FASB Rule Under Discussion Could Impact Lenders’ Use of Participations
The Financial Accounting Standards Board (FASB) appears to be leaning towards the adoption of a new rule that could make loan participations less attractive to lenders.

In a brief discussion paper recently released on the FASB web site, the FASB staff indicated that it was seeking comments on an initial determination that the transfers of financial assets involved in loan participations may not qualify to receive sale accounting treatment.

Loan participations are an important asset management tool to lenders, allowing them to underwrite large credit transactions to single borrowers and then transfer portions of the credit risk to other institutions. The institutions acquiring the participation interests obtain a benefit by purchasing earning assets without incurring the costs of origination. Loan participations differ from syndications in that the former are often transparent to the borrower.

The issue of whether the loan participations are treated as sales or as secured borrowings for accounting purposes is essential to their usefulness, as it is only the former that allows the credit risk to be removed from the transferor’s balance sheet. What makes a transfer a “sale” has been the focus of FASB Statement 140 since its inception, with one of the requirements being that the transferred assets must be “isolated” from the transferor and its creditors, even in a bankruptcy or receivership of the transferor.

In the discussion paper, the FASB staff indicated that it has become aware of a factor “not explicitly considered when Statement 140 was issued” that could run afoul of the isolation rule and prevent transactions such as loan participations from being accounted for as sales – namely, the right of “set-off” maintained by the transferor and the borrower.

FASB’s staff described the right of set-off as “the common-law right of debtors and creditors to set off (net) the amounts due to one another if one of the parties defaults, becomes insolvent, or enters into bankruptcy or receivership.” An example of a situation where set-off rights could be invoked is the case of a borrower with both a loan from, and deposits with, a single lender who declares bankruptcy. The borrower would have the right to set-off its amounts on deposit against the amounts due under the loan. The receiver or trustee of the bankrupt lender would have the mutual right to set-off loan amounts due against deposits.¹

The issue that appears to concern the staff of FASB is that if the same lender described in the example above had, prior to bankruptcy, entered into a loan participation in which it had transferred half of its credit risk to another institution, upon the bankruptcy of the originating lender, the common-law right of set-off could allow both the receiver and the borrower to set-off amounts on deposit against the entire loan balance and not just the amount that the originating lender continued to retain after entering into the participation.²

According to FASB staff, this would essentially mean that the value of the assets to the participating lender would depend on the financial performance of the originating lender – a fact inconsistent with the concept that the transferred assets had been isolated from the originating lender, and thus inconsistent with the concept that the transfer should be accounted for as a sale.

The FASB staff indicated that it is open to learning whether there are ways to eliminate set-off rights from loan participations in a manner that will “satisfy the isolation requirements of Statement 140.”

Comments on the discussion paper are being sought until May 10, after which FASB staff expects to invite approximately a dozen attorneys and representatives of regulatory and rating agencies to participate in a public roundtable discussion of the issue. The full text of the discussion paper is available at FASB’s web site, http://www.fasb.org.

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¹ Set-off rights may be stayed, at least temporarily, by statutes such as the automatic stay in bankruptcy (11 U.S.C. §362).

² Note also that to the extent that an outstanding loan balance is completely eliminated by set-off against deposits with the originating lender, the participating lender may have only a general claim against the originating lender and no claim against the borrower.