on the collateral in the event the underlying borrower defaults. The participant would have no security interest in the collateral because it did not “buy” a participation interest therein; it simply loaned money to the lead. Lastly, if it were reclassified as a loan to the lead, that loan would be unsecured. If the lead were to file bankruptcy, the participant would have little to no ability to get repaid (the underlying borrower’s payments would belong to the lead’s bankruptcy estate). To avoid this, many participation agreements will include self-serving clauses that confirm the relationship between the lead and participant is that of a buyer and seller of an interest in the transaction, rather than a lender and borrower. But many participation agreements will have guaranteed ROIs to the participants, and the ability of the lead to unilaterally repurchase the participant’s interest (mandatory puts) at any time, or conversely, the ability of the participant to require the lead to repurchase the participant’s interest (mandatory call). These features can threaten true sale classification. These features can be permissible as default cures or upon termination, to a degree. Still, if they are not drafted carefully, they can be indicative of lending features and therefore threaten a true sale classification. You should make certain your participation agreement is true-sale compliant. The Lead’s Lender and Its Security Interest in Your Deal You would rarely lend against accounts receivable (or purchase them in factoring deals) unless they were free and clear of liens. Because participations are true sales, if the lead has a secured lender, then the sale of the participation interest is subject to the lead’s lender’s lien. It’s no different than if the lead were selling any other asset and had a lender with a lien on those assets. Most participations require that the underlying borrower or account debtors make payments to the lead, which in turn are often mandated to be directed to the lead’s lender’s lockbox or controlled bank account. If the lead were to default on its loan to its own lender, then the lead’s lender could seize all the payments from the underlying borrower and apply them to the lead’s loan balance and not release them to the participant. The same is true, but worse, if the lead were to file for bankruptcy. To mitigate against this, participants should get a simple consent (and a type of limited subordination) from the lead’s lender, which recognizes and respects the participant’s percentage interest as being sold free and clear to the participant. Shadow Due Diligence Trust your lead but verify its due diligence. Most participation agreements will state that the participant has conducted its own investigation into the underlying borrower. Yet, many participants fail to do anything other than trust their lead. Not only should participants obtain the underwriting file from the lead, but they should also conduct a simple lien, standing and litigation search regarding the underlying borrower. You do not need approval from anyone, lead or borrower, to search for this publicly available information (although credit checks and specific background checks are a different matter). Prior to entering into a participation deal, I once discovered that the lead had not secured a subordination from the SBA, which had a prior lien. I once discovered that the lead had wrongly assumed a prior lien only secured a minimal balance that would soon be paid off; however, the creditor advanced additional sums (and its documents had a dragnet clause), eroding the equity in the collateral. I once discovered that the lead in a factoring deal had not delivered notices of assignment (UCC Section 9.406). Lastly, I once discovered that the borrower had its corporate charter revoked over three years prior. When it comes to due diligence, don’t be afraid to tell the lead, “Show me.” Other Small but Important Points Participant’s Own Separate UCC-1 Filing The lead will be in charge of filing a UCC-1 against the borrower, but participants should consider filing a “protective” lien against the lead (subject to the consent of the lead and the lead’s secured lender, if applicable), to protect the participant in the odd event that the participation transaction is reclassified as a disguised loan. If the lender files for bankruptcy, a trustee, creditor or, ironically, the lead itself (on the advice of counsel) could assert this argument, and if successful, the participant would be viewed as a lender, and an unsecured one at that. The underlying participation agreement needs to address this as well, ensuring that the protective UCC-1 is not viewed as worthless, unapproved or evidence of a loan between the participant and the lead. If your deal is reclassified as a loan, at least it will be a secured loan. Audit Rights/Payment Many participation agreements will omit the right of a participant to audit the records of the lead regarding the transaction history. Even if they do provide for one, they may omit the right to force the lead to pay for the audit in the event of a sizeable error. Lead’s Standard of Care I have seen in about 10% of my deals a participation agreement that omits the important clause requiring the lead to treat this particular deal in the same manner and with the same degree of care as they treat all of their other deals in which they are the sole owner. Conversely, I have seen several participation agreements omit the disclosure that the participant is a sophisticated commercial enterprise and is fully capable of understanding the risks associated with participating in a commercial finance deal. Suspending Distributions Upon Default; Catch-up Payments? Watch this provision carefully. The lead should be able to suspend distributions to the participant during a borrower default, but once the default is cured, or once it is written off, there should be a true-up The Show-Me Banker Magazine | 13
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