Debunking Myths about Loan Participations

September 21, 2021 by Tom Hajda, Esq. Kyle Niewoehner, Esq.

Loan participation agreements have ample benefits and risks for lenders.

Below are several common myths on loan participation agreements circulating in the private lending industry along with explanations on why they are incorrect.

Myth #1 – Only banks can sell participation interest in mortgage loans.

FALSE. Mortgage lenders can kick off a participation agreement with other lenders.

Myth #2 – All Lenders in the participation agreement need to maintain a relationship with the borrower.

FALSE. Only the lead lender needs to manage the borrower relationship. This is a huge benefit for purchasing lenders. In addition, the selling lender must originate the credit, draw up the agreement, and handle any associated services.

Myth #3 – Being the lead lender on a loan participation agreement is more trouble than it’s worth.

FALSE. Although there are inherent risks surrounding a loan participation agreement, there are also many benefits. If lenders properly underwrite, hold evidence, and retain a trusted law firm to facilitate the agreement, the lead lender can successfully generate servicing income, originate larger loans than the legal limit, and more.

Myth #4 – All participations involve the sale of a loan interest.

FALSE. A lead lender may sell either an interest in the loan itself or a contractual right to payment streams from the loan.

Myth #5 – There are no alternatives to a participation agreement.

FALSE. Persons interested in acquiring a fractional interest in a loan should consider the following alternatives in consultation with counsel:

Hypothecation Agreement

Lead lender receives a loan from a second person that is secured by the underlying loan made by the lead lender.

Loan Sale Agreement

Loan sale agreement addresses sale of fractional interest in a loan. Separate loan administration agreement addresses how the loan will be managed on a going-forward basis.

Dual Lenders

2 or more lenders make loan “up front” and are the initial lenders on the note.

Myth #6 – All participation agreements are the same.

FALSE. There is a big difference between a thorough participation agreement that responsibly covers the many important details in a complex participation transaction and a “short-form” agreement favored by certain lenders for brevity and simplicity.

Different lenders are concerned with different levels of detail to include in their participation agreements, and a balance should be struck in consultation with counsel.

Myth #7 – The borrower needs to consent to the loan participation.

FALSE. A borrower typically does not have the right to consent to a participation and, in most cases, will be unaware that a lender has sold a participation. 

Myth #8 – There are no securities law issues when you sell a fractional loan interest through a participation agreement.

FALSE. There are a variety of securities law concerns that arise whenever a lender tries to sell a fractional interest in a loan.

The securities law issues vary from state to state, so it is very important to consult with securities counsel when structuring a participation transaction.

If you have any questions about loan participation agreements or are interested in participating yourself, please reach out to Geraci’s Banking and Finance attorneys for a consultation.

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