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Loan participations: Proceed with caution

Commercial mortgage deals demand close attention to participation agreements

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  • Written by  Hugh Finnegan & Herman Lipkis, Sullivan & Worcester
Careful attention to detail in commercial mortgage loan participations proves essential to avoiding a bitter aftertaste. Careful attention to detail in commercial mortgage loan participations proves essential to avoiding a bitter aftertaste.

The purchase and sale of participations in commercial mortgage loans is a fixture of real estate lending, allowing the original lending institution to enhance liquidity and pursue additional financing opportunities while spreading its risk. For participating banks, diversifying portfolios without the responsibility of underwriting and servicing the loans are clear benefits.

Hidden within these transactions, though, are multiple risks for both the lead bank and those that buy-in. Let’s examine a few of the risks faced by participants in loan participations—and some mitigation strategies.

How the process works

In a typical participation loan, multiple lenders have an interest in the loan. However only one lender (the "Lead Bank") maintains control of the loan and the relationship with the borrower.

The Lead Bank originates the loan and is responsible for communicating with the borrower, servicing the loan on its own behalf and on behalf of the other lenders (the "Participants").

The Lead Bank is the only lender with a direct contractual relationship with the borrower. Thus the Lead Bank is the only lender with the right to receive loan payments from the borrower; pursue collection actions against the borrower or any guarantors; and enforce security interests in the borrower's assets. The Participants' only contractual relationship is with the Lead Bank.

As a matter of law, unless the participation agreement specifically says otherwise, Participants are not considered creditors of the borrower. Thus they may not make claims against the borrower or any collateral securing the loan. Participants may only pursue repayment of their participation from the Lead Bank.

Basics of participation agreements

The Lead Bank and Participants define their relationship in a participation agreement or, in some instances, a participation certificate.

At a minimum, the agreement should reflect the amount of the loan being purchased by the Participant, the interest rate; critical dates and deadlines; and all fees associated with the participation. Most also include limited representations from the Lead Bank to the Participants such as a statement that the loan is current or in good standing.

Lead Banks are usually reticent to make any additional representations or warranties. This reflects the limited standard of care that Lead Banks owe to Participants.

Participants should ensure that the participation agreement specifically outlines the duties of the Lead Bank. Such duties generally include a requirement to give the Participants copies of the executed loan documents; provide notice of material changes in the borrower’s status; and a general duty to maintain ongoing administration and enforcement of the loan.

Participants should also ensure that the agreement specifies that the Lead Bank consult with Participants prior to modifying any loan documents and before waiving any defaults or taking any enforcement action on defaulted loans.

Defining the relationship between the Lead Bank and borrower is a critical component of the agreement. This step should include prohibitions on the Lead Bank’s ability to change the basic loan terms, including the interest rate; principal balance of the loan; or the maturity date.

Furthermore, the Lead Bank should not be unilaterally permitted to consent to changes in the structure of any entity borrower or guarantor; waive material events of default; permit partial or full transfer of collateral; or other similar major modifications.

In the event of a default, the Lead Bank should be obligated to pursue remedies outlined in the underlying loan documents and to alert Participants of the default and the planned course of conduct in the enforcement action.

The rights and remedies available to the Lead Bank and Participants upon the borrower’s default should be unambiguously described in the participation agreement.

Courts have held that the terms in a participation agreement are not necessarily limited to those explicitly set forth in the agreement itself, but may also include terms found in the commitment letter, participation certificate, or other loan documents.

Thus, a potential participant and its counsel should carefully review all of the loan documents, including preliminary documents such as the term sheet, approval memorandum, and commitment letter, to obtain a full picture of the terms and conditions of the loan to the borrower.

Risk I: Role of Lead Bank versus Participant

To date, courts have held that no fiduciary relationship will be implied in participations among sophisticated financial institutions.

Participants should be aware that the Lead Bank is not their fiduciary unless the participation agreement expressly specifies that relationship. Some of the basic requirements of the Lead Bank when acting as a fiduciary may include the duty to act in good faith towards the Participants and with the level of care considered standard in the Lead Bank’s geographic area.

Lead Banks usually structure participation agreements as a contract between buyer and seller. The agreement may state that the Lead Bank’s intention is to transfer economic rights in the underlying loan to the Participant without the creation of an agency relationship. Many Lead Banks include broad exculpation language in their participation agreements, explicitly stating that they will not act as a fiduciary. These exculpation clauses may include disclaimers for all liability, with very limited exceptions.

Many agreements also require acknowledgements from Participants confirming that they have conducted their own due diligence and review of the underlying loan documents, the borrower, and the collateral and did not rely on the Lead Bank’s credit analysis or investigation in purchasing their participation interest.

Courts generally uphold exculpation clauses and similar limitations on liability of the Lead Bank. Therefore, a potential participant or its counsel should carefully review the exculpation provisions to understand the specific scope of the duties owed to them by a Lead Bank.

Participants should also conduct their own credit analysis of the borrower; inspect the collateral securing the loan and investigate the Lead Bank to determine the potential risks they face when purchasing an interest in the Lead Bank’s loan.

These steps are especially important when considering:

• Purchasing an interest in a new loan product.

• Participating in a loan with a borrower entering a line of business in which the Participant or the proposed borrower has limited experience.

• Participating in a loan with a borrower located outside the Participant’s normal geographic market knowledge.

Risk II: Borrower’s default and insolvency

No amount of due diligence and analysis can always predict the borrower’s failure to repay the underlying loan with the Lead Bank. Loan defaults can and do occur.

How does this affect the rights of the Participants? What are the obligations of the Lead Bank?

The response to a borrower’s default and the workout of a defaulted loan can be a delicate, complex process. Workouts are not always properly documented in the participation agreement. A well-drafted participation agreement should highlight the rights, duties, and obligations of the Lead Bank and the Participants in the event of a borrower default.

It is impossible to anticipate each potential scenario in a future workout situation with the specificity necessary to address every risk.

For example, a borrower may seek to transfer the collateral securing the loan to the Lead Bank in exchange for a release and termination of the loan in lieu of foreclosure or collection actions.

Some Participants may not have any interest in owning the collateral or granting the Lead Bank the ability to do so. Other Participants may encourage a transfer of the collateral to the Lead Bank so long as the Lead Bank agrees to properly manage the collateral and the Participants receive their share of the proceeds from the rental of the property, if applicable, and in the eventual sale of the collateral.

However, what happens if the Lead Bank is not competent to properly manage the collateral or, worse yet, causes damage to the collateral?

What if the participation agreement requires input from the Participants and agreement among the parties prior to the liquidation of the collateral but the parties cannot agree on a plan or alternatives?

Courts have held that a true loan participation is not an assignment of the Lead Bank’s right to receive payment from the borrower. (A true participation is one properly constructed as a contract of sale of an interest in a loan from the Lead Bank to the Participant—and not a loan from the Participant to the Lead Bank.)

Thus, Participants are not considered “creditors” of the borrower under bankruptcy law. Only the Lead Bank has the right to pursue legal recourse against a defaulted borrower and pursue a claim in the borrower’s bankruptcy case.

Unity among multiple Participants and a Lead Bank can be an elusive goal following a borrower’s bankruptcy. Some lenders may wish to pursue certain workout strategies while others may not. Disagreements and disputes among the lenders can delay and harm the lenders’ ultimate recovery in bankruptcy court proceedings.

Accordingly, it is imperative that Participants work quickly and diligently to resolve any conflicts among themselves and with the Lead Bank. In a workout situation only one lender—the Lead Bank—will speak on behalf of the group in bankruptcy court.

Risk III: Lead Bank’s financial strength

Participants generally focus on the borrower’s credit risk when evaluating a potential participation, but additional attention should also be focused on the Lead Bank’s creditworthiness. What if the Lead Bank defaults or becomes insolvent? What recourse is available to the Participant?

These questions are not often considered in a participation agreement. However, financial institutions of any size can fail. So a prudent evaluation should include a review of the Lead Bank’s financial health; its experience and history with the borrower; and its expertise in originating and underwriting loans similar to those of the type and size being offered for sale.  

Should the Lead Bank file for bankruptcy, the bankruptcy court first looks at the nature of the participation before determining the rights of the parties involved.

Specifically, the court will assess whether the participation agreement evidences a “true participation” which reflects the sale of an interest in the loan to the Participant rather than a loan to the Lead Bank.

Courts will also examine whether the participation reflects a transfer of the economic and other interest in the loan. The factors considered include:

1. Whether the major terms (i.e., maturity date and interest rate) in the participation agreement match those in the loan documents.

2. Similarity of the payment terms in the participation agreement versus the underlying loan documents.

3. Whether the Lead Bank provided a guarantee of the borrower’s repayment obligation of the underlying loan. (Such a guarantee is not common.)

If the bankruptcy court concludes that the participation is a “true participation,” it will likely find that the Participant holds an ownership interest in the loan.

Next, the court will examine whether the Lead Bank established a fiduciary or trust relationship with the participant. The court will examine whether the Lead Bank agreed to hold proceeds from the underlying loan for the sole benefit of the Participant and, if so, whether those funds were actually segregated from the Lead Bank’s other funds.

If the answer to these questions is yes, the court may, upon motion from the Participant, construe the participation as a direct assignment, provided this is not prohibited under the underlying loan documents. Thus, court could thus allow the Participant to establish a direct relationship with the borrower.

A poorly drafted participation agreement may lead a court to decide that the participation is not a true participation but is rather a form of loan. In that case the court will likely not find that the Participant has an ownership interest in the underlying loan with the borrower. Thus, the Participant’s only recourse would be an unsecured claim against the Lead Bank.


As in any credit decision, a potential participant in a loan participation should approach such a transaction carefully and perform its own due diligence on both the borrower and the lead bank.

Despite the perception to the contrary, there is no standard form of participation agreement and each deal will have its peculiarities. However, a prudent Participant and its counsel will negotiate a participation agreement that properly addresses the risks inherent to these types of transactions.

About the authors

Hugh P. Finnegan is a partner and co-director of the Real Estate Department at Sullivan & Worcester. His practices focuses on commercial real estate financings, loan restructurings, and construction matters.

Herman R. Lipkis is a real estate associate in Sullivan & Worcester's New York office focusing on commercial real estate finance transactions, development, leasing and construction matters.

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