I. Introduction to "Last-Out" Participations
A. Ordinary Participation vs. "Last-Out" Participation
1. A Participation is a hybrid arrangement comprised of an assignment of an interest in an intangible right, a contract that prescribes the duties between the lender and the participant, and a document that creates an agency.
2. A "last-out" participation subordinates the participant's right to loan proceeds to the prior payment of the lender's interest.
3. In many ways, the "last-out" participation is closer to an intercreditor/subordination arrangement than to a standard participation.
a) In a standard participation, the participant shares ratably with the lender.
b) Under a typical intercreditor/subordination agreement, the senior creditor is entitled to all proceeds (other than regularly scheduled payments) until its loan is paid in full, with the junior creditor subordinating its rights to payment and to enforce its security interests.
c) Under a "last-out" participation as with a standard participation, the participant has no direct collateral rights and must rely upon the lender for collection and enforcement.
d) Unlike a standard participation, though, the lender's acts to maximize its recovery may be to the detriment of the last-out participant.
4. Accordingly, the "last-out" participation agreement should cover many of the issues addressed in a typical intercreditor/subordination agreement, in addition to standard participation provisions.
II. Example: Borrower requires $25 million in debt and Lender is only willing to advance $20 million of a maximum $30 million facility. Borrower finds an equity fund willing to make a $5 million loan coupled with warrants. Borrower wants to close immediately and not incur the costs of an additional set of loan documents. The solution: equity fund, as Participant, buys a $5 million "last-out" participation in Lender's facility.
III. Preference Exposure
A. If a junior creditor receives a payment when it is undersecured, it may be liable for a preference. The senior creditor is not involved in that situation. However, when the transaction is structured as a "last-out" participation, funds flow through the senior lender
B. Assume a payment made by Borrower to Lender within ninety days of Borrower's bankruptcy is subject to avoidance as a preference. The preference may simply be in the form of interest payments forwarded to the Participant, or could be the final payment on the loan, including the "last-out" portion.
C. The Lender is the initial "transferee" of the debtor's property for preference purposes, even if the Lender forwarded the payment to the Participant.
D. Although the bankruptcy estate may have the right to pursue the Participant as a subsequent transferee, it is not obligated to do so.
E. An argument can be made that the Lender is an "initial transferee" liable to the bankruptcy estate. The Lender, in turn, will need to seek reimbursement directly from the Participant. To remedy this problem, the "last out" participation agreement should provide that the Participant shall repay the Lender upon demand any amounts recovered by the bankruptcy estate from the Lender in respect of such preference, as well as interest on the judgment and attorneys' fees and costs incurred in connection with such lawsuit.
IV. Recovery of Post-Bankruptcy Interest, Fees and Other Costs
A. Pursuant to Section 506(b) of the Bankruptcy Code, an oversecured creditor is entitled to post-petition interest, fees, costs and other charges to the extent the value of its collateral exceeds the amount of its debt as of the petition date.
B. Consider the example above and further assume that the collateral value is $25 million. As between Borrower and Lender, there is no equity cushion: the loan is $25 million and the collateral is worth $25 million. Millions of dollars of post-petition interest, fees and other charges could accrue but would not be allowed as "claims" in the Borrower's case.
C. As between the Lender and the "last-out" Participant, however, the Lender has an "equity cushion" of $5 million. In that sense, Lender may have affected its rights to receive post-bankruptcy entitlements for interest and fees.
D. Practice Tip: To deal with this problem, the "last-out" participation agreement should provide that the Lender has the right to apply all proceeds received first to its $20 million piece, plus post-petition interest, fees and costs, whether or not allowed as claims in the bankruptcy case. This is akin to standard language in intercreditor/subordination agreements whereby the junior creditor acknowledges the senior lender's entitlement to post-petition interest whether or not allowed.
E. Similarly, the "last-out" participation agreement should discuss the circumstances when the Participant should reimburse the Lender for its pro rata share of fees and expenses incurred for matters such as liquidation and enforcement. If the Lender is not so reimbursed, the amount should be deducted from the amount of the Participant's interest.
V. Jeopardizing Participant's Share
A. Suppose the Borrower is in default and needs additional capital. Borrower proposes that Lender consent to Borrower's sale of $5 million of excess equipment and the use of the proceeds for working capital.
B. Lender determines that its $20 million advance is adequately secured by the remaining collateral and, therefore, consents.
C. The problem from the Participant's perspective is that the $5 million of excess equipment is the collateral for its "last-out" piece.
D. In the intercreditor/subordination arrangement, this issue is addressed in the agreement between the creditors, each of whom has an independent security interest in the collateral, by providing that the junior creditor is deemed to have consented to any such transfer to which the senior creditor consents.
E. The "last-out" participation agreement should contain similar provisions as to the Lender's right to make decisions relating to collateral, without having to obtain the consent of the Participant. The Participant, of course, will seek to limit the Lender's ability to jeopardize the value of the participation interest.
F. The foregoing issue is amplified in the event of bankruptcy.
1. The Lender may wish to consent to the use of cash collateral, which could cause irreparable harm to the "last-out" piece.
2. Just as the senior creditor often seeks in an intercreditor/subordination arrangement the junior creditor's waiver of the right to object to use of cash collateral or extension of credit in a bankruptcy case, the "last-out" participation should spell out the rights of the Lender to make such decisions in a bankruptcy case without interference from the Participant.
G. A further issue is the right of the Lender to vote in favor of a plan. Suppose the Borrower proposes a plan that will distribute cash, debt and securities to the Lender with a present value of $20 million.
1. Acceptance by the Lender will protect its interest to the detriment of the Participant's "last-out" piece.
2. By comparison, if the Participant instead had structured its interest as a separate junior loan, the intercreditor agreement likely would contain provisions permitting the junior creditor to retain securities subordinate in right to payment to the senior creditor's outstanding claim.
H. For a recent opinion discussing a participant's inability to participate in a bankruptcy case of the borrower, see In re Okura & Co. (America), Inc., 249 B.R. 596 (Bankr. S.D. N.Y. 2000)
VI. Equity Holder as Participant
A. It is not uncommon for the borrower or its equity holders to suggest a "last-out" participation.
B. The borrower may not want to incur the costs of another loan closing; time may be a factor; or the equity holder may be seeking to jump priority over an existing junior secured creditor.
C. The latter situation was the subject of a recent bankruptcy opinion, In re Autostyle Plastics, Inc., 216 B.R. 784 (Bankr. W.D. Mich. 1997), involving CIT Group/Credit Finance, Inc. ("CIT") as the senior secured creditor.
1. CIT sold a last-out participation to MascoTech, Inc., the fifty-percent (50%) owner of the debtor's parent.
2. The junior creditor, Bayer Corporation, claimed that its debt should be paid ahead of MascoTech's based upon MascoTech's status as an insider of the debtor.
3. The Bankruptcy Court, in an important opinion given the dearth of case law relating to participations, ruled:
However, Bayer has pointed to no law, nor did the Court's independent research find any, in support of the contention that otherwise valid participation agreements become invalid merely because a participating creditor is an insider. Such a conclusion borders on the bizarre, especially under the circumstances now before the Court. Bayer had notice before it determined to again lend money. In deciding to extend further "secured" credit, it is undisputed that Bayer always knew that is was second to CIT's first position and that CIT had the ability and the right to enter into participation agreements. In fact, it should be immaterial to Bayer as to with whom those participation agreements were executed. Bayer always knew it would be second to such loans, but still decided to lend.
4. The Bankruptcy Court's ruling that the participation agreement is valid notwithstanding the participant's status as an equity holder is consistent with Matter of Lifschultz Fast Freight, 132 F.3d 339, 348-49 (7th Cir. 1997), a recent decision from the Seventh Circuit upholding the validity of a loan made by an insider. In that case, the Seventh Circuit observed that "assuming there was no deception, we see no reason to treat an insider's loan to a company more poorly than that of a third party's."
5. The Bankruptcy Court's ruling on this point was affirmed by the District Court opinion, 1999 WL 1005647 (W.D. Mich. 1999). According to the District Court, "there is no reason why an insider may not purchase a participation interest in another lender's credit facility rather than loaning funds directly to the debtor."
D. The treatment of the participation agreement, and potentially the Lender's direct loan, may be different if the Participant engages in improper conduct.
1. Bayer Corporation had argued in Autostyle for equitable subordination of the portion of CIT's loan consisting of MascoTech's participation interest.
2. The Bankruptcy Court refused, finding that there had been no inequitable conduct connected with the participation agreement.
3. The lender should consider carefully the risk of having as its participant a controlling shareholder who may engage in misconduct. A shareholder who buys a last-out participation may exercise control over the conduct of the corporation in order to favor repayment of the senior secured loan and, in turn, its last-out participation. Moreover, the participation itself is often characterized as an "undivided" interest. It is not inconceivable, therefore, that a court would subordinate more than the participant's share of a loan even though the lender did not engage in wrongful conduct.
4. Practice Tip: In all events, the lender should attempt to obtain an indemnification from the participant for claims resulting from the participant's misconduct.
5. Also, in the context of a participant who has warrants to acquire equity but is not yet an equity holder, it may be prudent for the "last-out" participation agreement to prohibit the participant from owning equity and engaging in any management activities while a participant.
a) The "last-out" participation agreement can provide for "cashless" exercise of the warrants (extinguishing the portion of the loan in which the participant has an interest in exchange for equity) or simultaneous exercise of the warrants and repayment of the participant's share.
b) Note, however, that repayment of the participant's share through the lender can create preference exposure as discussed above.
c) In appropriate transactions, it may also make sense to include a "kick-out" clause that gives the lender the right to terminate the participation and cause the participant to make an independent junior loan, the proceeds of which will repay the participant's "last-out" piece.
6. Practice Tip: Consideration should also be given to structuring the transaction with the participant acquiring a 100% participation interest in a separate term note, subordinated in right to payment to all other obligations under the loan agreement.
a) While having 20% of 100% of a loan may be the economic equivalent of 100% of 20% of the loan, there is some appeal to having a separate note evidencing the participant's share.
b) If the participant engages in misconduct, instead of having an undivided 20% interest in the entire loan, the lender can attempt to shield itself by claiming the separateness of its notes from the last-out subordinated note.
c) The result of separate notes issued under the same facility is not unlike an equity holder making a separate junior loan.
d) In Autostyle Plastics, Bayer Corporation also argued that the insider's participation interest in CIT's loan should be recharacterized as equity. Both the Bankruptcy Court and the District Court rejected Bayer's argument, in part because the insider, as a participant, did not have a direct claim against the debtor. Nevertheless, separating the participation as a 100% interest in a separate note may offer additional protection for the non-insider lender.
VII. Repayment of Lender's Share.
A. What happens when the Lender's $20 million is repaid? The Lender wants to book the payment and move on, but the Participant still needs the Lender to enforce its security interest to cause repayment of the $5 million "last-out" piece.
B. The "last-out" participation agreement should permit the Lender to assign to the Participant its interest in the loan (now limited to the Participant's $5 million), without recourse, representation or warranty.
C. If possible the Participant should be a permitted assignee under the loan agreement.
D. Prior to repayment in full, the Participant may wish to take control of its fate and acquire the Lender's interest. Accordingly, the Participant may negotiate an option to purchase the Lender's interest.
E. Practice Tip: Note that the purchase price should include any prepayment premium that the Lender would have earned if the prepayment had been made by the Borrower.
F. The "last-out" participation agreement may also contain a right of first refusal in favor of the Participant in the event the Lender seeks to sell its interest at a discount.
A. A "last-out" participation is a hybrid between a participation and a junior subordination agreement.
B. For purposes of the mechanics of applying collateral proceeds or other loan payments, the last-out participation resembles a straight participation. Funds are paid by Borrower to Lender and from Lender to Participant.
C. For purposes of enforcement, however, the Lender must have the ability to protect its own interest, which may be to the detriment of the Participant's last-out share. After the occurrence of an event of default or the commencement of a bankruptcy case, the interests of the Lender and the Participant may diverge, resulting in a true test of the "last-out" label.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.