Selling participation interests in mortgage loans is a common practice in the real estate lending industry—enabling the initial lender to improve liquidity and explore further funding opportunities while mitigating its risk profile.
Participating lenders receive several benefits, including the ability to diversify their portfolios without the burden of underwriting and servicing the loans. Despite these obvious upsides, however, there are several somewhat discreet risks associated with the buying and selling of participation interests. These risks can cause significant issues if lenders fail to promptly identify and mitigate them.
Structuring Participation Agreements
Generally, participation agreements involve one or more participants who purchase an interest in the underlying loan, but a single lender, the lead lender, retains control over the loan and manages the relationship with the borrower. The lead lender, as the sole lender of record, is responsible for originating the loan, handling communication with the borrower, and servicing the loan for both itself and the participants. The lead lender is the only investor with authority to accept payments from the borrower, initiate collection actions against the borrower or a guarantor, and foreclose on the loan collateral in the event of a default. The participants, on the other hand, only have a contract with the lead lender and are thus not deemed creditors of the borrower unless otherwise specified in the participation agreement. Accordingly, they are not permitted to make claims against the borrower and can only request reimbursement for their participation from the lead lender.
The relationship between the lead lender and the participants is laid out in a participation agreement or certificate that reflects the investment made by each participant, the interest rate, and all other terms related to the participation. The agreement should explicitly state the lead lender’s duties, which include:
- Providing the participants with copies of the executed loan documents
- Giving notice of material changes in the borrower’s financial standing
- Servicing the loan
- Enforcing the loan
- Consulting with the participants before making substantial modifications to the loan documents
Furthermore, the participation agreement should clearly define the rights and remedies of all parties in the event the borrower defaults on the loan and establish a plan of action for any subsequent enforcement actions. Judicial precedent has made it clear that the terms of a participation agreement include those encompassed in preliminary documents such as the commitment letter, participation certificate, and related loan documents. Accordingly, all participants should thoroughly review this documentation in advance to get a clear understanding of their obligations as well as those of the lead lender.
Participation Agreement Risks
It is important that the parties fully comprehend the underlying risks of the participation arrangement:
Lead Lender Exculpatory Clause
Currently, the controlling view in courts is that there is no implied fiduciary duty in the case of agreements between sophisticated financial entities. Lead lenders craft participation agreements as a buy/sell contract stating that the lead lender is transferring economic rights in the associated loan to the participant(s) without creating an agency relationship. The lead lender will want to include sweeping exculpatory language in the participation agreement expressly stating that they will not incur any sort of fiduciary obligations towards the participant(s). Agreements also commonly require participants to acknowledge that they have performed their own due diligence and reviewed all pertinent loan documentation. As courts typically honor exculpation terms and liability limits for the lead lender, participants will need to be aware of the specific duties the lead lender owes them and conduct their own independent credit analysis of the debtor.
Borrower Default
Regardless of the scope and quality of the due diligence, there is always a possibility that the borrower may default on the underlying loan. The response to a default can be complicated and lengthy. A properly drafted participation agreement should clearly describe the rights, duties, and obligations of the lead lender and the participants in situations involving a borrower default. Courts have ruled that a loan participation relationship does not involve an assignment of the lead lender’s authority to receive loan payments from the borrower. Accordingly, participant lenders are not considered creditors of the borrower as only the lead lender has the legal power to pursue recourse against a delinquent debtor. As such, it is essential that participants collaborate effectively with the lead lender in order to establish and adhere to an agreed-upon plan of action in the event of a default and memorialize this in the participation agreement. The lead lender and the participants should particularly agree on the priority of the respective parties to receive funds from any post-default recovery.
Loan Participation Agreements: Be Proactive
As with any loan investment strategy, creating a loan participation agreement requires careful consideration and knowledgeable drafting to make sure that the rights and obligations of all the parties are clearly delineated at the start. Proactive lenders, with the assistance of counsel, can effectively mitigate the risks associated with participation loans by negotiating the terms of the agreement to ensure they sufficiently address the relevant risks.
