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Seek sound legal advice before entering into loan participation agreements, P.2

Last time, we began looking at the topic of loan participation agreements, which are common in commercial lending. As we noted, there are certain risks associated with these agreements and it is important for all parties involved to clearly establish the rights and duties of all involved lenders.

For participating lenders, doing their own due diligence. Two areas where participating lenders need to be particularly cautious are the financial strength of the original lender and the credit risk of the borrower. To begin with the issue of the credit risk presented by the borrower, participating lenders need to realize that simply because the lead bank underwrites a loan for a given borrower doesn’t mean the participating lender is well advised to participate in the transaction. 

If a borrower goes into default, participating lenders have limited options for recovery. Because a loan participation agreement is a contract for the sale of an interest in a loan from the lead bank to a participating lender rather than a loan from the lead bank to the participating lender, participating lenders are not true creditors. While the lead bank has the right to pursue legal action against a borrower in default, participating lenders do not.  This includes filing a creditor claim in bankruptcy court. Establishing a clear plan to work out disagreements among the various parties involved in the transaction is important to avoid unnecessary problems.

Participating lenders also need to be aware of and prepared for the possibility of the default of a lead bank in a participation agreement. Participating lenders need to do their due diligence about the lead lending institution and take steps to protect themselves in the event of default. Of particularly importance is ensuring that the agreement is set up as a true participation agreement, since this allows participating lender to establish an ownership interest in court.

For businesses involve in commercial lending transactions, it is critical to have the counsel and advocacy of an experienced business attorney to ensure things are done correctly and in the best interest of the business. Good legal advice ensures the transaction will go as smoothly as possible and that the financial and legal risks are minimized.

Source: Banking Exchange, “Loan participations: Proceed with caution,” Hugh Finnegan et al., Jan. 19, 2017.

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