A "loan participation" is a transfer or acquisition of a lender's interest in a loan.

Typically, the interest transferred or acquired will be less than 100%, with the originating bank retaining a percentage interest in the loan and, often, retaining responsibility for servicing the loan and maintaining direct interaction with the borrower as the "lead bank". The acquiring bank, often referred to as the "participant", will (if the transaction is properly structured) become an "owner" of a portion of the loan with all benefits of full performance and all associated risks of loss, as if the participant had originated the loan itself.

The reasons financial institutions enter into loan participations are varied. For some, a primary motivation is to enable the institution to originate loans that would otherwise exceed the legal lending limit of the institution. By selling loan participations to other financial institutions, a lead bank can stay within its legal lending limits while continuing to serve as the primary banking contact for a valuable customer whose borrowing needs are outgrowing the legal limits of the bank. For other financial institutions, purchasing loan participations allows them to earn market interest rates for money lent, even when lending opportunities in their own banking community may be limited. In other cases, financial institutions may sell or purchase loan participations as a risk management vehicle to diversify loan risks among a variety of loans in multiple lending communities.

Whatever the reasons, it is critical that financial institutions engaged in the purchase or sale of loan participations understand the rules in order to be able to achieve their intended objective.

For FDIC insured financial institutions, the rules changed on January 1, 2002. Loan participation transfers occurring on or after January 1, 2002 are now subject to the provisions of Financial Accounting Standard 140 ("FAS 140") adopted September 2000 (as a replacement to FAS 125), including, for the first time, the FAS 140 "isolation test". FAS 140 establishes proper accounting treatment of loan participations for both the transferor (the lead bank) and the transferee (the participant).

Loan participations are accounted for as "sales" under FAS 140 if the following three criteria (focusing on whether control has been effectively transferred to the participant) are met:

1. The participant's interest in the loan must be isolated from the interest of the transferring lead bank and thereby "presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or receivership". [The so-called "Isolation Test".]

2. The participant must control the interest acquired, with the right to pledge or exchange the interest, with no condition that both (a) constrains the participant from taking advantage of its right to pledge or exchange the interest; and (b) provides for more than a trivial benefit to the transferring lead bank in the event the participant's right to pledge or exchange the interest is exercised.

3. The transferring institution must not maintain effective control over the transferred interest through either (a) an agreement that both entitles and obligates the transferring institution to repurchase or redeem the interest before its maturity; or (b) the ability of the transferring institution to unilaterally cause the participant (or successor holder of the transferred interest) to return its interest in the loan to the transferring institution, other than through a clean up call.

To determine whether the FAS 140 criteria for "sales accounting" have been satisfied, special consideration must be given to any participation agreement that provides any form of recourse between the transferring institution and the acquiring institution, whether it be in the form of a formal recourse arrangement, right of repurchase, right of set off or otherwise.

Even "implicit recourse" arrangements (meaning unwritten, non-contractual "understandings") can create detrimental results. Although they will not ordinarily affect sales accounting treatment of the transaction, because the accounting standards look to the contractual terms of an asset transfer to determine whether the criteria for sales accounting have been satisfied, implicit recourse arrangements may affect the risk-based capital treatment of a participation. This will occur if the transferring institution demonstrates an intent to repurchase a participation, even if it has no contractual obligation to do so.

The FAS 140 criteria are not violated, however, if a condition is "embedded" in the underlying debt instrument entitling the underlying borrower to prepay the loan indebtedness. Under this circumstance it is not the transferring institution that controls the participant's interest in the loan but, rather, the underlying borrower through a contractual right to prepay.

The criteria for sales accounting treatment of participations under FAS 140 is very similar to the criteria previously existing under FAS 125 with the exception of the "isolation test" established by the first stated criteria.

If a loan participation fails the FAS 140 "isolation test" it will not be treated as a sale/purchase of an interest in a loan. Instead, for the "transferring" lender (the so called "lead bank"), the transaction will be treated as merely a secured borrowing (with the lead bank as "borrower"). For the participant, the transaction will be treated as a loan to the lead bank (and should be reported on the participant's Call Report in Schedule RC-C as a "loan to depository institutions and acceptances of other banks"). Consequently, the entire loan will remain as an asset on the books of the lead bank. If a purpose of the loan participation was to remove from the books of the lead bank that portion of the loan that exceeded the lead bank's legal lending limit, the effort will have failed. Additionally, continued ownership of the entire loan as an asset may affect calculation of the lead bank's risk-based capital ratios.

When the Financial Accounting Standard's Board initially promulgated FAS 125, the FASB believed isolation of the interest automatically existed. Under FAS 125 the sales accounting criteria were based upon a belief that the FDIC lacked the power under its receivership authority to reclaim assets sold by a failed FDIC-insured institution. The FASB understanding was that such assets were beyond the reach of creditors in an FDIC receivership. Based upon this belief, the FASB concluded under FAS 125 that the existence of even formal written recourse provisions in a participation agreement with an FDIC-insured institution would not preclude sales accounting treatment if all other criteria were met.

Subsequent to issuance of FAS 125, the authority of the FDIC to reclaim loan participations was clarified at Part 360 of the FDIC Rules and Regulations. At section 360.6 the FDIC clarified that it would not seek to reclaim loan participations sold without recourse, but left open the ability of the FDIC to reclaim loan participations sold with recourse. For purposes of section 360.6, the phrase "without recourse" means that the lead bank has no legal obligation to repurchase the loan participation or otherwise compensate the participant in the event of default in the underlying loan.

It is the position of the FDIC, as set forth in its Manual of Examination Policies, that: "FDIC-insured institutions which account for loan participations transferred after December 31, 2001, as sales rather than as secured borrowings for financial reporting purposes should generally do so only if the participation agreement is supported by a legal opinion explaining how the isolation test for sales accounting treatment is met given the FDIC's receivership powers".

It should be noted that it is not at violation of the sales accounting criteria established by FAS 140 to provide in a participation agreement that loan payments are to be allocated on a basis other than percentage of ownership in the loan prior to a default.

For instance, if a participant acquired a 25% interest in a loan, leaving the lead bank a 75% interest in the loan, a usual payment allocation would provide that for each $100 repayment, $75.00 would be allocated to the lead bank and $25.00 would be allocated to the participant (subject to payment of applicable loan service fees, if any). It would not violate the recourse or other sales accounting treatment criteria applicable to the transaction, however, to provide that loan payments are to be allocated between the lead bank and the participant on a different basis, such as 50% to each, prior to default.

Upon default, however, and thereafter, all future payments and credit risks must be shared on a pro-rata basis (determined as of the date of default based upon the respective ownership interests of the lead bank and the participant as that date). Therefore if, through the foregoing allocation of payments prior to default, the outstanding indebtedness owned by the participant as of the date of default had been reduced to only 15% of the total outstanding indebtedness, with the lead bank owning the other 85%, any and all recoveries after default must then be allocated based upon such ownership, with 15% of post-default receipts going to the participant, and 85% of the post-default receipts going to the lead bank.

Other important considerations for banks considering entry into a loan participation arrangement include (i) the need for the participant to conduct an independent credit analysis of the prospective borrower; (ii) the need for the participant to conduct an independent underwriting analysis of the loan in which it is acquiring an interest; and (iii) the need to draft the Participation Agreement in a way that adequately addresses the consequences of a borrower's default and also addresses the legal remedies available to the participant in the event the lead bank becomes insolvent or defaults in its obligations under the Participation Agreement.

The participant must always keep in mind that even though it is not originating the loan it is acquiring an ownership interest in the loan (if properly structured) and is, therefore, a "lender" with respect to the loan, with all the usual duties inherent in that role. In particular, even though originated by the lead bank, the participant must independently determine whether the loan being acquired through participation is consistent with sound and safe banking practices and satisfies the participant's own lending policies.

As a final caveat, the rules for participation accounting may once again be about to change. The FASB continues to evaluate accounting procedures for loan participations and syndications in light of the fall-out from the off-balance-sheet scandals epitomized by the Enron Corp. scandal. Future developments must be closely monitored to assure future compliance with applicable rules to enable financial institutions to continue to enjoy the benefits that may be derived from loan participation transactions.