When leading a panel presentation on participation agreements for the International Factoring Association a few years ago, I asked the panelists what they considered the most important element of a participation agreement; they unanimously answered “trust.” I can draft the tightest participation agreement, but ultimately, having the right partner in the deal is what determines its success. (Well, that and whether the borrower pays.) Therefore, I started adding a provision to my participation agreements that required the other party to be trustworthy. All joking aside, that was the right answer, but trust can’t be properly drafted into an agreement. Here, I outline a few key provisions to strengthen the trust factor between a lead and a participant.

With lending limits under pressure and with the rising cost of money and other market uncertainties, participations have been an ever-popular tool among lenders (and the factoring industry). They help smaller banks retain clients that require more capital, and they help lenders hedge their bets when deals are riskier on paper. They are also useful in helping private commercial financiers pair up with banks or other non-bank lenders when licensing issues or other regulatory limitations present themselves. 

Unfortunately, I have observed wide variations in participation agreements and have encountered many that lack some of the critical provisions they should contain. I have seen many participants or leads gloss over certain issues that should be addressed upfront, and which could later become devastating to the parties. Here are some potential traps to be mindful of in these agreements.

True Sale

A participation must be structured as a true sale. If not, that means the money provided by the participant to the lead could be viewed as a disguised loan. I’ve had to defend true sale in front of many judges, and it is an unfamiliar concept to most of them. If a participation agreement were reclassified as a loan by a court, that would create several problems. It imparts usury limitations and lending/borrowing limits. It also threatens the participant’s ability to have derivative lien rights on the collateral in the event the underlying borrower defaults. The participant would have no security interest in the collateral because it did not “buy” a participation interest therein; it simply loaned money to the lead. Lastly, if it were reclassified as a loan to the lead, that loan would be unsecured. If the lead were to file bankruptcy, the participant would have little to no ability to get repaid (the underlying borrower’s payments would belong to the lead’s bankruptcy estate). 

To avoid this, many participation agreements will include self-serving clauses that confirm the relationship between the lead and participant is that of a buyer and seller of an interest in the transaction, rather than a lender and borrower. But many participation agreements will have guaranteed ROIs to the participants, and the ability of the lead to unilaterally repurchase the participant’s interest (mandatory puts) at any time, or conversely, the ability of the participant to require the lead to repurchase the participant’s interest (mandatory call). These features can threaten true sale classification. These features can be permissible as default cures or upon termination, to a degree. Still, if they are not drafted carefully, they can be indicative of lending features and therefore threaten a true sale classification. You should make certain your participation agreement is true-sale compliant.

The Lead’s Lender and Its Security Interest in Your Deal

You would rarely lend against accounts receivable (or purchase them in factoring deals) unless they were free and clear of liens. Because participations are true sales, if the lead has a secured lender, then the sale of the participation interest is subject to the lead’s lender’s lien. It’s no different than if the lead were selling any other asset and had a lender with a lien on those assets. Most participations require that the underlying borrower or account debtors make payments to the lead, which in turn are often mandated to be directed to the lead’s lender’s lockbox or controlled bank account. If the lead were to default on its loan to its own lender, then the lead’s lender could seize all the payments from the underlying borrower and apply them to the lead’s loan balance and not release them to the participant. The same is true, but worse, if the lead were to file for bankruptcy. To mitigate against this, participants should get a simple consent (and a type of limited subordination) from the lead’s lender, which recognizes and respects the participant’s percentage interest as being sold free and clear to the participant.

Shadow Due Diligence

Trust your lead but verify its due diligence. Most participation agreements will state that the participant has conducted its own investigation into the underlying borrower. Yet, many participants fail to do anything other than trust their lead. Not only should participants obtain the underwriting file from the lead, but they should also conduct a simple lien, standing and litigation search regarding the underlying borrower. You do not need approval from anyone, lead or borrower, to search for this publicly available information (although credit checks and specific background checks are a different matter). Prior to entering into a participation deal, I once discovered that the lead had not secured a subordination from the SBA, which had a prior lien. I once discovered that the lead had wrongly assumed a prior lien only secured a minimal balance that would soon be paid off; however, the creditor advanced additional sums (and its documents had a dragnet clause), eroding the equity in the collateral. I once discovered that the lead in a factoring deal had not delivered notices of assignment (UCC Section 9.406). Lastly, I once discovered that the borrower had its corporate charter revoked over three years prior. When it comes to due diligence, don’t be afraid to tell the lead, “Show me.”

Other Small but Important Points

Participant’s Own Separate UCC-1 Filing
The lead will be in charge of filing a UCC-1 against the borrower, but participants should consider filing a “protective” lien against the lead (subject to the consent of the lead and the lead’s secured lender, if applicable), to protect the participant in the odd event that the participation transaction is reclassified as a disguised loan. If the lender files for bankruptcy, a trustee, creditor or, ironically, the lead itself (on the advice of counsel) could assert this argument, and if successful, the participant would be viewed as a lender, and an unsecured one at that. The underlying participation agreement needs to address this as well, ensuring that the protective UCC-1 is not viewed as worthless, unapproved or evidence of a loan between the participant and the lead. If your deal is reclassified as a loan, at least it will be a secured loan.

Audit Rights/Payment
Many participation agreements will omit the right of a participant to audit the records of the lead regarding the transaction history. Even if they do provide for one, they may omit the right to force the lead to pay for the audit in the event of a sizeable error. 

Lead’s Standard of Care
I have seen in about 10% of my deals a participation agreement that omits the important clause requiring the lead to treat this particular deal in the same manner and with the same degree of care as they treat all of their other deals in which they are the sole owner. Conversely, I have seen several participation agreements omit the disclosure that the participant is a sophisticated commercial enterprise and is fully capable of understanding the risks associated with participating in a commercial finance deal.

Suspending Distributions Upon Default; Catch-up Payments?
Watch this provision carefully. The lead should be able to suspend distributions to the participant during a borrower default, but once the default is cured, or once it is written off, there should be a true-up and a reconciliation of whatever amounts were received during the default (e.g., from account debtors making payments), net of lawyer fees and expenses.

Ability to Modify Underlying Agreement
I have seen participation agreements negate the lead’s autonomy, and I have seen them fail to address this issue completely (meaning, I suppose, that the lead could conceivably release collateral, or release a guarantor, or reduce the interest rate or whatever else it wanted to do) without consent of the participant. Make sure to pay close attention to this important provision.

Inviting Additional Participants? Keeping Skin in the Game
Some participants are jealous lovers, and they don’t want other participants in the deal. Some participants want to ensure that the lead retains a sizeable percentage interest (typically, at least 51%) in the agreement so that they retain some skin in the game. Some leads simply want to be servicing agents, or they want the ability to syndicate the deal. Regardless, make sure that the participation agreement addresses this properly.

There are a myriad of other boilerplate provisions and “standard” provisions in a participation agreement, and this article cannot address all of them. The trick is not to get lulled to sleep because the participation agreement proposed by the counterparty looks like the hundreds you’ve seen before. Review it carefully, and have your attorney do the same.