Loan Participation Agreements: Contract Drafting Perspectives for the Lead Bank

In a perfect world, all loans would be performing, and the lead bank and participant would share in the profits of a loan participation with minimal risk of loss. In the real world, a promising participation loan easily becomes a problem loan, and the lead bank and participant bank can find themselves embroiled in litigation against each other. Such litigation puts a substantial strain on the lead bank’s resources to enforce the loan documents against the defaulted debtor, at a time when the parties should be sharing resources for loss mitigation. One common reason a participant may sue a lead bank after borrower default is based upon the participant’s assessment of collectability. If the participant determines that the collateral is worthless or the borrower is otherwise judgment-proof, the participant may look to the lead bank to recover its share of participation in the failed loan.

By virtue of this lead-participant relationship, the lead bank—who often originated the loan—is privy to many of the borrower’s financials in loan origination. To that end, participants may rely on the lead bank’s assessment of the borrower’s creditworthiness, and further, participants may expect the lead bank to produce all the documentation necessary for underwriting to the participant before it enters a participation agreement. Some of the many theories of recovery used by participants against lead banks are negligent administration of the loan, negligent misrepresentation and fraud. To avoid the pitfalls of protracted litigation later, a prudent bank should give close consideration to the language of the participation agreement, which can properly allocate the risk of participation loans before problems arise.

A loan-participation generally involves an agreement between sophisticated lending parties, transacted at arms-length. Therefore, courts all across the country consistently enforce participation agreements according to their terms. New Bank of New England v. Toronto-Dominion Bank, 768 F. Supp. 1017, 1020 (S.D.N.Y. 1991); See e.g. Banco Espanol de Credito v. Security Pac. Nat’l Bank, 973 F.2d 51, 56 (2d Cir. 1992), cert. denied, 509 U.S. 903 (1993). Each participation agreement is unique, but many agreements contain standard provisions to promote consistency and conformity with the standards of sound banking practices and previous judicial interpretations of participation agreements. This article focuses on those standard provisions and how they may affect rights and obligations of the lead bank and participant.

When a participant unambiguously disclaims reliance upon a lead bank, the participant cannot establish a prima facie claim for misrepresentation or fraud.

It is well established that participation agreements containing specific disclaimers of reliance can preclude a participating bank from recovery in actions of misrepresentation and fraud against a lead bank. When a participant unambiguously disclaims reliance upon a lead bank in its decision to purchase a participation interest, the participant cannot prove a necessary element to either negligent misrepresentation or fraud: justifiable reliance. Such a determination begins with contract interpretation.

At least one court has found that a participating bank’s fraud and misrepresentation claims against a lead bank should be dismissed due to the unambiguous disclaimers of reliance in the participation agreement. See UniCredito Italiano SPA v. JPMorgan Chase Bank, 288 F. Supp. 2d 485 (S.D.N.Y. 2003). In UniCredito, the participation agreement provided in pertinent part:

Each Bank acknowledges that it has, independently and without reliance upon the Paying Agent or any other Bank and based on the financial statements referred to in Section 4.01(d) and such other documents and information as it has deemed appropriate, made its own credit analysis and decision to enter into this Agreement. Each Bank also acknowledges that it will, independently and without reliance upon the Paying Agent or any other Bank and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under this Agreement and the other Loan Documents.

Id. at 492.

In UniCredito, the lead bank moved to dismiss the participants’ claims for failure to state a claim due to the terms of the participation agreement. In dismissing the participants’ fraud and misrepresentation claims, the court held that the “contracts pursuant to which they made their [customer] loan investments preclude them from establishing essential elements of those claims, namely that the Defendant banks had a duty to disclose information regarding or gained from their business dealings with [customer], and that any reliance by Plaintiffs on misrepresentations by the Defendants was reasonable.” Id. at 498. Thus, claims of misrepresentation or fraud under similar contracts language are likely unsustainable upon a motion to dismiss.

When interpreting substantially similar disclaimers in participation agreements, a multitude of courts have granted summary judgment in favor of lead banks on claims of fraud and misrepresentation. In Banco Espanol de Credito v. Security Pac. Nat’l Bank, 973 F. 2d 51 (2d Cir. 1992), a participant sued the lead bank for, among other things, breach of contract, tortious misrepresentation, and breach of duty to disclose based on superior knowledge. Id. at 54. By way of background, in Banco Espanol, the lead bank refused to extend further credit to a borrower when it became aware of the borrower’s financial difficulties. Id. at 54. Despite this refusal, the lead bank sold participations on the original loan, and the borrower ultimately defaulted. Id. When the borrower defaulted, the participating bank sued on the basis that the lead bank withheld material information to the transaction. Id. The lead bank moved for summary judgment on participant’s misrepresentation claims based on the disclaimer provision in the participation agreement. Id. at 54.

The Banco Espanol Master Participation Agreement stated in pertinent part that the participant: “[A]cknowledges that it has independently and without reliance upon Security [Pacific] and based upon such documents and information as the participant has deemed appropriate, made its own credit analysis.” Id. at 53. The district court granted summary judgment to the lead bank, holding that the express disclaimer provisions of a Master Participation Agreement precluded the participant’s contract and common law claims. Id.

On appeal, the Second Circuit Court of Appeals affirmed the judgment, stating that the waiver provisions “specifically absolved [lead bank] of any responsibility to disclose information relating to [the borrower’s] financial condition. Moreover, as an arms-length transaction between sophisticated financial institutions, the law imposed no independent duty on [lead bank] to disclose information that the plaintiffs could have discovered through their own efforts.” Id. at 56. In sum, the participating bank had no actionable claims in contract or common law misrepresentation or fraud claims against the lead bank.

Another court held that, in light of express disclaimers, a participant could not have reasonably relied upon the lead bank’s representations, even though the lead bank may have knowledge of the borrower’s fraud. See Banco Totta e Acores v. Fleet Nat’l Bank, 768 F. Supp. 943 (D.R.I. 1991). In Banco Totta, the participant sued a lead bank, alleging that (1) the lead bank failed to disclose fraudulent practices of the borrower known by the lead bank prior to the closing of the loan, and (2) participant reasonably relied on lead bank’s assessment of borrower’s creditworthiness. Id. at 945.

The court cited the disclaimers in the participation agreement as dispositive on the motion for summary judgment. Id. at 949. The participation agreement stated that participant’s “decision to purchase [its] Participation was based solely upon its independent evaluation of the Loan, the Borrower’s creditworthiness and the value and lien status of the Collateral and all matters relating thereto.” Id. The court found that the disclaimer clause—specifically, that the participant made its decision “solely upon its own independent evaluation”—“renders legally irrelevant all misrepresentations, innocently, negligently, or intentionally made by [lead bank] to [participant] before the Participation Agreement was signed.” Id. The court reasoned that “[t]hough the three causes of action differ in some respects, one element necessary to establish a prima facie case common to all three is that the plaintiff must have justifiably relied on the representation, mistaken or deceitful, made by the defendant.” Accordingly, the Banco Totta e Acores court held that the participant’s reliance on the lead bank’s representations was not justifiable as a matter of law and granted summary judgment for the lead bank.

Many more cases follow this reasoning. See Bank of the West v. Valley Nat. Bank of Arizona, 41 F. 3d 471 (9th Cir. 1994) (holding participant did not justifiably rely on lead bank’s investigation of the borrower, when the participation agreement expressly provided that participant agreed that it “independently and without reliance upon any representations of Lender … made and relied upon [its] own credit analysis and judgment.”); Purchase Partners LLC v. Carver Federal Sav. Bank, 914 F. Supp. 2d 480 (S.D.N.Y. 2012) (holding participant cannot establish reasonable reliance, when the agreement states “[p]articipant has made, independently, and without reliance on Lender, and based on such documents as the Participant shall have deemed appropriate, its own credit analysis and/or investigation….”).

The “Banco” cases cited supra are significant because the cases involved allegations that the lead bank knew of the borrower’s fraud or negative creditworthiness prior to offering participations, and yet—in light of the unambiguous disclaimer—such knowledge was immaterial as to whether participant justifiably relied on lead bank’s representations. The cases restrict sophisticated parties transacting at arms-length to warranties and representations of the express terms of their unambiguous agreements. The legal effect of reliance disclaimers precludes participant banks from proving a necessary element to negligent and fraudulent inducement claims: justifiable reliance.

Consequently, drafting disclaimers and representations in the participation agreement as to the availability of all relevant documents and assessment of the borrower’s creditworthiness can be a very effective tool to prevent allegations of reliance on any representation or inducement against lead banks. The agreement should make clear that (1) the participant has access to all the necessary information to make its decision to purchase a participation; (2) participant independently reviewed all the relevant documents that it requested and that were in lead bank’s possession; (3) the lead bank makes no representations as to the collectability or continued validity or sufficiency of the collateral; and (4) participant acknowledges that it did not rely on lead bank for its investigation or assessment of the risks, rather, participant made its decision based solely on its own independent evaluation of the loan and the value, and lien status of the collateral securing the loan.

In sum, the agreement should reflect that the participant entered the participation agreement equipped with all the information as it would require as if it originated the loan itself. However, lead banks should endeavor to provide participant with all relevant information received from the borrower, and in the form it was received, to assist the participant in meeting its obligation to make its own independent credit analysis of the borrower. Such obligation is consistent with regulations and guidance promulgated by banking regulation agencies.

Pursuant to the authority of the Office of the Comptroller of Currency, acceptance of a Lead Bank’s favorable loan analysis does not satisfy the Participant’s need to conduct an independent credit analysis.

Many banks are subject to administrative oversight by the Office of Comptroller of Currency (“OCC”). Banking Circulars issued by the OCC provide guidance to national banks; and a national bank’s conduct in contravention to those guidelines may constitute unsafe and unsound banking practices that are cause for an OCC regulatory discipline and enforcement action.[1] Specifically, Banking Circular 181 was drafted to address the risks arising from the purchase of loans and participations in loans, where “participations in loans may constitute an unsafe or unsound banking practice in the absence of satisfactory documentation, credit analysis, and other controls over risk.” See Comptroller of the Currency, Banking Circular 181 (rev. Aug. 2, 1984), Fed. Banking L. Rep. (CCH) ¶ 60,799 (the “Circular”). The Circular provides that satisfactory controls over the risks inherent in loan participation require an independent analysis of credit quality by the Participant bank.

Although the nature and extent of each credit analysis is transaction-specific, the Circular states that the purchasing bank should conduct an independent credit analysis to the extent that the loan participation is a credit which the purchasing bank would make directly. Id. The OCC provides that banks should have written policies and procedures governing loan participation transactions, and such policies should include “an analysis of the value and lien status of the collateral.” Id. To make informed evaluations of creditworthiness, the purchasing bank cannot solely rely upon representations of the Lead Bank. “The acceptance by a purchaser of a favorable analysis of a loan issued by the seller, a credit rating institution, or other entity does not satisfy the need to conduct an independent credit analysis.” Id. (Emphasis added).

Many cases regarding a participant’s responsibility to conduct an independent investigation cite to the OCC Banking Circular as authority. See Colorado State Bank of Walsh v. FDIC, 671 F. Supp. 706 (D. Colo. 1987) (noting that OCC guidelines provide that participants should conduct independent and prudent evaluations of loans offered for participation, and holding that a participant is responsible for “determining for itself the value and security of the loan it was participating in”) (citing Northern Trust Co. v. FDIC, 619 F. Supp 1340, 1343 (W.D. Okla. 1985).

As such, the participation agreement should impose the duty to conduct an independent credit analysis upon the participant, and the agreement should reflect the guidelines issued in OCC Banking Circular 181. But even in the absence of such terms in the participation agreement, the OCC guidelines may preclude participant’s claims of misrepresentation and fraud. As a regulated bank, participants are expected to comply with sound banking practices promulgated by the OCC.

Lead bank’s standard of care in administering the loan should also contain exculpatory language to limit the lead bank’s liability.

As previously stated, each bank’s rights and obligations are expressly set forth in the participation agreement. Generally, the parties will agree that the lead bank will exercise a certain degree of care in regard to making, monitoring, administering, and enforcing the loan. An example of such language is as follows: “Lead Bank shall exercise the same degree of care and discretion in making, monitoring, administering, and enforcing the Loan as the Lead Bank would ordinarily take in making, monitoring, administering, and enforcing the Loan solely for its own account.”

Synthesizing this “standard of care” clause, it is less material how other banks would treat origination and administration of the loan than as to whether lead bank handled the loan in accordance with its own internal standards. This provision does not employ an analysis of commercial reasonableness, rather, the standard is whether lead bank treated the loan as if it were its own. The “standard of care” clause provides a general standard of care to lead bank’s conduct as it relates to the loan. However, the lead bank should disclaim liability to the participant through an exculpation clause.

An example of such language is as follows: “nothing contained herein shall impose any liability upon the Lead Bank for its failure to provide Participant any of such information or financial statements except for the Lead Bank’s own bad faith; willful misconduct or gross neg1igence.”

Exculpatory language can be used to protect the lead bank from claims of simple negligence, where the lead can only we liable for conduct surmounting to bad faith, gross negligence or willful misconduct. On one hand, participants can ensure that the lead will treat the loan with a degree of care as it would treat its own loans. However, lead bank will only be liable to participant for its failure to meet that standard of care if participant can demonstrate that the lead acted with bad faith, willful misconduct or gross negligence. Pragmatically, participants must not only prove that the lead breached the participation agreement, but it must also prove that lead bank did so in a manner of willful and evident disregard for its duties under the contract, which can become a difficult task.

In fact, courts may properly enter summary judgment for breach of a participation agreement against a participating bank that fails to meet the gross negligence standards governing the participation agreement. Although summary judgment procedures are generally applied with caution in negligence actions, summary judgment is appropriate when the lead bank points to an absence of evidence to support the participant’s breach of contract claims that are governed by a typical gross negligence standard found in participation agreements. See Sperry Associates Federal Credit Union v. Space Coast, 877 F. Supp. 2d 1227 (M.D. Fla. 2012). In Sperry, a participant brought suit against lead bank alleging breach of loan participation agreement, fraud, misrepresentation, and fraud in the inducement. Both parties moved for summary judgment. Id. The unambiguous terms of the participation agreement limited the lead bank’s liability to acts constituting “willful misconduct or gross negligence.” Id. at 1236. Specifically, the participation agreement provided:

Seller Related Person agrees to exercise the same care in administering the Loan Documents as it exercises with respect to similar transactions entered into solely for its own account, and otherwise no Seller Related Person shall be liable to Participant, except to the extent of its willful misconduct or gross negligence . . . .

Id. at 1237.

The participant alleged that the lead bank acted in a grossly negligent manner, or engaged in willful misconduct with respect to several obligations, among them: failing to disclose accurate financial information; failing to adhere to commercially reasonable underwriting standards; and most notably failing to detect and disclose the existence of a forged signature in a “mail-away” closing of the loan documents. Id. at 1242. The court held that, while lead bank’s conduct may have been flawed, there was no evidence that Defendant lead bank or its agents had “knowledge of the existence of circumstances which constitutes a clear and present danger” or otherwise acted with gross negligence. Id. at 1243 (citing Central State Transit, 206 F. 3d at 1377).

In regard to whether the lead bank knew the loan documents were forged, the court noted that “[p]articipant has not provided evidence supporting this allegation, and indeed, the evidence shows that [lead bank] was reasonable in assuming that the SFP Loan was validly executed, and only found out about [the] forgery long after entering the SFP Participation Agreement.” Id. at 1244. Accordingly, the court granted lead bank’s motion for summary judgment on the breach of participation agreement and fraudulent inducement and negligent misrepresentations claims. Id. at 1247.[2] This example of judicial interpretation of the exculpatory clause is favorable to lead banks; it is language that should be strongly considered by the lead to protect its interest in the participation agreement.

Making decisions regarding administration and enforcement of the loan.

When the time comes to make administrative decisions, the lead bank does not want to be impeded from taking action by one or more participants. After all, the lead bank originated the loan and takes on the responsibility of enforcement of the loan documents. Therefore, the lead https://www.jimersonfirm.com/wp-admin/admin.php?page=s2bank should negotiate for the broadest discretion in making decisions regarding administration and enforcement of the loan. It is generally acceptable for a lead bank to make decisions regarding, among other things, noticing default or foreclosure of the loan. However, it is not unreasonable for the participant to seek limits on the lead bank’s discretion to act unilaterally for major changes regarding the loan. For instance, actions such as release of collateral, release of guarantors, or modification of the interest rate under the promissory note, may be considered decisions requiring the approval of participants. Given that the lead and participant’s interests in the loan are generally aligned, if the lead bank maintains an open discourse and provides justification for substantial decisions, the lead bank should have no issue in obtaining participant approval.

However, the parties may not always agree on the best course of action regarding major administrative decisions on the loan participation. In cases where there are only two parties—a lead and one participant—this can result in deadlock. For this reason, a participation agreement should always contain a buy-out provision, wherein the lead bank can elect to purchase the participant’s interest in the loan. At such point, the lead bank would be free make any administrative decision deemed necessary. In case where there is more than one participant, many participation agreements set forth voting rights of the parties to determine whether a major decision can be made. Typically, voting rights on major decisions are allocated by each party’s pro rata percentage interest in the loan. Some agreements may require a greater than 50% aggregate voting interest to make substantial decisions, while others may require the consent of at least two-thirds of the participated interest, as such percentages are subject to negotiation.

The key takeaway is to initially determine what actions the lead bank may make unilaterally, with the expectation that such decision making will be limited. The lead bank should always consider how decisions will be made with multiple participants, and further, on what terms the lead can buy-out the participants, should the parties become deadlocked or cooperation with the participant becomes difficult.

Allocation of expenses and setoffs between the lead bank and participant.

The parties should determine how funds received on account of the borrower should be applied. For instance, lead bank is responsible for enforcement of the loan documents; and the lead will incur expenses of enforcement, such as legal fees, which must be recouped. The participation agreement should state that the funds received from the borrower will first be applied to certain expenses incurred in the enforcement of the loan and secondly to the interest and principal. This will ensure that the participant shares in the risks of the loan as well as the rewards.

Because the lead bank originates and maintains the relationship with the borrower, the lead bank may also hold some of borrower’s money on deposit in account—property for which the lead bank may have setoff rights regarding any indebtedness owed to the lead bank. For this reason, participants will generally negotiate for a right to have the funds obtained through lead bank’s exercise of a setoff to be applied pro rata to the lead and the participant.

Conclusion

Loan participations can be a favorable arrangement to lead banks and participants alike. Originating lenders can use the participation to lay off risk to participants while maintaining its relationship with particular borrowers. Participants benefit from those established relationships. With the lead bank’s outlay of risk also come several obligations, many of which should be considered in detail before entering the participation agreement. A lead bank should always define its standard of care and expressly limit liability to participants as it relates to the making, monitoring and administration of the loan. Disclaimers of reliance and representations by the participant that it has conducted its own independent credit analysis are effective tools to protect the lead bank from allegations of fraud or misrepresentation. The parties should always address the decisions that can be made unilaterally and the decisions that require consent of all parties, with an opportunity for the lead bank to buy-out the participant if there is possibility of deadlock. Lastly, by establishing expectations regarding the allocation of funds received on the borrower’s account, the parties will appreciate the gravity of any decisions in administering the loan as it relates to allocating expenses and sharing profits.

[1] The OCC has issued Consent Orders requiring adherence to the Circular. See Farmers National Bank of Buhl, Idaho, Art. VII, ¶ 1, EA #2009-233 (Feb. 3, 2014) (“Bank shall not purchase any loan participation unless the Bank acquires the necessary knowledge, skills and ability to underwrite the loan on its own in accordance with the safe and sound banking practices and guidelines set forth in Banking Circular 181 (Revised), dated August 2, 1984.”).

[2] The judgment was later vacated by the Eleventh Circuit Court of Appeals for lack of diversity jurisdiction.