A Tale of Two Participations

It was the best of times. Or was it the worst of times? Depends on which side you are on.

This article will address two decisions concerning loan participations. The decisions were issued on the same day but by different courts (the Third Circuit of Appeals and the Bankruptcy Court for the Eastern District of New York). The facts are not so different, yet the decisions are.

The first case concerns a motion brought by two individuals (the Movants) seeking to compel the bankruptcy trustee (the Trustee) to abandon property that they claimed was not property of the bankrupt estate. The Debtor was a provider of merchant cash advances and purportedly sold participations in its advances to third parties including the Movants. The Movants argued that certain accounts (the Account Funds) were established for their benefit in accordance with the terms of a so-called Syndication Participation Agreement (the Agreement). The Trustee opposed the motion on the grounds that the Agreement was not a true participation agreement but rather a disguised loan, or alternatively a security, and as a result, the Movants did not have a legal or equitable right to the Account Funds.

The Court stated:

In a traditional participation agreement the Account Funds would constitute the proceeds of loans originated by the Debtor but in which the [Movants] owned a fractional share. This is so because a true loan participation would have resulted in a sale to the [Movants] of a fractional interest in specific loans originated by the Debtor. However, the Court finds the [Movants] did not in fact purchase a participating interest in the underlying loans. Rather the[y] acquired a right as set forth in the Agreement to share not directly in the underlying loans but rather in the economic gain or loss of the Debtor.

In determining that the Agreement was not a true participation, it expressed two alternatives to its nature – either a loan or a security. However, inasmuch as neither of these alternatives would exclude the Account Funds from being property of the estate, the Court ruled that they were not subject to abandonment.

The Agreement provided that the Debtor was to make merchant cash advances with some unknown proportion of principal coming from the Movants. The Movants were to be repaid proportionately based on funds they provided to the Debtor and based on the Debtor’s estimates of and adjustments to payment amounts from its merchants. The Agreement indicates that the Movants were to provide funds to the Debtor, and that the Debtor was to determine how to advance the Movants money with “sole discretion” in credit underwriting and origination decisions. The Movants did not introduce any evidence from which the purported participations could be traced to specific merchant advances or to the Account Funds. The Court said:

When it comes to analyzing the true nature of a financial arrangement this Court may look past form and into substance, disregarding what the parties may call the transaction and inquiring into its true economic realities. . . .

Courts have articulated four factors . . . for finding a true loan participation, asking whether: (1) money is advanced by participant to a lead lender; (2) a participant’s right to repayment only arises when a lead lender is paid; (3) only the lead lender can seek legal recourse against the borrower; and (4) the document evidences the parties’ true intentions. . . . For purposes of a[n]. . . equitable interest analysis, a loan participation is one in which a lead lender originates a loan and then sells an equitable right to payment from that loan while retaining legal title.

The Court identified two factual predicates to finding true participations: either (1) the purported participation is entered into to facilitate a specific credit transaction, or (2) the purported participation is entered into to facilitate general lending operations, but loan proceeds are segregated and traceable to the underlying loans. The Court noted that in cases where courts have found a true participation to exist, the facts reflect that there is a known and specific borrower and loan in which the participation is sold.

The true loan participation test is commonly a test for determining whether a credit investment is in fact a disguised loan. A financial arrangement that passes the true loan participation test might be found to be a disguised loan if the weight of the following factors is answered in the affirmative: (1) whether there is a guarantee of repayment by the lead lender to a participant; (2) whether the participation lasts for a shorter or longer term than the underlying obligation; (3) whether there are different payment arrangements between the borrower and the lead lender and the lead lender and the participant; and (4) whether there is a discrepancy between the interest rate due on the underlying note and the interest rate specified in the participation. The Court stated:

The first factor is the most significant as it would evidence payment to the investor based solely on the credit risk of the lead lender rather than of the borrowers in whose credit transactions the investor is purportedly participating.

The Court also considered whether the Agreement was actually a note or a security but declined to reach a conclusion. It was sufficient to conclude that it was not a participation and, thus, the Account Funds remained property of the estate and not subject to abandonment.

By contrast, the Third Circuit case concerned an intercreditor agreement between the secured lender in a lender finance transaction and a claimed participant in loans made by the secured lender. It is interesting that the parties and the courts (including the lower court and the court in the borrower-finance company’s bankruptcy proceedings) never focused on whether the participation agreement was a true participation or a disguised loan. Instead, they focused on various theories to either support or undermine the workings of the intercreditor agreement. The court below and the Third Circuit each ruled in favor of the participant solely on the terms and conditions of the intercreditor agreement. However, had the secured lender challenged the true participation and succeeded on that theory, the outcome would likely have been different. If the participation was not true, the participation agreement would have been deemed a disguised loan (as described by the first case discussed) and the participant would have been deemed an unsecured creditor, leaving the proceeds held by the secured lender available to reduce the indebtedness owed by its borrower.

The take-away is when dealing with participations, understand what rights you are receiving and what risks you are taking. The Movants invested over a million dollars but did not obtain an undivided interested in the Debtor’s merchant cash advances and, as a result, their investments remained property of the Debtor’s estate. Instead of being a participant, it was a lender to the Debtor or a beneficiary of a security. Similarly, the secured lender by not scrutinizing the participant’s interest, may have missed its opportunity to prevail in the intercreditor dispute. True sale issues need to remain a focus in these types of transactions.

In re: SRS Capital Funds, Inc. et al, 2022WL1110557 (Bankr. EDNY 2022)
CoFund II LLC v. Hitachi Capital America Corp., 2022WL1101576 (3d Cir. 2022)

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