The lead-participant relationship arising from a loan participation has become a fairly contentious one over the last two years as the interests of the two have diverged. For example, loan participants that may be in a troubled condition are never terribly anxious to hear that the lead bank has obtained a current appraisal of the primary collateral. Likewise, a strong loan participant my push a weak lead bank to take more decisive action regarding collecting the loan and possibly foreclosing on the collateral. Throw in the implications inherent in a loss-share transaction where a lead bank’s losses may be reimbursed by the FDIC and things really get interesting. At the end of the day, however, the lead bank and the participants generally have the same economic interest in taking steps to maximize the economic recovery on the loan. Likewise, if bad things happen on the loan then lead and participants are all in it together.

What if participants could tell the lead that it had to keep the losses while they kept the loan payments? A recent bankruptcy case from Kansas provides an interesting illustration of that situation. In the case of In re Brooke Corp., the debtor filed bankruptcy after having made three payments to Stockton National Bank, the lead bank, totaling $487,973 in the 90 days prior to filing. Stockton kept its portion of those payments and forwarded the remainder to the participants. The Bankruptcy Trustee later sued Stockton for recovery of the three payments on the grounds that they were preferential transfers. Stockton, which had sold 94.44% of the loan to the participants, prepared to take the pretty standard defense of the matter arguing that it had merely served as a “conduit” for the payments and should thus have very limited liability. Interestingly, the participants filed pleadings arguing that the lead bank was in fact liable for the entire amount, arguing that the lead bank had dominion and control over the loan proceeds.

In effect, the participants sought to bifurcate the lead-participant relationship by arguing that the lead bank had a certain amount of discretion over what to do with the loan proceeds it received and the fact that it passed them along to the participants was a nice gesture but was no different than using the proceeds to pay salaries or the rent. In a lengthy opinion the bankruptcy court rejected multiple arguments by the participants and found that whatever discretion the lead had was solely as to the administration of the loan, not to whether it could decide to keep the loan proceeds for itself rather than passing them along to the participants. Ultimately, the Trustee would be allowed to pursue the participants if in fact all of the elements of preferential transfer were met.

If you are a lead bank how do you protect yourself in this type of situation?

First, your loan participation agreement should contain express provisions requiring participants to reimburse the lead if the lead is forced to disgorge any payments arising out of litigation by a bankruptcy trustee claiming that the payments were fraudulent or preferential transfers.

Second, part of the lead’s strategy will involve working with the bankruptcy trustee. In the In re Brooke case, the Trustee originally sought full recovery from the lead bank but later amended its pleadings to confirm that it would seek recovery from the participants if the court determined that the lead did not exercise complete control and dominion over the payments.