Here’s an easy one for you: How many of you (lenders) think that you should have to get consent from the borrower to sell a participation in a loan? I’ll take the safe bet and guess “none” — since it’s such standard practice for lenders to sell participations to other lenders without borrower consent. Really, you’d be hard pressed to find a credit agreement that said otherwise.
With that in mind, let’s take a quick look at a recent case from a federal court in Manhattan that said just the opposite. The Cablevisión case, reported on by the Wall Street Journal last month, says that despite the fact that the loan agreement plainly stated that the lenders could sell participations without consent from the borrower, the lender did in fact need borrower consent and was prohibited from selling a participation without it.
How can this be? On the surface, this decision is surprising and a bit disturbing, since it seems to cut against both the specific terms the parties agreed to and the common market practice in this area. To be fair, though, the participation in this case was not an ordinary loan participation, and the court was heavily influenced by the facts. Much can be said about this case, but let’s just focus in on a couple of issues that are particularly important for us here.
First, it turns out that the would-be participant was a major competitor of the borrower. This topic isn’t often addressed in loan agreements, and I think that’s because it isn’t a practical concern in most cases. Unless the borrower’s competitors (or their affiliates, as in this case) are in the lending business, negotiating limits on assignments or participations to competitors won’t be high on the borrower’s issues list. Also, the lenders themselves generally aren’t interested in participating the loan to a competitor of the borrower, as in some cases this could undercut the borrower’s business (and the lenders’ ability to get repaid). Because the borrower’s confidential information can be freely shared with participants and lenders alike, allowing a competitor into this group could be a bit like inviting the fox into the henhouse. We all need to know who we’re dealing with — and what each person’s affiliations are.
Second, we learn from the court’s comments in this case that the lender had originally planned to do a full assignment of the loan, and, as required under the loan agreement, had asked for the borrower’s consent to the assignment. (In contrast to participations, where the lender remains party to the loan agreement and the participants just share risk behind the scenes among themselves, an assignment substitutes a new party to the loan agreement in place of the original lender and typically requires borrower consent.) Not surprisingly, the borrower declined to consent to this proposed assignment to its competitor.
The lender then decided to sell the competitor a participation, which didn’t require consent. It seems clear that the lender in this case thought and fully intended that its participation would comply with the terms of the loan agreement — and indeed the participation appeared to do so. This participation was a bit unusual, though, since it was for 90% of the loan amount. Also, the participation agreement included some very favorable terms for the participant. Two terms in particular — automatic assignment of the entire loan to the participant upon an event of default, and a very broad right to demand that the lender obtain and deliver additional confidential information from the borrower — led the court to believe that this participation was really intended to be an “end-run” around the consent requirements applicable to assignments.
As mentioned in a prior post, loan agreements in the United States include an implied covenant of “good faith and fair dealing” which is deemed to be part of the loan terms regardless of what the agreement actually says. Since there was nothing stated in the loan agreement that would prohibit the participation, the court instead based its decision on this implied covenant of good faith and fair dealing. The court thought the lender’s actions were unfair and granted a preliminary injunction against the participation.
Though the facts of this case are unusual, the outcome is instructive. Similar to the increase in lender liability cases that we’re already seeing, we may start to see more judges applying the doctrine of good faith and fair dealing with a broader brush, as here. And, yes, there might be some participations that require consent.