Morris Manning & Martin, LLP

Loan Participation Agreements – The Do's and Don'ts

05.07.2014

Loan participation agreements between banks are becoming more and more commonplace. Banks that originate loans want to spread their risk by selling participation interests to other banks. Participating banks want to share in the profits to be made by loaning money to a borrower originated by another bank.  In such arrangements, the rights and duties of the originating bank and the participating bank will be governed by the participation agreement. Both originating banks and participating banks should be careful to properly document the precise terms of their relationship. Otherwise the parties might get more (or less) than they bargained for. 

In particular, the parties need to be clear on what standard of care the originating bank will owe to the participating bank. In other words, what degree of scrutiny will be applied to the originating bank’s actions in administering the loan? Will mere negligence suffice to create liability on the part of the originating bank? Or will gross negligence or intentional misconduct be required before the originating bank can be liable to the participant? Most importantly, is the originating bank the fiduciary of the participant bank, such that tort liability is created should the originating bank breach its duties?

Unfortunately for Georgia community bankers, the Courts of Georgia have yet to address the issue. However, Courts outside Georgia have.  A leading case on this subject is First Citizen’s Federal Savings & Loan Assoc. v. Worthen Bank & Trust Co., N.A. In First Citizen’s, a participant bank sued an originating bank for breach of fiduciary duty. The participation agreement in that case provided that the originating bank would “administer the loan in accordance with the same degree of care that the administrator would exercise in servicing and administering a loan of its own account.” The United States Court of Appeals for the Ninth Circuit, applying California law, held the language of that participation agreement did not create a fiduciary duty, because it imposed“ a lower standard of care than that ordinarily imposed on fiduciaries, who generally must exercise greater care in handling property with which they are entrusted than in handling their own.”  Many courts from around the country have followed the First Citizen’s holding and held that in order for a loan participation agreement to give rise to fiduciary duties the parties must expressly create such a duty through the language in the participation agreement.

The key takeaway from First Citizen’s is that originating banks and participating banks should be very clear on the standard of a liability to which the originating bank will be held should a dispute arise between the parties over the administration of loan. An originating bank should always seek to expressly disclaim the existence to any fiduciary duty. On the other hand, a participant should try to obtain the highest standard of care it can negotiate, up to and including a fiduciary standard.

But participant banks should beware, many participation agreements provide that the participant bank is required to take over administration of the loan upon the occurrence of certain events, and a participant bank who is owed fiduciary duties under a participation agreement can have the tables turned on it and become a fiduciary should it become the administrator.

This article was originally published in the Community Bankers Association of Georgia newsletter, CBA Today. The views expressed in this article are those of the author and are not meant to be construed as legal advice.