Draw a structure diagram showing the parties and legal obligations for an
Assignment
Novation
Declaration of trust
Participation
Risk participation
Now draw another diagram showing how the party who now receives the benefit (from the modes above) would take legal action to enforce the debt against the debtor and whether it would have to join any other party?
In conclusion the nature of the participation arrangement is that:
the participant is not a direct party to the loan agreement governing theunderlying loan;
the lender does not transfer or assign rights or obligations under the loan or loan documentation to the participant;
the participant has no proprietary interest in either the loan or the loan documentation. The participant therefore has a contractual nexus with the lender only, and has no direct rights against the borrower.
if the consent of the borrower is required for an assignment or novation;
if assignment or novation is permitted but is unlikely to be obtained (for example in the borrower’s insolvency);
if the proposed transferee is prohibited from being a lender of record because it is not a permitted transferee under the loan agreement (see previous discussion in section 4 above);
if the proposed transferee is prohibited from being a lender of record for regulatory reasons;
if the proposed transferee would give rise to a withholding tax liability ie it does not fall within the “qualifying lender” definition; or
remove the risk relating to the loan from the lenders balance sheet. However, whether a participation achieves off-balance sheet accounting treatment will depend on the application of the relevant accounting standards; or
if the transfer of a loan mid-interest period would trigger a break funding cost.
Because the participation is a contractual arrangement an additional risk for the participant is if the borrower exercises a right of set off against the lender.
This could happen if the lender is a bank and the borrower has a deposit with the lender or if the lender has entered into a swap or derivative transaction with the borrower, as is often the case.
The participant will therefore want to ensure that the borrower has waived its rights of set off under both the loan with the lender and any derivative or other transaction entered into with the lender.
Remember that the funded participation is not like an assignment where the notice could be provide the borrower and therefore crystalise any set-off when the notice is delivered.
The participant may take some comfort by insisting that the lender represents that is the case. In any respect the participant may also find it prudent to undertake some due diligence to ensure the documentation (loan and derivative) between the lender and borrower does include a waiver of set off by the borrower.
Sometimes a party will not want to take a direct novation of a loan but for one reason or another will want a commercial exposure in the loan. It may be motivated to do this because it has taken a positive credit position on the borrower and would otherwise be prohibited for one reasons or another from lending directly to the borrower as a lender of record.
Under a funded participation the existing lender (as grantor) and the participant enter into a contract providing that in return for the participant paying the existing lender an amount equal to all or part of the principal amount of the loan made by the existing lender to the borrower – it is a separate back-to-back contract which creates a debtor-creditor relationship between the existing lender and the participant
The ‘commitment’ that the participant provides is often referred to as a deposit. The existing lender agrees to pay to the participant principal and interest due under the loan (proportional to the participant’s commitment or deposit) and which is received by the existing lender from the borrower.
Because the funded participation agreement is made between the existing lender and the participant the borrower will be unaware of the arrangement. The participation creates a new contractual rights between the existing lender and the participant which are drafted to emulate the same rights that the lender has with the borrower.
However a participation is not an assignment of those existing rights and the existing lender remains in a direct contractual relationship with the borrower. In a funded participation, the participant agrees that its deposit will be serviced (in terms ofpayment of interest) and repaid only when the borrower services and repays the loan from the existing lender.
The participant has effectively taken on the risk of the first loan.
The participant effectively faces two credit risks although the quantum of risk is the same.
However a participation is not an assignment of those existing rights and the existing lender remains in a direct contractual relationship with the borrower. In a funded participation, the participant agrees that its deposit will be serviced (in terms ofpayment of interest) and repaid only when the borrower services and repays the loan from the existing lender.
The participant has effectively taken on the risk of the first loan.
The participant effectively faces two credit risks although the quantum of risk is the same.
Firstly, if the borrower does not pay the existing lender under the loan.
The second risk is that the lender does not pay the participant under the participation agreement.
The first risk is a credit risk attributed to the borrower which the participant may have assessed before entering into the participation, so presumably would have comfort on that risk.
The second risk is the risk that the lender becomes insolvent. As we mentioned earlier the participation is only a contractual agreement between the participant and the lender therefore the participant will only have a contractual claim against the lender for amounts owed by it under the participation agreement.
