward with local residents and businesses.

How a Loan Participation Note Works

To meet the needs of local borrowers and increase loan income, many community banks use loan participation agreements in which one or more banks share in the ownership of a loan. Community banks have also formed lending consortia. One example is the Community Investment Corporation of North Carolina (CICNC), an affordable housing loan consortium that provides long-term, permanent financing for the development of low- and moderate-income multifamily and elderly housing throughout North and South Carolina.

One of the purposes of loan participation notes is to help meet the needs of borrowers within a local community. Several other institutions have also sprung up for similar reasons. Credit unions are one such example. A credit union is a financial cooperative that is created, owned and operated by their participants. While some credit unions can be large and national in scale , such as the Navy Federal Credit Union (NFCU), others are smaller in scope.

Cooperative principles of credit unions include: voluntary membership, democratic organization, economic participation of all members, autonomy, education and training for members, cooperation, and community involvement.

Credit unions and banks generally offer the same services, including accepting deposits, originating loans for individuals or small businesses and offering financial products such as credit and debit cards and certificates of deposit (CDs). Key structural differences exist in terms of how a commercial bank and credit union use their profits, however. While traditional banks function to generate profits for their shareholders, many credit unions operate as not-for-profit organizations, putting excess funds into concrete projects that will better serve their community of de-facto owners (i.e. members).

Example of an LPN

For example, Angel V. Castro, a pioneer in the Latin American credit union movement, was recently recognized for his efforts by the National Credit Union Foundation. Castro believed that the traditional U.S. model of consumer credit-based poverty reduction would not fit the needs of the people in the communities he worked with. In Ecuador, he focused on organizing credit unions that extended access to credit for its members specifically for agriculture and other endeavors.

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What You Should Know About Loan Participation Accounting

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If you’re a banker, you are probably curious about loan participation accounting. It is an essential part of determining your loan’s true worth. The purchaser and originator of the loan both want to see the true sale of the participating interest in the loan. However, when it comes to accounting for loan participation, you should remember that there are several different rules that apply. Read on to find out more about loan participation accounting. Here are a few of them:

Bank’s Obligations to Participant

As a bank, a participating company in loan participation accounting has certain rights and obligations. The Bank is required to pay payments promptly and shall apply the money received from a Participant’s loan to the bank account designated by the Participant. However, the Participant may be required to provide written instructions to the Bank on how to receive payments from the Bank. Listed below are some of the Bank’s obligations to a Participant in loan participation accounting.

In addition to the requirements for loan participation , banks must be aware of the potential consequences of changing FASB standards. In addition to ensuring that loan participations are compliant with the new standards, banks must make sure that their participation agreements contain specific provisions that protect them from adverse consequences. To prevent such a problem, banks should review participation agreements and implement a process to review them before entering into a loan participation.

In addition, loan participations can be beneficial to community banks when the lead bank maintains control of large customer relationships. However, lending limits and capital adequacy issues should be carefully considered before entering into a participation agreement. To understand the benefits and drawbacks of loan participations, banks should take the time to review the FDIC’s guidelines on loan participation accounting. It can help them decide if loan participations are right for them.

In today’s competitive financial environment, loan participations have become an important tool for community banks. They provide liquidity to the financial system by enabling banks to participate in loan transactions, purchase interest in the loans, and transfer funds to the originating bank in exchange for cash payments. By following these guidelines, participating banks can minimize the risks and maximize the profit of their lending operations. If a bank can meet these requirements, it will remain competitive.

Bank’s Share of Collections

A bank’s share of collections in loan participation accounting is determined by the amount of its participation in the total collection of the customer’s loans. Before, loan participations were commonly structured using the Last-In-First-Out (LIFO) or First-In-Last-Out (FILO) method. These accounting variations were used by lead banks to facilitate the sale of loan participations, but these practices do not meet the new requirement that loan participation ownership is structured on a pro-rata basis.

Lenders should make sure their loan participation agreements contain a clause protecting them from potential liability for losses or adjusting the lender’s share of collections. A loan participation agreement should specify the role of the lead institution and define how its participation obligations should be measured. It should also state the rights and responsibilities of each party, including dispute resolution procedures. These provisions are crucial in loan participation accounting. Moreover, banks must comply with the lending restrictions of the government when entering into loan participation agreements. One exceptional feature of BankLabs Participate platform is the built-in NDA and loan agreement documents. Of course, there is always an option to upload and use your own custom document if you need. 

Tracking Transactions

Whether the Bank’s Share of Interest in a Loan Participation is deductible in the Accounting Book or Balance Sheet is a question you might have. Loan participations are financial products in which the Bank participates in a loan and accepts part of the risk for the borrower. Typically, these loans are for small business loans or large commercial real estate loans. Banks can use loan participations for many different purposes, including improving their liquidity, interest rate risk management, diversified portfolios, and attracting and retaining customers by serving their credit needs, even if they are above their lending limit.

One of the most difficult tasks when originating and managing loan participation is the back office organization. Keeping track of transactions, dates, approvals, and important loan documentation can be tedious for a loan officer. That is why investing in loan participation management software is so important, especially if you originate multiple loans with multiple institutions participating. 

Even if you participate in several loans, the organizational aspects can get confusing and lost in the inbox. With a central location for all transaction history and dates noted, a loan officer can get a full picture of the status of your bank’s loan portfolio instantly. You can see which will close next and which have already been completed. Custom reports also help you share this information with your team. Having correspondences in one central location rather than several different inboxes can be a lifesaver and easily pulling up documents with specific accounting information on them with the click of a button can make balancing your accounts easy.

What is a Participation Loan?

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