When a participation is sold, the lead bank generally assumes that the amount will be removed as an asset from its books - in accounting parlance, "derecognized."
This assumption may be challenged by a recently issued promulgation of the Financial Accounting Standards Board titled "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."
Under the new standard, which would affect transactions occurring after Dec. 31, 1996, derecognition requires that the accountant determine that "the transferred assets have been isolated from the transferor - put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership."
This would not be a difficult judgment to make if the documentation for a participation sale typically included an opinion of the seller's counsel concluding that the portion sold could not be reclaimed by a trustee in bankruptcy or, in the case of a bank failure, by the Federal Deposit Insurance Corp. The accountant would be entitled to rely upon the opinion in making its determination.
Participation documentation, however, rarely includes an opinion of counsel. In addition, the FDIC, acting as liquidator of a failed lead bank, can repudiate contracts that it considers burdensome.
Although participation buyers and sellers have long assumed that the FDIC's repudiation powers would not be exercised gratuitously to the detriment of participants, burdensomeness is in the eye of the liquidator.
A participant's "good deal" - involving perhaps a generous interest rate and a right to payment superior to that of the lead bank - might be a liquidator's "burdensome contract."
Therefore the accountant must take into consideration not only the law that permits the regulator to act, but also the likelihood that the regulator will do so.
There is one further problem. Under a line of cases stemming from the failure of Penn Square in the 1980s, it has been recognized that the FDIC, without repudiating the participation, might permit the borrower's deposits in the failed bank to be offset against the amount due on the participated loan, thus effectively reducing the participant's recovery.
For all practical purposes, setoff would place at least a portion of the participation "within the reach" of one creditor of the transferor, namely, the borrower.
Would the accounting judgment be easier if the participant could claim the status of a secured creditor with a perfected security interest against the selling bank?
Under present law, the participant would be required to file a financing statement against the lead bank to achieve this result. Few lead banks would permit filings - and, in any event, becoming a secured creditor does not always insulate the participation from the seller's creditors, particularly when the participation sale and filing was made on the eve of bankruptcy.
How, then, is the accountant to determine whether the sold portion has been isolated from the risk of the lead bank's bankruptcy?
The accountant might:
*Ask counsel for the lead bank to render an opinion relating to its participation sales program generally.
*Make a facts-and-circumstances determination on a case-by-case basis, questioning only those participation agreements that appear to give the participant too sweet a deal.
*Form its own opinion, based not upon the rules that enable the FDIC to disaffirm contracts, but upon statistical probabilities extracted from the FDIC's historical treatment of participations sold by failed banks.
It is to be hoped, however, that the FDIC will issue a statement of policy making the determination easier.
Ms. Stern is a member of the New York-based Nordquist & Stern law firm and is the author of "Structuring Loan Participations," published by Warren, Gorham & Lamont.
