LOAN PARTICIPATIONS

like the participant is financing the grantor’s loan to the borrower, where the US and UK participant’s right against the grantor for repayment is limited to funds received from the borrower. So if the grantor becomes insolvent, the participant holds no more compared preferred as a creditor of the grantor with respect to funds received from the Fundamental differences remain between the markets. borrower than any other unsecured creditor of the grantor, and the Privy Council’s But is it worth considering using a New York participation judgment in Lloyds TSB Bank v Clarke agreement in an English deal? [2002] UKPC 41 confirms that there is no doubt as to this treatment. The risk of insolvency of the grantor Notwithstanding the increasing convergence of from the borrower. presents not only the obvious commercial market practice in New York and London for The back-to-back approach of considerations, but, for banks that do not syndicated loans, differences remain. These participations may be useful in overcoming report in accordance with IAS, some differences are attributable to many factors, obstacles that would prevent an assignment accounting and regulatory issues referred to including different English and New York legal but not a participation, for example below. Although there are methods to principles, expectations of market participants contractual limitations prohibiting structure transactions that enable and, sometimes, habit. This article is the first assignments, regulatory requirements that participants to mitigate this risk, as in a series comparing syndicated loan market apply to lenders of record, withholding tax described in some detail in the LMA’s paper practice and underlying legal considerations in treatment and the disclosure to the Funded Participations – Mitigation of London and New York. borrower, the administrative agent and Grantor Credit Risk, these methods add other parties that would necessarily result complexity to what many regard as routine Aside from transactions such as credit from an assignment but not a participation. trades and are not generally adopted. default swaps and other derivatives Notwithstanding the same basic The LMA’s form of credit agreement does instruments, the principle means by which structure and business impetus for not address whether the grantor may vote lenders reduce existing credit exposure to participations, the legal characterisation of its interest as directed by the participant. borrowers is by assigning or transferring these arrangements and some of their Absent special provisions in the credit those credit exposures to other lenders or structural elements are different under agreement, the grantor would continue to by selling to other lenders participations (in English and New York law. vote and control its entire interest in the New York parlance) or sub-participations loan (including the portion subject to the (in British parlance) in those credit London participation). Where the participation exposures. Under the form of participation agreement relates to the grantor’s entire interest in the In the case of assignments and transfers, recommended by the Loan Market loan, the grantor and the participant may the assignee or transferee becomes the Association (LMA), which has been widely agree that the grantor will exercise voting lender of record: it becomes a party to the adopted in transactions, the rights as directed by the participant, which underlying agreement and thereby comes lender of record (or grantor of the may concern a borrower that was counting into contractual privity with the borrower. participation) undertakes to pay to the on its relationship with the lender of record. But in participations (which term shall be participant a percentage of amounts received Conversely the inability of the grantor to used throughout this article in order to from the borrower. split its voting entitlement where the avoid repeated references to the different This form explicitly provides that “the participation does not relate to the whole of New York and London nomenclature), the relationship between the Grantor and the its interest may not be entirely satisfactory participation agreement is solely between Participant is that of debtor and creditor for the participant. the lender of record and the participant and with the right of the Participant to receive Absent clear provisions in the credit thus creates no privity between the monies from the Grantor restricted to the agreement dealing with pass through of participant and the borrower. Under the extent of an amount equal to the relevant increased costs, mandatory costs and the participation agreement the lender of portion of any monies received and applied benefit of tax gross-ups and indemnities, record simply agrees to turnover to the by the Grantor from any Obligor”. The the grantor is unlikely to be able to pass on participant whatever amounts it receives participation is thus substantively treated to the participant the benefit of the provisions typically seen in the market.

New York In New York, case law has developed that In contrast to London, a New York law distinguishes between a “true participation” “ and a “financing”. In a true participation, credit agreement typically prescribes what the participant acquires a beneficial interest in the underlying loans. a participant may vote upon This means that the participant is entitled to ” its share of payments from the borrower notwithstanding the insolvency of the grantor (so the participant does not have to

42 IFLR/October2009 www.iflr.com LOAN PARTICIPATIONS

generally address increased costs by participants directly. Since it is no longer the beneficial owner of the portion of a A New York law participation agreement loan sold by participation, the seller is not “ likely to suffer increased costs from owning could provide an elegant alternative in that portion of the loan and would have the UK difficulty claiming indemnification for its ” own costs under the credit agreement. At the same time, a participant is likely to want the ability to recover any increased costs that it may suffer from being the share those payments with the grantor’s grantor, on the one hand, and the grantor holder of the participation. Accordingly, other creditors) even though the beneficial and the participant, on the other hand; and credit agreements frequently provide that ownership does not create privity between (iv) there is a discrepancy between the participants may benefit from the increased the participant and the borrower. On the interest rate due on the underlying loan costs indemnities, so long as the borrower other hand, a participation that is and the interest rate specified in the does not thereby become liable to pay more characterised as a financing would have the participation. than it would have paid in the absence of same consequences as an English-law Of these four factors, the guarantee of the sale of a participation. participation. repayment is the most important in The most fundamental requirement for determining classification of a given Query characterisation as a true participation is transaction, because the failure by a Given the advantages that a New York law the effective transfer of the economic risks participant to take the full risk of participation agreement brings to and rewards of ownership. Section 22 of ownership of the underlying loan is a participants (by mitigating credit risk of the the forms of participation agreements for crucial indication of a financing rather than grantor) and certain grantors (by better par or near par trades and for distressed a true participation. Other factors accounting treatment under US Gaap), can trades proposed by The Loan Syndications indicating that a participant is not subject these advantages be realised by using such an and Trading Association (LSTA) provide to the normal risks of ownership include agreement for a loan made under an English that “the relationship between [grantor] guaranteed returns by the grantor and law credit agreement? and [participant] shall be that of seller and required repurchase arrangements. English should apply New York buyer. Neither is a trustee or agent for the Whether a participation is characterised law to such an agreement and therefore give other, nor does either have any fiduciary as a true participation, which transfers it the same effect that it would receive in a obligations to the other. This Agreement beneficial ownership, or a financing, which New York . However, the English shall not be construed to create a does not, may also have other courts have not specifically considered this partnership or joint venture between the consequences. Of particular relevance for issue so one cannot be certain. It is possible Parties. In no event shall the Participation be grantors that report under US Gaap, that an English court would view the construed as a loan from [participant] to Financial Accounting Standards Board beneficial ownership conveyed under New [grantor].” (emphasis added). Statement 140 disallows grantors from York law as equivalent to an assignment (or, In the absence of the characteristics taking off-balance treatment for loans less likely, a declaration of trust). If the referred to below, courts would treat a subject to participations regarded as mere participation is construed as equivalent to participation sold under an LSTA form as a financings. In addition, whether or not a an assignment under English law it is likely true participation. This is consistent with participant is considered to be the to be ineffective in practice unless the position taken by the FDIC in its beneficial owner of a loan may have contractual requirements with respect to regulation 12 CFR 360.6, which provides withholding tax implications under the assignments under the credit agreement are that it will not use its authority to reclaim laws of the where the borrower complied with. This uncertainty, however, as property of an institution under is located. should not adversely affect the treatment of conservatorship or receivership any In contrast to the London market that participation in relation to the possible financial assets transferred in connection approach to voting by participants, a New insolvency of the grantor or the positive with a participation, provided that the York law credit agreement typically treatment under US Gaap. transfer meets all conditions for sale prescribes what a participant may vote This risk can be avoided if a credit account treatment under US Gaap (other upon. Even though the voting rights agreement is drafted to ensure that New than a condition relating to “legal themselves are contained in the York law participation agreements (in an isolation”). participation agreement (to which the approved LSTA form) are a permitted form Courts have held that the following four borrower would generally not be a party) of assignment (as is the case for security factors typically indicate that a transaction the credit agreement addresses this issue assignments, which benefit from a specific is a financing rather than a true directly by prohibiting any lender from exemption under the LMA’s form of credit participation: entering into a participation agreement agreement). Where this is feasible, a New (i) the grantor guarantees repayment to entitling a participant to direct its voting, York law participation agreement could the participant; except as to certain matters. These matters provide an elegant alternative worth (ii) the participation lasts for a shorter or are usually the same ones that would considering. longer term than the underlying loan that require unanimous consent or the consent is the subject of the participation; of affected or directly affected lenders By Richard M Gray (New York) and Suhrud (iii) there are different payment under the credit agreement. Mehta (London) of Milbank Tweed Hadley arrangements between borrower and the Credit agreements in New York also & McCloy LLP www.iflr.com IFLR/October2009 43