Participation Post Mortem

            Over the past several years, banks in search of new and diverse loan product have engaged in the mortgage loan participation market. These participations gave banks access to new borrowers and new markets without establishing a direct relationship with the borrower. Unfortunately, many participant banks are starting to learn that when you’re not the lead dog, the view is pretty ugly.

With borrower defaults on the rise, many banks are analyzing their prospects for recovery. Since participant banks do not have a direct relationship with the borrower, this article will explore the initial review a bank should undertake to evaluate possible legal action against the lead bank or sponsor of the participation.

It all begins with the Participation Agreement. The Participation Agreement is the document that governs the relationship between the participants. There will also typically be a Pooling and Servicing Agreement which dictates the rights and obligations of the Servicer, but the initial focus should start with the Participation Agreement.

The Participation Agreement should be closely scrutinized in order to evaluate your potential to recover. The Participation Agreement will typically disclaim a fiduciary relationship. It may even state that the lead lender will only be liable for acts of willful misconduct or gross negligence. The Participation Agreement may have a jurisdiction/venue and choice of law provisions. Every item discussed below must be considered within the context of these parameters.

The Participation Agreement will also set forth the actions a lead lender is permitted to take with and without the consent of the participants. Many lead lenders play fast and loose with these restrictions so a loan transaction history needs to be reviewed to make certain the lead lender did not take any unauthorized and harmful actions. In other words these restrictions are the starting point in determining whether the lead lender violated the terms of the Participation Agreement.

Another line of inquiry may involve the representations and warranties that were made by the lead lender. These representations and warranties are usually fairly innocuous. However, one should carefully evaluate the entire set of offering documents as well as the underlying loan documents to determine whether any of these representations were breached.

Keep in mind that loan documents are often modified and tweaked up to the very minute of closing. Therefore it is imperative that a participant bank compare the participation documents with the loan documents signed by the borrower to find out whether discrepancies exist.

Conflicts of interest are another potential area of concern. Lead lenders may have significant relationships with borrowers which overlap with other financing transactions. This may very well be the reason the lead lender sought participants in the first place. The relationship between the lead lender and the borrower needs to be explored and, oftentimes this relationship is not apparent in the loan documents.

An example of a conflict of interest is the scenario where a lead lender makes a subordinate loan to the same borrower or affiliate of the borrower. This may cause a lead lender to refrain from enforcing a senior lien position for fear that such action may compromise their subordinate position.

This area of the law is fraught with peril. There are a number of considerations at play; however it is imperative that banks closely monitor their participations to mitigate disasters. And in the event a disaster has already occurred, banks owe it to their shareholders to determine whether recovery is viable.

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