This Legal Update explores the considerations that a warehouse lender should bear in mind when deciding whether to provide borrowing base credit for participation interests and defining eligible participation interests.
Example of Eligibility Criterion:
Such Collateral Loan is not a participation in a debt obligation or a loan unless it is an Eligible Participation Interest.
Why Do Lenders Care if an Underlying Asset is a Participation Interest?
A participation interest is a contractual right held by the participant to receive a portion of the loan receivables payable by the underlying obligor that are allocable to the participant’s interest. The participant is not the lender of record and usually has no contractual privity with the underlying obligor. Rather, the underlying obligor maintains its direct relationship with the lender of record, and the participant’s interest may be undisclosed.
From a warehouse lender’s perspective, participations can introduce legal uncertainty and practical constraints when the lender is relying on such assets for credit support. In particular, taking a first-priority, properly perfected security interest in an asset that is both transferable and directly collectible is more complicated when the asset is a participation interest. Although specifics vary, issues relating to (a) the legal characterization of the participation and insolvency risk of the lender of record; (b) transferability, control and enforcement; and (c) liquidity and valuation generally weigh against giving full borrowing base credit to participations (subject to potential mitigants, as discussed below).
Legal Characterization and Insolvency Risk
Participations are designed to be a true sale of an undivided, pro rata interest in the economic rights of an underlying loan, with the underlying obligor’s credit risk passing to the participant on a non-recourse, pass-through basis. As such, the participant is generally expected to be a secured creditor of the underlying obligor, consistent with the lender of...