A recent court decision involving JPMorgan and Mexican cable operator Empresas Cablevision sent another blow to the securitization market, and especially to collateralized loan obligations (CLOs), but gave more of a say to borrowers when lenders want to pass on their loans to others. It could have a broad-reaching impact on structured financings.
At the end of July, the US District Court for the Southern District of New York invalidated a participation granted by JPMorgan to another bank in a loan from JPMorgan to Cablevision. The terms of the loan allowed participations, but the court recharacterized the participation as an assignment-which required the borrower's consent.
Corporate loan documents typically permit a lender to transfer its interest in a loan via either an assignment or a participation. In an assignment, the assignee becomes the new lender and consent from the borrower is required. In a participation, the lender remains a party to the loan but transfers its right in the loan to the participation purchaser. The borrower continues to deal only with the original lender and may not even know that the lender has granted participation in the loan.
As CFOZone mentioned back in March, borrowers need to keep in mind that restrictions on assignments and participations must be explicit in debt agreements. Nonetheless, the Cablevision case actually ended up ruling in favor of borrowers.
JPMorgan wanted to assign participation to Banco Inbursa but Cablevision refused because Banco Inbursa was an affiliate of one of Cablevision's major competitors and didn't want it to have access to confidential information. So JPMorgan granted participation in the loan to Banco Inbursa, thus making available the confidential information of Cablevision-directly contrary to the wishes of the company. The court found that JPMorgan violated the implied covenant of good faith and that the participation was actually a disguised assignment.
"This case is a negative credit development for purchasers of participations, including securitization transactions such as CLOs, because it recognizes the merit of a borrower's challenge to a participation after its creation, even though the participation complied with the express requirements of the loan agreements," Moody's Investors Service noted in a research report Monday.
The results of the case have broader implications to other structured finance vehicles, but especially to CLOs. Typical indentures allow CLOs to hold up to 20 percent of their loan assets in the form of participations. But by recharacterizing the participation as a disguised assignment, this decision has recognized the ability of a borrower to challenge the validity of a participation for reasons other than non-compliance with the terms of the underlying loan, according to Moody's
"The decision creates uncertainty about the validity of participation interests to which the borrower hasn't consented, even when the participation is in compliance with the terms of the underlying loan," it wrote.