Secondary Debt Trading – Part 4

Sub-participation

In a sub-participation, the existing lender retains all of its rights and obligations under the loan documentation, however, a third party (called a “participant”) enters into a private agreement with the existing lender under which either:

1. The participant agrees to pay to the existing lender an amount equivalent to an agreed proportion of the loan, in exchange for which the existing lender agrees to pay a fee to the participant and to pass on to the participant the relevant repayments of capital and interest when made by the borrower (a.k.a. “funded participation”); or
2. Much like under the mechanics of a guarantee, in exchange for a fee, the participant agrees to pay to the original lender an amount equivalent to the borrower’s repayment obligations in the event that the borrower defaults and is unable to repay the loan (a.k.a. “risk participation”).

Sub-participation can take place without the borrower being made aware of it and, because the existing lender remains the lender of record, security does not need to be retaken. On the other hand, for the same reason, the existing lender will not achieve a clean break from the loan  (the loan will still appear on its balance sheet) and the participant will not acquire any rights in relation to the loan documentation. The participant will also take a double credit risk as it will be reliant both on the borrower paying the existing lender and on the existing lender paying the participant its participation in the capital and interest repayments.

Q: As a borrower, I am uncomfortable with the idea of sub-participation. Is there anything I can do?

A: Strictly speaking, there is no obligation on the existing lender to let you know that they have entered into a sub-participation agreement in relation to your debt. However, clauses which require the consent of the borrower are becoming more common and, if this is an element which you feel strongly about, it may be prudent to negotiate the incorporation of such a clause into the facility agreement.

Q: I am a lender and my participant has failed to fund the debt. What happens next?

A: This situation can only happen in a risk participation, as participants in a funded participation pay at the outset of the transaction. If the participant does not pay, then you have a cause of action against them for breach of contract. If their failure to pay was caused by financial difficulties and/or insolvency, it may be more advantageous for you to enforce the security against the borrower – although whether this will be sufficient to repay the loan is uncertain in situations where the borrower has already defaulted. Your immediate concern will be to meet the funding obligations, either via self-funding or (if there is sufficient time) arranging for a further sub-participation or trading the debt.

Q: I am a borrower and the participant has failed to fund the debt. What happens next?

A: You may not in fact be aware that a sub-participation agreement was entered into, therefore all you may realise is that, for one reason or another, the lender is not able to put you in funds when you submit drawdown requests. You have no recourse against the defaulting participant but you will be able to sue your lender. In a syndicated loan, your facility agreement may contain provisions which force the defaulting lender to exit the syndicate, their commitment to be cancelled and which allow you to choose a replacement lender to fund the relevant drawdown.

Q: I am a participant and the borrower has defaulted under the loan. What happens next?

A: Under a funded participation, nothing. If the borrower fails to repay the existing lender, then the existing lender does not have to repay you. Under a risk participation, you will need to pay to the existing lender whatever capital and interest amounts the borrower has failed to pay. These are significant credit risks which make sub-participation especially unattractive in the context of distressed loans.

Q: As a participant, can I enforce the security granted by the borrower?

A: As a participant in a risk sub-participation, if the borrower defaults under the loan as per the above, you will be able to enforce the security against the borrower as though you were the original lender, but only once you have paid the original lender (effectively stepping into their shoes). Under a funded sub-participation, you cannot enforce any security unless you have agreed this with the existing lender under the terms of the sub-participation agreement.

We have now looked at the three main debt transfer methods: novation, assignment and sub-participation. In our final article of this series, we will discuss how a buyer or seller is likely to decide which method best serves their interests.