Industry Standards for Loan Participation Litigation
As a lender that has sold and bought many loan participations, and as a banking regulator that has had the job of making sense of and straightening out many loan participations that have gone bad, I have experienced just about everything that exists involving loan participations.
This includes intervening as a governmental banking regulator where an unprincipled lead lender may have sold participations that total 300% of the amount of the loan. Talk about creative financing! This situation was the exception, and you will find that the vast majority of loan participations are legitimate transactions entered into for practical financial reasons.
Lenders sometimes originate a loan and then sell part or all of the loan off to another lender or investor. Usually, the originating lender – usually called the Lead Lender - continues to service the loan, and is paid a fee for providing this service.
The nationwide industry standard practices for loan participations are the same regardless of what type of financial institutions are involved, be it savings and loans, banks, credit unions, mortgage companies, or asset-based lenders.
Reasons Why Lenders Sell Loan Participations
There are many reasons why a lender may sell off participations in a loan, including:
● To increase profits by earning the servicing fee even though the originating lender may have sold off a large part or even all of a loan to another lender or investor so that the originating lender has a small or no remaining principal investment in the loan.
● To originate a large loan that is larger than the lender’s legal lending limit or the institution’s own lending limit. The purpose might be to obtain a high-quality loan or to accommodate a bank customer that needs a loan that exceeds the originating lender’s legal lending limit.
● To originate a type of loan, such as an acquisition and development loan, with which the originating lender has expertise, and then selling part or all of the loan to another financial institution that does not have that expertise but that wants to earn the higher yield typical of this type of loan.
● To originate a type of loan, such as an acquisition and development loan, with which the originating lender has expertise, and then selling part or all of the loan to another financial institution that does not have that expertise but that wants to diversify its loan portfolio risk profile by including this type of loan.
● To reduce the originating lender’s exposure in a particular type of loan, collateral property type, geographical area, borrower type, et al.
● To accommodate a good borrower with whom the originating lender is at or close to its maximum lending limit to one borrower.
● To take advantage of a profitable quality loan opportunity by originating a loan that would exceed the lender’s legal lending limit without selling off a portion of the loan.
Imbedded in the above list of reasons why an originating lender may want to sell participations, you can see where there are advantages for the loan participation purchasers as well.
Who is Responsible for What in a Loan Participation Arrangement
Arrangements establishing loan participations vary greatly and are controlled by the documents to which the parties agree and sign. The controlling document typically is a Loan Participation Agreement accompanied by a participation certificate, or alternatively just a participation certificate. Often, these documents are fill-in-the-blanks documents where the details of the transaction are cited, including:
● Typically, the originating lender is responsible for closing the loan and providing copies of the loan documents to the participating lenders.
● A loan participation agreement or participation certificate will specify the percentage ownership that the participating institution has purchased, and will address where the participant’s payments are to be sent, etc.
● The originating lender or Lead Lender typically is responsible for loan servicing matters including collecting payments, insurance and escrow matters, and all other servicing duties; and is responsible for forwarding to the participants their pro-rata portion of the payments received, net of the Lead Lender’s servicing fee.
● If the originating lender has agreed to buy back the participant’s interest in event of default, then this will be spelled out in the participation agreement or participation certificate.
● If the originating lender is originating the loan at one interest rate but selling a lower interest rate to the participant, then that is detailed out as well.
● The agreements also address who is to receive or how any points that the borrower pays at closing will be divided among the originating lender and the participant.
While the originating lender is responsible for due diligence, it is prudent for the participating lenders to perform their own due diligence as well since it is an investment that they are making.
Loan participants should be aware of any irregularities or unusual factors that might affect the loan, and bring them to the attention of the Lend Lender for discussion.
If the loan participation arrangement is one where the originating lender has agreed to buy back the loan in case of default, then the participant has to be concerned whether or not the Lead Lender will have the financial capability to buy back the participant’s interest without violating the originating lender’s legal lending limit or loans to one borrower limitation.
Remember that the documents establishing the participation arrangement always control the relationship.
“He said. She said,” disagreements between lead lenders and participants have to be decided by a court.
Since lenders in all areas of the country sell loan participations to lenders in other parts of the country, nationwide industry standards for loan participation practices are the same regardless of the geographical location of the parties, financial institution type and loan collateral type.
ABOUT THE AUTHOR: Banking and Lending Expert Witness Don Coker
Expert witness and consulting services. 600 cases for plaintiffs & defendants nationwide, 146 testimonies, 12 courthouse settlements, all areas of banking and finance. Listed in the databases of recommended expert witnesses of both DRI and AAJ.
Clients have included numerous individuals, 100+ banks, and governmental clients such as the IRS, FDIC.
Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, and a two-year term as a high-level governmental banking regulator.
B.A. degree from the Univ. of Alabama. Completed postgraduate and executive education work at Alabama, the Univ. of Houston, SMU, Spring Hill College, and the Harvard Business School.
Called on by clients in 36 countries for work involving 64 countries.
Widely published, often called on and quoted by the media.
Don Coker serves clients worldwide from his Atlanta metro area office.
Copyright Don Coker
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.