January 14, 2016
Authored by: Jerry Blanchard
(Note: Part 1 is available here.)
One of the problem areas that came up during the recession was the accounting treatment for loan participations and loan sales. The difficulty arose from the fact that FASB changed the guidance for how to recognize a “true sale” several times over the last decade and not all banks realized that their form documents needed to be changed to reflect those changes. The current guidance is now found in Accounting Standards Codification Topic 860 “Transfer and Servicing” (formerly FAS 166 “Accounting for Transfers of Financial Assets”) which itself was an update of FAS 140 “Accounting Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
If we go back ten years ago, there were several different variations on how loan participations divided distributions from loan payments among the parties. Pro rata is perhaps the most common but it was also typical to see both LIFO (last in first out) and FIFO (first in first out) arrangements. The older accounting treatment allowed an institution using any these different distribution models to be treat the transaction as a true sale, thus removing the asset from its books. The accounting treatment today is dramatically different. Under ASC 860, neither LIFO nor FIFO participations transferred on or after the beginning of a bank’s first annual reporting period that began after November 15, 2009 qualify for sale accounting and must instead be reported as secured borrowings.
Many banks actually used preprinted loan participation forms where one simply checks the block showing whether distributions were shared pro rata, LIFO, or FIFO and continued to use such forms after the FAS change. This resulted in interesting situations where pieces of the same loans can receive differing accounting treatments. For example, assume that Bank A originated a $1 million loan on June 1, 2009 and sold 50% of it on a LIFO basis to Bank B on the same date. Assuming that it meets all of the tests necessary to move an asset off of its books then Bank A can treat that as a true sale. If Bank A later sells another 10% of the loan to Bank C on March 1, 2010, also on a LIFO basis, that transfer will not be treated as a true sale and must be accounted as a secured loan by Bank C to Bank A.
Why, you ask, should anyone care about the accounting treatment. Well, it depends on what the selling bank was intending to accomplish. If the purpose of selling a loan participation was to cure a loan to one borrower violation the selling bank may find that the loan participation failed to move the loan off of its books and is thus still in violation. It also results in both banks having filed incorrect Call reports with the FDIC which may then need to be amended. Finally, if the lead lender fails, the participant’s status as an owner of an interest in a loan is fundamentally different than if it is treated as a lender to the failed bank.
The allocation of loan payments and other distributions is not the only test that must be met. ASC 860 speaks in terms of “derecognition” and “isolation” of an asset. In order to be treated as a true sale the sold asset must be isolated from the seller, the transferee must have the full rights to pledge or sell the asset and finally, the seller cannot retain effective control over the transferred assets. For example, assume that a loan participation agreement or a whole loan sale allows the seller to demand that the buyer return the participated interest or the whole loan at the seller’s sole option. The seller is attempting to retain too much control over the asset and the transfer is going to be treated as a loan and not a sale.
Banks that are using current preprinted forms generated by a major bank forms vendor and which have been updated to take into consideration the accounting changes should be fine. You should make certain, however, that forms being used in your loan administration are in fact current versions. Banks who use typed documents that were created many years ago to document a specific transaction and have simply been copied from time to time are at more risk. It would be a good idea to look at those older bank created forms being used for both buying and selling participations and whole loans and make sure that they are up to date.
In our practice representing financial institutions we have come across a myriad of variations of loan participation and loan sale agreements. We have advised both buyers and sellers and understand the business and regulatory issued involved in such transactions. We understand not only the importance of the right language on the front end but we also understand the issues that can arise in the servicing of loans.