A lender’s management of any distressed loan can have significant business and legal implications. Participated loans have an added risk — the risk of litigation between the lead lender and participants if the loan defaults. Such litigation peaks shortly after times of financial distress and the last significant round of loan participation litigation arose out of the 2008 economic crisis. Given the current uncertainty in the economy and credit markets, it is a good time for lead lenders and participating banks to take a short refresher course on minimizing the risk of loan participation litigation.

In a loan participation, a lead lender makes a loan and then sells an interest in all or part of the loan to other lenders. The lead lender has two separate contractual relationships, one with the borrower and one with participants. Participants have a contract only with the lead lender, not the borrower.

The relationship between a lead lender and a participation lender is almost completely determined by the loan participation agreement. To meet the definition of a “Participating Interest” under FASB 166, no participant may have recourse to the lead lender or another participant other than remedies for (1) breaches of representations and warranties and (2) breaches of ongoing contractual servicing obligations. Participation agreements set the standards for lead lenders to follow in servicing the loan and, more importantly, managing borrower defaults. Some actions can be taken in the lead lender’s discretion, and other actions may require a majority or unanimous consent of all participants.

Litigation usually starts when a loan does not pay off in full, and a participant second-guesses the lead lender’s decision-making. But the set-up to litigation is what happens during the work-out, as lead lenders try to best manage the credit while obtaining appropriate direction and input from participants. Six tips for averting litigation include:

1. Working Together. Lead lenders and participants should review, understand and work in good faith to comply with the terms of the participation agreement any time there is a risk of default. If there are any disagreements amongst the parties as to the meaning of various participation agreement provisions, the parties should work to document a modification so no ambiguity exists going forward. Lead lenders should be aware of disclosure and notification requirements, and any need to obtain consent before waiving defaults or restructuring a loan. Participants should fully engage when a lead lender calls for a vote.
2. Document. Lead lenders and participants should document in writing key facts and communications that relate to the management of the loan and the relationship among the banks.If litigation is threatened or becomes likely, make sure all relevant documents are preserved.
3. Defaults. Lead lenders should follow commercially reasonable practices in managing credit and addressing defaults.
4. Participants should support a lead lender’s decision to engage in commercially reasonable practices.
5. Collateral. Lead lenders should update appraisals and exercise their contractual rights to inspect collateral. This will help lenders identify collateral deficiencies and provide lenders with information that may be needed to obtain orders for replevin, receivership, etc.
6. Outside Counsel. If the lead lender brings counsel in, make sure it is clear that such counsel does not represent the participants. Participants should rely on their own counsel.

Finally, a reliable way to minimize risks with loan participation litigation is to manage the credit so that the loan pays off in full. Keep focused on this best outcome.

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