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What Exactly Are Participation Agreements?

Aug 18, 2008
It happens from time to time that even banks do not have enough money. A lender may make a loan request that one single bank cannot handle, either because it does not have the funds or because to make such a loan would put the bank outside its legal lending limits. The solution for this bank is the participation agreement, also called a loan participation agreement. A participation agreement allows a bank to enlist the wealth of other banks to handle this one loan. Typically, a single bank, called the lead bank, will originate the loan and then seek other banks to share in the risk and the revenues. The lead bank sells participation shares to the participating banks. The lead bank also services the loan and deals directly with the borrower, thereby retaining control of the relationship.

The act of selling shares can be seen as a securities issue - and banks can run afoul of securities laws - unless the participation agreement contains certain language about the exposure to risk and loss.

Participation agreements are mainly two-tracked. On the first track, all banks share equally in the profits and the risk in what is called a pari passu arrangement. On the second track, the lead bank is senior to the other subordinate banks; the lead bank is paid first. This second track can be subdivided further in to Last In, First Out and First In, First Out arrangements.

Banks are motivated to use participation agreements for several reasons. From the lead bank's perspective, they are useful because they generate income for the lead bank; they spread the risk among other institutions; they allow the lead bank to manage the client relationship; and they offer the lead bank the opportunity to originate a loan that it might otherwise have been able to handle. From the perspective of the participating banks, these agreements share the wealth and allow such banks to generate income in slow markets and to diversify their investment portfolios.

Where banks run into trouble, apart from the securities question, is in glossing over scenarios that are possible, even likely to happen - that is, default by the borrower, profit sharing among the lenders, and the duties of the lead bank. Participating banks may not like the terms of the lead bank's participation agreement - such as loan fees paid by the borrower to the lead bank will not be shared with participating banks, that the lead bank owes no fiduciary duty to the participating banks - but they will certainly appreciate seeing and knowing such terms up front and in clear language, rather than finding out later, only after such problems have surfaced. Banks are well advised to make the terms of the agreement very clear and to address all of these points.
About the Author
Mark Warner is a Participation Agreements Analyst for RealDealDocs.com. RealDealDocs gives you insider access to millions of legal documents drafted by the top law firms in the US. Search over 10 million Documents, Clauses, and Legal Agreements for Free at http://www.RealDealDocs.com
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