Loan Participation Agreements: Does Borrower Fraud Relieve a Participating Bank of its Obligations?

After entering a participation agreement, a once promising loan sometimes becomes a problem loan once the borrower defaults. Following default, both the lead and participating banks always assess collectability. If the parties find the borrower is uncollectible based upon changes in circumstances, flaws in the underwriting or borrower fraud, it leads business partners to evaluate their own relationship and the finger pointing often commences. Having purchased a worthless participation interest, the participating bank sometimes seeks creative ways to relieve itself from its obligations, despite the very one-sided terms that comprise most all participation agreements. The question we often get is, does a borrower’s fraud relieve the participant from its obligations in a participating agreement, particularly when the lead bank should have noticed the fraud in their underwriting? This article will discuss common theories of recovery used by participating banks in cases of borrower fraud, and how the likelihood of success for such claims is almost entirely determined by the express terms of the participation agreement.

The Participation Agreement

Looking to reduce its credit risk, a lender may enter a participation agreement with other lenders. Essentially, a participation agreement provides for an originating lender (the “lead bank”) to sell other lenders (the “participants”) a portion of an existing loan. Undoubtedly, a participation agreement creates a contractual relationship between the lead bank and the participants. Additionally, due to the sophisticated nature of these agreements, courts consistently enforce participation agreements according to their express terms, as they are presumed to be highly negotiated and transacted at arms-length. New Bank of New England v. Toronto-Dominion Bank, 768 F. Supp. 1017, 1020 (S.D.N.Y. 1991). Thus, in the event of borrower default, the parties should examine the terms of the agreement to determine their rights and obligations.

After borrower default, participants usually look to the lead bank to recover their share of participation in the failed loan because participants have no direct rights against the borrower. Participants often believe the lead bank has a duty to repurchase their participation interest. However, obligations to repurchase rarely exist in participation agreements. Further, courts will not impose an obligation upon the lead bank that has not been specifically agreed to by the lead bank in the participation agreement.  See First Citizens Fed. Sav. and Loan Ass’n v. Worthen Bank & Trust Co., N.A., 919 F.2d 510, 514 (9th Cir. 1990). Therefore, unless the agreement states otherwise, the lead bank has no obligation to repurchase a participation interest.

Alternatively, a participant may sue the lead bank if the borrower fraudulently induced it into making the loan. For example, similar to the hypothetical above, if a participant determines that the collateral is worthless or the borrower is otherwise judgment-proof, a participant may attempt to recover from the lead bank for negligent misrepresentation or fraud. However, the success of such claims will almost entirely be determined by the parties’ right and obligations as defined in the participation agreement.

Negligent Misrepresentation and Fraud

To establish negligent representation, the participant must prove: (1) the lead bank was required to give correct information due to a special relationship; (2) the lead bank knew or should have known the information was false; (3) the lead bank knew it was desired for a serious purpose; (4) the participant intended to rely and act upon it; and (5) the participant justifiably relied on it to its detriment. See e.g. UniCredito Italiano SPA v. JPMorgan Chase Bank, 288 F. Supp. 2d 485, 498 (S.D.N.Y. 2003) (citing Hydro Investors, Inc. v. Trafalgar Power, Inc., 227 F.3d 8, 20 (2d Cir. 2000)).

To establish fraud, the participant must prove: (1) the lead bank made a material misrepresentation; (2) the lead bank knew the representation was false; (3) the lead bank made the misrepresentation with the intent that the participant act thereon and be defrauded; (4) the participant justifiably relied on the representation; and (5) the participant suffered damages as a result of its justifiable reliance. See e.g. Bank of the West v. Valley Nat’l Bank, 41 F.3d 471, 477 (9th Cir. 1994).

The common element for both negligent misrepresentation and fraud is establishing that the participant justifiably relied on the lead bank’s representation. However, proving justifiable reliance on the lead bank may be limited by the provisions of the participation agreement and the participant’s own due diligence requirement.

Reliance Disclaimer Provisions

While the exact terms of each participation agreement may vary, many agreements contain standard provisions to promote consistency and conformity with the standards of sound banking practices and previous judicial interpretations of participation agreements.

A common provision found in participation agreements is a reliance disclaimer, which states that the participant has not relied on information provided by the lead bank on the borrower’s creditworthiness. As a result, many courts have held that a participant could not have reasonably relied upon the lead bank’s representations if the participation agreement contains a reliance disclaimer. In other words, these disclaimers preclude a participating bank from recovery in actions of negligent misrepresentation and fraud because the participant will be unable to prove justifiable reliance. 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) (holding an express disclaimer provision “specifically absolved [lead bank] of any responsibility to disclose information relating to [the borrower’s] financial condition”).

Indeed, even if the participant can establish that the lead bank was aware of the borrower’s fraudulent practices but failed to disclose them, the participant will still be denied recovery if the participation agreement expressly disclaims certain warranties in regards to the loan transaction. See Banco Totta e Acores v. Fleet Nat’l Bank, 768 F. Supp. 943, 949 (D.R.I. 1991) (noting the participation agreement stated that the 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”).

In short, if the participation agreement contains a disclaimer clause, which states that the participant made its decision solely upon its own independent evaluation of the borrower’s creditworthiness, then the participant will likely be precluded from recovery in actions of negligent misrepresentation and fraud against the lead bank.

Due Diligence Requirement

Participants may face similar difficulties with proving justifiable reliance even if the participation agreement does not contain a disclaimer clause. Generally, there is no independent duty on the lead bank to disclose information that the participant could have discovered through its own efforts. Banco Espanol de Credito, 973 F. 2d at 56. Thus, to establish justifiable reliance, courts frequently impose a due diligence requirement upon the participant. The due diligence requirement mandates that the participating bank perform its own due diligence inquiries and make its own credit evaluation of the potential borrower. See Banco Urquijo, S.A. v. Signet Bank, 861 F. Supp. 1220, 1248-49 (N.D. Pa. 1994). Indeed, the Office of the Comptroller of the Currency (“OCC”) has specifically noted that satisfactory controls over the risks inherent in loan participation require an independent analysis of credit quality by the participant bank. See Comptroller of the Currency, Banking Circular 181 (rev. Aug. 2, 1984), Fed. Banking L. Rep. (CCH) ¶ 60,799.

The nature and extent required for each credit analysis by the participant is transaction-specific. In general, to satisfy the due diligence requirement, the participant should have conducted an independent credit analysis to the extent that the loan participation was a credit which the participant would have made directly. On the other hand, mere reliance on the lead bank’s representations will not satisfy the due diligence requirement and thus preclude claims of negligent misrepresentation and fraud.

Conclusion

Like any loan, there is a risk of borrower default. Often, when the borrower perpetrates fraud on the lead bank in obtaining the loan, the participating bank will look to the lead bank to recover its share of participation in the failed loan. However, standard participation agreement provisions, such as reliance disclaimers, and the participating bank’s own duty of due diligence may preclude recovery from the lead bank. Therefore, before entering a participation agreement, the participant should negotiate for entitlement to certain information about the borrower and understand the effect of any reliance disclaimers. See Loan Participation Agreements: Contract Drafting Perspectives for the Lead Bank (our recent in-depth article on drafting the participation agreement). Additionally, the participant should make sure that it conducted its own due diligence on the borrower’s creditworthiness before seeking recovery. Participation agreements carry a lot of risk for a participating bank, but they are also founded on the premise that a participating relationship is very rewarding.