Buyers beware

With the distribution of bank debt set to become more problematic in the wake of Lehman Brothers’ collapse, Diane Roberts asks what regulators can do to shore up the sub-participation market

Buyers beware Following the Lehman bankruptcies and administrations and amid the ongoing ­financial crisis, it is likely that the ­distribution of bank debt will become more difficult as the sub-­participation market shrinks in response to heightened concerns over the credit of bank lenders of record. This article ­examines why this is the case.

What are sub-participations?

One common method of debt syndication is through the use of a sub-participation, which is an arrangement under which the seller (the grantor) matches part or all of its loan to a borrower with a corresponding loan or deposit from a buyer (the sub-­participant). The sub-participant then agrees that its loan or deposit will be serviced and repaid only when the borrower services and repays the underlying loan from the grantor on equivalent terms.

Risk participation is a form of participation that acts like a guarantee. The risk participant does not immediately place any money with the grantor, but agrees (for a fee) to put the grantor in funds in certain circumstances (normally an event of default by the borrower).

An English law sub-participation does not transfer any rights or obligations in the underlying loan from the grantor to the sub-participant – the grantor’s contractual ­relationship with the borrower under the loan agreement is unaffected. Furthermore, the sub-participant does not gain any rights to sue the borrower in the event of default, nor does it gain the direct benefit of any ­security package, the rights to which remain with the grantor. Unless there is a prohibition in the loan agreement (which is unusual), the grantor may sub-participate without the ­borrower’s consent or knowledge.

Understanding the credit risk of grantors

Following ;the ;bankruptcies ;and ­administrations of various Lehman entities, partici­pants in the loan market have been forced to take a fresh look at their English law bank debt sub-participations. This is because, as most commonly structured, sub-participants under English law sub-­participations only have contractual rights as unsecured creditors against the grantor in any insolvency of the grantor, and have no rights as against the underlying borrower to force them to ­recognise the sub-participant’s synthetic ‘interest’ in the underlying loan.

Thus, participants who previously were willing to accept the credit risk of grantors are now re-evaluating that decision. They appreciate that a limitation of sub-participations includes not only the econo­mic risk of that first loan (made by the grantor to the borrower) not being paid by the borrower, but also the credit risk of the grantor.

If the borrower goes into liquidation, the sub-participant receives only what the grantor can reclaim; if the grantor goes into liquidation, the sub-participant then only has a claim as an unsecured creditor in the insolvent estate of the grantor and cannot proceed directly against the borrower.

Further, many par sub-participation agreements do not contain an ‘elevation’ clause that contractually requires the grantor to transfer the underlying loan to the sub-participant. Perversely, while much of the recent focus under sub-participations has been on the credit risk of the sub-participant vis-à-vis the grantor, the credit risk of the grantor is now viewed as being as much of a liability as the credit risk of the underlying borrower. The possible rejection of the ­credit risk of some grantors could hardly come at a worse time, as the financial community is seeking to improve the liquidity of some of the world’s most distressed loan assets.

In contrast, properly structured participations governed by New York law convey an ownership interest in the underlying loan and any collateral securing that loan to the participant. In those sub-participations, the sub-participant arguably has an ­automatic perfected security interest in the loan participation as against the grantor under Revised Uniform Commercial Code ­Section 9-309(3).

The fact that the participant has a ­property interest that the borrower loan has to recognise and a perfected security interest as against the grantor means that sub-­participations governed under New York law are in certain circumstances more powerful instruments for the participant than ;English ;law-governed ;sub-­participations.

The issue is more acute in Europe than in the US because sub-participations are ­common. This is because the acquisition of a European loan asset, in which borrowers and guarantors are incorporated in a variety of jurisdictions by way of novation or assignment and assumption, is not as standard as the acquisition of a US loan – largely due to the different tax, regulatory, security and insolvency regimes that apply throughout Europe.

For example, many prospective lender entities – which may be special ­purpose vehicles – are not banks or authorised credit institutions, which means that the ­regulatory and withholding tax position can be more complex than for typical bank lenders in the European market.

Further, obligor consent, minimum ­transfer and hold and other contractual restrictions or requirements on transferees in loan agreements means that many prospective lender entities run the risk of not satisfying the contractual requirements to become a lender. Under most trading protocols, which endeavour to enshrine a principle that trades are binding, the ­suggested fall-back method of settlement when a party encounters any of these ­obstacles is to take a sub-participation.

Possible solutions

To address the weaknesses apparent in sub-participations, grantors may consider ­setting up a trust or similar collateral structures over loan proceeds in favour of a security trustee to hold for the benefit of the grantor’s sub-participants from time to time – or alternatively directly provide security over particular loan assets in favour of the participant, ­subject to security registration, cost considerations and contractual restrictions.

In the long run, European regulators may want to consider expanding Directive 2002/47/EC on financial collateral arrangements and the provision of financial collateral to include bank loans as collateral for further protection to the sub-participant in the event of a grantor’s insolvency. In the meantime, some grantors should be ­prepared to accept that certain counter­parties will not agree to take their credit risk, and sub-participants will not agree to enter into sub-participations with them.

Diane Roberts is a partner in the ­securities and structured finance ­department at Ashurst