Good Fences Make Good Neighbors: Solidifying Loan Participation Relationships In Light of Recent Federal Case Authority

Loan participation between Ohio’s community banks is a powerful tool. It can open access to new, large-scale markets while significantly distributing risk for those involved. Through participations, Ohio’s community banks can further compete with regional and national lenders on even-footing, which benefits Ohioans on the whole.

But like so many of our business relationships, participations should be governed by a clear, strong agreement so as to reasonably avoid losses and manage disagreements. That point has been made very clear by the United States District Court for the Southern District of Ohio concerning a recent dispute between Wells Fargo Bank and Fifth Third Bank.ⁱ

In Wells Fargo Bank v. Fifth Third Bank, a dispute arose between Wells Fargo, a participant, and Fifth Third, the lead-bank, over advances and payments made under a participated $32.5 million line-of-credit loan. Specifically, Wells Fargo alleged that Fifth Third failed to apply extensive amounts of income related to that loan. Rather, Fifth Third allegedly caused that income to be deposited in accounts that did not benefit Wells Fargo or the loan itself.

Wells Fargo subsequently sued Fifth Third for breach of the participation agreement and, more importantly, the tort of gross negligence. It is here that Wells Fargo’s desire to obtain punitive damages conflicted with Ohio law—even though the participation agreement appeared to allow for that recovery.

According to the federal court, Wells Fargo was unable to proceed with a gross negligence claim because Fifth Third owed no independent duty to Wells Fargo to refrain from such negligence. As counterintuitive as that appears, it is the result of Ohio’s Independent-Duty Rule, which prohibits the recovery of tort (non-contract) damages when a duty only arose under a contract (here, the duty to not engage in gross negligence). As a result, Wells Fargo could not recover punitive damages from Fifth Third and had to proceed solely under its breach-of-contract claim.

The Wells Fargo Bank case illustrates why community banks must take special steps to protect themselves as lead-banks and participants because available remedies are not always what they appear to be.

Example

John Smith borrows $4 million from First Bank to purchase land for residential real estate development. First Bank participates under that loan with Second Bank and Third Bank, which they memorialize under a participation agreement that names First Bank as the lead-bank servicer.

Under the participation agreement, First Bank agrees to always act on the behalf and for the benefit of Second and Third Banks, and to not service the loan in a negligent manner. First Bank’s interest in the loan will be paid first under a first-in,first-out structure.

During the life of the loan, John Smith violates its terms by installing numerous underground storage tanks for petroleum. Those tanks ultimately leak, which renders the land unfit for most purposes and without significant value.

John Smith then defaults under his loan, in part due to the land’s environmental issues. First Bank, however, has been paid in full under the participation agreement’s FIFO provision. Second and Third Bank accuse First Bank of negligently servicing the loan (by failing to prevent the misuse of collateral) and demand to be paid in full for their participation share despite the collateral’s lack of value. First Bank refuses and the participating banks sue.

Under the Wells Fargo fact pattern, the participating banks will likely be unable to successfully sue First Bank for negligence, including the increased damages that may be available under that legal theory (punitive damages, damages not permitted by contract, and the like), because First Bank has no independent, non-contractual duty to the participants to act without negligence. The participating banks are instead limited to recovery permitted by the participation agreement itself, including any limitations contained in it (such as damage caps, damage waivers, and limits on available claims).

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How do we avoid such unfair results? And how do participants and lead-banks alike ensure their interests will be adequately protected? The answer lies in thoughtful, well-planned participation agreements. Courts leave community banks to the plain meaning of their contractual words. Well-drafted, custom participation agreements can offer extensive protections to all involved, while boilerplate agreements can, and often do, result in unintended consequences. If a participating bank wants to ensure a certain level of recovery, it must clearly seek it in the participation agreement and not rely on noncontractual theories. Likewise, those lead-banks who wish to limit their liability and establish manageable risk must do so in the agreement. Once the loan is made and participation shares are sold, the parties’ duties and remedies are established and binding on all involved.

ⁱ Wells Fargo Bank, N.A. v. Fifth Third Bank, 2013 U.S. Dist. LEXIS 35375 (S.D. Ohio Mar. 14, 2013)

© 2013 Stultz & Stephan, Ltd.

This article is not a solicitation for business and is not intended to constitute legal advice on specific matters, create an attorney-client relationship, or be legally binding in any way.