Bank sub-participation: a hidden risk transfer mechanism

"`html

In the world of structured finance, bank sub-participation operates in the shadows. Unlike the direct syndication where all the lenders sign the contractual documentation, this mechanism enables a bank to transfer all or part of the risk of its loan to other institutions, often without the borrower's knowledge.

1. Definition and forms of sub-participation

Sub-participation does not require any specific legal formalities. For its legal statusA simple exchange of letters, a certificate of participation or an interbank protocol will suffice. It takes two main forms.

Risk-only under-participation

In this configuration ("unfunded sub-participation"), the sub-participant only undertakes to take a percentage of the risk. The lead manager takes sole responsibility for the cash flow. The sub-participant becomes a conditional debtor and receives commission in return.

Article 5-2, paragraph 3 of CRBF regulation 91-01 of 16 January 1991 stipulates that each institution involved "records its share of the final risk in the off-balance sheet statement".

Risk and cash under-participation

Here ("funded sub-participation"), the sub-participant undertakes to disburse funds corresponding to its percentage of participation. The sub-participant becomes the holder of a conditional repayment claim.

Banks generally set up "pro rata" sub-participations: the sub-participant provides a fixed percentage for each advance and receives an equivalent percentage on repayments.

Contractual variants

The methods of intervention can vary considerably:

• Variable payment" sub-participations: the sub-participant benefits from an interest rate different from that paid by the borrower.
• Last in - first out" sub-participations: the first reimbursement is allocated in priority to the sub-participant's share.
• Last out" sub-participations: the sub-participant does not receive its share until the lead manager has been reimbursed.

2. Relative effects of the sub-participation contract

Not enforceable against the borrower

The sub-participation is not translative but constitutes rights. It is governed by the principle of the relativity of agreements (article 1165 of the French Civil Code).

The Paris Court of Appeal has clearly established that "the hidden nature of a sub-participation agreement has the direct effect that no legal relationship is created between the sub-participating bank and third parties, including borrowers, to whom the agreement is unenforceable" (Paris Court of Appeal, 15th Ch. B, 5 July 2002, M. Da Costa Antonio v SA Banque La Henin).

The borrower may not use this contract to avoid its obligations to the lead arranger. Conversely, the sub-participant may not bring a direct action against the borrower.

No right to security

The sub-participant does not benefit from the securities guaranteeing the loan granted by the lead manager. Case law is consistent on this point (CA Paris, 3rd ch., 7 July 1975, Bellat c/ BNP).

This impossibility even applies to sureties granted to the sub-participant in its bilateral relations with the borrower outside the syndicate. The Court of Cassation has confirmed that "a bank cannot obtain from the guarantors of a debtor in receivership the payment of debts which have been contracted with another lead bank in a banking pool of which it was a member" (Cass. com., 17 June 1986, Société Générale c/ Consorts Billaud).

Impact of the lead manager's insolvency proceedings

Residual but real risk: if the lead partner goes into receivership, the sub-participants will be considered as mere unsecured creditors.

Although the Act of 8 August 1994 improved the protection of creditors of credit institutions in difficulty, it generally excluded funds paid out under syndicated transactions.

Only a trust can avoid this risk. Assets held in trust constitute a separate estate from the lead manager's assets and are not liable to be shared with creditors. However, separate accounts must be kept for the sums received under the sub-participation contract.

3. Relationship between banks in sub-participation

Rights and obligations of the sub-participant

The sub-participant is entitled to repayment of the principal and payment of interest in proportion to the sums actually paid by the borrower.

It is obliged to contribute to the risks of the transaction according to its shareholding (CA Versailles, 12th ch. 2, 18 Sept. 1997). As the lead manager is bound by the same terms, it cannot be released before the due date.

If the sub-member goes into receivership, the lead partner may declare its claim in the proceedings. The Paris Court of Appeal has ruled that "each member is obliged to honour its commitments during the period of operation of the syndicate and, where applicable, to contribute the agreed financial resources, failing which the syndicate would have no raison d'être" (Paris Court of Appeal, 3rd Ch. C, 2 Apr. 1996).

Obligations and responsibilities of the lead manager

The lead arranger remains fully committed to the borrower. Sub-participation never constitutes a waiver of the original contract.

In relation to the sub-participant, the leader has a pre-contractual obligation to provide information. The Court of Cassation ruled that a leader had committed fraud by providing "erroneous information and presenting it as if he had checked it, whereas this obligation was incumbent on him" (Cass. com., 22 May 2001).

He also owes obligations arising from the management of the credit. The extent of his powers depends on the contractual stipulations. In the absence of any specification, he is deemed to have received a tacit mandate limited "to the scope of the proposal" made to the sub-participant (CA Paris, 15th Ch. B, 19 Feb 1999).

He may be held liable for negligence, gross negligence or breach of his general duty of good faith. The Paris Court of Appeal has ruled that a lead manager has "an obligation to perform the contract in good faith and therefore to look after the interests of the members of the pool" (Paris Court of Appeal, 15th Ch. B, 26 Nov. 1999).

Limitations on acts of disposal

The case law is clear: the lead bank can only commit the sub-participating banks with their prior and express authorisation, except for routine management acts.

Any act of disposal carried out without such authorisation will be unenforceable against the sub-participant. This applies in particular to

• Debt write-offs (Cass. com., 27 March 2001)
• Out-of-court settlement protocols (Cass. com., 27 March 2001)
• Transactions involving staggered payments (CA Paris, 15th Ch. B, 30 Nov. 2001)
• Changes to the terms, amount or maturity of credit (Cass. com., 17 Dec. 2002)

The lead partner may justify exceeding his powers by proving the implicit agreement of the sub-participant, the abusive nature of the sub-participant's refusal, or the reasonableness of his decisions in the common interest.

4. Practical issues for banks

Advantages and risks for the lead manager

The lead manager maintains the customer relationship while sharing the risk. They generally receive a commission for their role as credit manager.

The main risk lies in its increased responsibility. It must control the information provided at the pre-contractual stage and exercise diligent credit management.

Some sub-participation agreements contain liability waiver clauses, but these are ineffective in the event of fraud or gross negligence.

Benefits and risks for the sub-participant

The sub-participant accesses transactions without any direct relationship with the borrower. This enables them to bypass certain geographical or sectoral restrictions.

In return, it bears two major risks:

• No direct claim against the borrower
• Its status as an unsecured creditor in the event of default by the lead manager

This second risk, although residual, remains a tangible reality in a globalised banking environment.

Situations requiring legal advice

Sub-participation remains a sui generis mechanism whose legal nature is controversial. The diversity of proposed classifications (reinsurance, joint venture, mandate of common interest, dealer agreement) illustrates this complexity.

Specialised legal support is essential for :

1. Draft an agreement that accurately reflects the intentions of the parties
2. Assess the specific risks associated with the chosen structure
3. Anticipating the consequences of a possible default by the lead partner
4. Defining the exact powers of the lead arranger in the management of the loan
5. Contractually organising the flow of information between the parties

Our banking law experts can help you structure these complex transactions. Don't take the risk of discovering the legal subtleties of sub-participation during a dispute. Contact us to secure your upstream operations.

Sources

• Fasc. 506: UNION CREDITS - Sub-participation, JurisClasseur Droit bancaire et financier, Emmanuelle Bouretz (2003, updated 2016)
• Fasc. 505: syndicated loans - direct syndication, JurisClasseur Droit bancaire et financier, Emmanuelle Bouretz (2003, updated 2019)
• CA Paris, 15th ch. B, 5 July 2002, M. Da Costa Antonio c/ SA Banque La Henin (Juris-Data no. 2002-194848)
• Cass. com. 22 May 2001, SA Banque pour l'Industrie Française c/ SA Sté Omnibanque (RJDA 10/2001, n° 1013)
• CRBF Regulation 91-01 of 16 January 1991, Article 5-2, paragraph 3
• Cass. com. 17 June 1986, Société Générale v Consorts Billaud (Bull. civ. IV, no. 125)
• CA Paris, 15th ch. B, 26 Nov. 1999, SOFIC c/ White SAS (Juris-Data no. 1999-105109)

" `