A recent decision out of federal court arising out of litigation involving a Ponzi scheme has reinforced the principle that the lead in a loan participation does not owe a fiduciary duty to participants.  The case of Finn v. Moyes (Finn v. Moyes,  2017 WL 1194192 (D Minn 2017)) arose from a Ponzi scheme whereby First United Funding, LLC (“First United”) defrauded numerous banks of over $90 million.  A receiver was appointed to recover funds and sued a number of parties for, among other things, aiding and abetting the fraud carried on by First United.

The receiver claimed that one group of defendants (the “Moyes”) had actual knowledge of the fraudulent conduct and aided and abetted First United by fraudulently over-pledging collateral. The Receiver also alleged that the most of the other loans made by First United were to parties that the Moyes had introduced to First United.

Moyes moved for summary judgment on the Receiver’s aiding and abetting claim. The court noted that under Minnesota law to prove its claim the Receiver would need to show: (1) First United committed a tort that caused an injury to the participant banks; (2) Moyes knew that First United’s conduct constituted a breach of duty; and (3) Moyes substantially assisted or encouraged First United in the achievement of the breach.

(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 when I had written the cisa exam, 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.

Watching loan participation activity over the last decade has been like watching the progression of a car on a roller coaster. The early to mid-2000’s showed the car heading ever upward and then in 2008-09 it hurtled downwards at breakneck speed. The last several years have shown a resurgence as the car begins climbing slowly back up the track. Not surprisingly, the FDIC has taken notice of that trend and issued a Financial Institution Letter on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations in November of 2015.

The reasons why lenders want to sell either loan participations or whole loans and others want to purchase them remain the same today as they were a decade ago. Sellers may have loan to one borrower issues that a loan participation may cure, they may be seeking to reduce overall exposure to a particular borrower or industry or they may find that providing loan product for other institutions is a profitable venture as it may generate gains on sale as well as servicing income depending on how the sale is structured. Buyers are looking to broaden their geographic and industry diversity in order to better manage the overall credit risk inherent in their portfolio and it may be more cost-effective to source loans from another lender than trying to originate them yourself. Another, more recent development, has been the purchase of loans from peer-to-peer non-bank lenders who operate on a national basis.

When the US economy hit the skids in the 2007-2010 time frame with its corresponding bank failures, it became clear that in many situations loan participations had not generated the expected benefits. There were several reasons for this, the most significant being that simply obtaining geographic diversity of ADC loans still left a lender susceptible to outsized losses when that segment of the economy ground to a halt. Too many community banks failed to realize that true diversity in a loan portfolio means that ADC can only be a portion of the entire portfolio, not the entire portfolio, even if you have geographic diversity. The perceived reduction in risk was therefore illusory.

On November 6th, the FDIC issued an advisory letter discussing risk management practices that FDIC-supervised banks should implement with regards to purchased loans and loan participations. While the FDIC acknowledges the benefits accruing from the purchase of these loans and loan participations, such as achieving growth goals, diversifying credit risk, and deploying excess liquidity, the FDIC also recognizes that purchasing banks have oftentimes relied too heavily on lead institutions when administering these types of loans. In such a case, over-reliance on the lead banks has resulted in significant credit losses and failures of the purchasing institutions. Thus, while the FDIC reiterates its support for these types of investments, the FDIC also reminds banks to exercise sound judgment in administering purchased loans and participations.

A summary of the key takeaways from the FDIC’s advisory letter follows below:

• Banks should create and utilize detailed loan policies for purchased loans and loan participations.  The loan policy should address various topics, including but not limited to: defining loan types that are acceptable for purchase; requiring independent analysis of credit and collateral; and establishing credit underwriting and administration requirements unique to these types of purchased loans.
• Banks should perform the same level of independent credit and collateral analysis for purchased loans and participations as if they were the originating bank. This assessment should be conducted by the purchasing bank and should not be contracted out to a third party.
• The agreement governing the loan or participation purchase should fully set out the roles and responsibilities of all parties to the agreement and should address several topics, including the requirements for obtaining timely reports and information, the remedies available upon default and bankruptcy, voting rights, dispute resolution procedures, and what, if any, limitations are placed on the purchasing bank.
• Banks should exercise caution and conduct extensive due diligence when purchasing participations involving out-of-territory loans or borrowers in an unfamiliar industry. Banks should also exercise due diligence, including a financial analysis, prior to entering into a third-party relationship, to determine whether the third party has the capacity to meet its obligations to the purchasing bank.
• Finally, banks should not forget to include purchased loans and loan participations in their audit and loan review programs and to obtain approval from the board before entering into any material third-party arrangements.

Banks have increasingly used participation agreements over the last several decades to pool loans among multiple lenders—with an originating or lead bank selling a portion of the loan to one or more banks as loan participants.  Loan participations can inure to the benefit of both the lead and participating bank, allowing the banks to pool their resources. Through loan participations, lead banks obtain the opportunity to make larger loans to their customers without the obligation to carry the entire asset on their books, and participant banks obtain the ability to participate in larger loans or in different markets than would otherwise be available to them.

To facilitate a loan participation, the lead and participating banks typically enter into a written participation agreement to govern the relationship and the obligations owed to each other with respect to the loan. While often derived from bank forms that have been widely circulated and revised on an ad hoc basis over years, participation agreements can differ significantly in their terms and requirements. These terms are far from boilerplate and can have a critical impact upon the rights of the parties when there is a dispute over the administration of the loan or the collateral.

During the recent economic recession, disputes between originating and participating banks over loan participations have become all too common. These disputes have arisen most frequently because the banks involved find that when the loan is downgraded or the borrower defaults, the banks discover that they have differing interests in the handling of the loan. Some originating banks have a greater interest in working with the borrower in such situations than their participants. Some participant banks have a greater interest in pursuing an aggressive collection of the loan than their originating banks and sometimes vice versa. No situation is identical. Unfortunately, when the banks involved in such disputes have turned to their participation agreements for guidance, only then have they discovered that the time-worn forms that they have been using for years leave much to be desired. As a result, litigation has frequently ensued.

One of the very powerful rights that the FDIC possesses in any receivership is a provision added by FIRREA which states that the FDIC may enforce any contract entered into by the depository institution notwithstanding any provision of the contract providing for termination, default, acceleration, or exercise of rights upon, or solely by reason of, insolvency or the appointment of or the exercise of rights or powers by a conservator or receiver (i.e., “ipso-facto” clauses). Many typical vendor contracts will oftentimes contain just such a clause providing that one party to the contract can terminate the contract at will if the other party files for relief under the Bankruptcy Code or is taken over by the government. The logic is pretty compelling, a party wants to be able to decide if it is comfortable dealing with an entity that is insolvent or attempting to reorganize.

​A recent Georgia Court of Appeals decision raises interesting issues about how this specific FDIC power can be used in the context of a loan participation. In CRE Venture 2011-1, LLC v. First Citizens Bank of Georgia, First Citizens found itself the surviving bank of a group of four banks that had been involved in a loan participation. The lead bank and two others had been placed into receivership and the FDIC had sold the lead position to CRE Venture 2011-1, LLC. As is oftentimes the case in such situations, the local bank objected to the manner in which the lead was handling the credit, specifically, the proposed foreclosure of the real property securing the participated loan. First Citizens sought equitable relief based on its argument that if the foreclosure went forward, First Citizens would lose most of its interest in the loan and would be forced to account for the sale in a manner that would do it serious and irreparable harm to its finances and business prospects. First Citizens pointed out that unlike the two other loss-share banks that had succeeded to the other failed banks shares in the loan, it had not entered into a loss-sharing agreement with the federal government. Moreover, First Citizens argued that CRE Venture purchased the Loan at a significant discount and would not suffer the same loss, and might even profit from a quick sale of the property.

The lead-participant relationship arising from a loan participation has become a fairly contentious one over the last two years as the interests of the two have diverged. For example, loan participants that may be in a troubled condition are never terribly anxious to hear that the lead bank has obtained a current appraisal of the primary collateral. Likewise, a strong loan participant my push a weak lead bank to take more decisive action regarding collecting the loan and possibly foreclosing on the collateral. Throw in the implications inherent in a loss-share transaction where a lead bank’s losses may be reimbursed by the FDIC and things really get interesting. At the end of the day, however, the lead bank and the participants generally have the same economic interest in taking steps to maximize the economic recovery on the loan. Likewise, if bad things happen on the loan then lead and participants are all in it together.

What if participants could tell the lead that it had to keep the losses while they kept the loan payments? A recent bankruptcy case from Kansas provides an interesting illustration of that situation. In the case of In re Brooke Corp., the debtor filed bankruptcy after having made three payments to Stockton National Bank, the lead bank, totaling $487,973 in the 90 days prior to filing. Stockton kept its portion of those payments and forwarded the remainder to the participants. The Bankruptcy Trustee later sued Stockton for recovery of the three payments on the grounds that they were preferential transfers. Stockton, which had sold 94.44% of the loan to the participants, prepared to take the pretty standard defense of the matter arguing that it had merely served as a “conduit” for the payments and should thus have very limited liability. Interestingly, the participants filed pleadings arguing that the lead bank was in fact liable for the entire amount, arguing that the lead bank had dominion and control over the loan proceeds.

In effect, the participants sought to bifurcate the lead-participant relationship by arguing that the lead bank had a certain amount of discretion over what to do with the loan proceeds it received and the fact that it passed them along to the participants was a nice gesture but was no different than using the proceeds to pay salaries or the rent. In a lengthy opinion the bankruptcy court rejected multiple arguments by the participants and found that whatever discretion the lead had was solely as to the administration of the loan, not to whether it could decide to keep the loan proceeds for itself rather than passing them along to the participants. Ultimately, the Trustee would be allowed to pursue the participants if in fact all of the elements of preferential transfer were met.

If you are a lead bank how do you protect yourself in this type of situation?

One of the unique aspects of the current real estate downturn has been the large number of disputes over participation agreements. While these disputes have occurred in the past, the current downturn has produced more and varied disputes, especially disputes between originating banks and participating banks, than we have previously seen even during other challenging times.

As a result, the various form participation agreements and the standard terms contained in those agreements have undergone considerable scrutiny both inside and outside of litigation. Many Bryan Cave lawyers, including Jerry Blanchard, Bill Custer, or Jennifer Dempsey, have advised numerous banks on all aspects of these agreements and have represented parties in a number of these disputes including:

• Representing originating/lead banks in disputes brought by participant banks regarding the administration of the loan.
• Representing participant banks in disputes with originating/lead banks regarding the administration of the loan.
• Enforcing provisions requiring the repurchase of a participant bank’s interest in a loan by an originating bank as a result of the originating bank’s fraud.
• Representing groups of up to 60 loan participants in collection actions against borrowers.
• Providing general advice regarding questions about the interpretation of loan participation agreements.
• Providing advice when the lead position in a loan participation was assigned by the FDIC as Receiver to a third party under circumstances where the validity of the transfer was in question or the assignee was a non-bank with markedly different standards of administration.
• Providing advice on the effect of receiverships and loss share arrangements on participation agreements.
• Providing advice on the forced removal of lead banks.

The attorneys at Bryan Cave are here to help you with your questions regarding loan participations, whether your bank serves as the originating bank or as a participant bank.

In the event you have a dispute involving any of the above, or merely want to discuss your questions with an attorney, please call Jerry Blanchard, Bill Custer, or Jennifer Dempsey at (404) 572-6600. They will be happy to discuss your questions with you to help you better understand your options.

On February 9, 2010, a federal district court in Macon, Georgia issued a noteworthy decision in a dispute over a participation agreement finding the lead bank to have breached the agreement and ordering the lead bank to repurchase an interest from a participating bank.

The case of Sun American Bank v. Fairfield Financial Services, Inc. involved a claim by Sun American that Fairfield Financial had breached its obligations under a loan participation agreement involving a condominium project in north Florida.  Sun American contended that Fairfield Financial had breached the agreement by failing to disclose to participants in a timely manner the downgrades in its credit relationship with the borrower and of circumstances that were likely to have a material, adverse effect on the loan.  Sun American sought to compel Fairfield Financial to repurchase its interest in the loan as a remedy for the breach.

Judge Ashley Royal, of the United States District Court for the Middle District of Georgia, granted summary judgment in favor of Sun American finding that Fairfield Financial had failed to meet its disclosure obligations to the participants.  Judge Royal noted that the disclosure requirement with respect to credit downgrades was particularly important given that the lead bank possessed substantial information regarding the borrower’s affairs that was not available to Sun American as a participant bank.

The Wall Street Journal has compiled a database showing banks that annouced Treasury approval for TARP Capital, including the amount of capital that Treasury has committed.  As of the morning of October 29, 2008, the smallest institution to be included is First Niagra Financial Group, which had approximately $9.0 billion in assets as of September 30, 2008.

In today’s Research and Trading Thoughts, FIG Partners includes a TARP Scorecard for TARP Participants, that analyzes the warrant pricing and concludes that investor complaints about dilution should be curtailed.  The FIG Partners analysis includes an announcement by Saigon National Bank that they have been approved by the Treasury Department.  Saigon National Bank is a de novo institution located in Westminster, California with $43.2 million in assets at June 30, 2008, and is traded on the Over-The-Counter market.  We are seeking more information from management, and will update as we know more.