True Sale Participation Agreements and the Risk of Counterparty Insolvency

Client Advisory

March 17, 2008
by John J. Hanley and Karl Schaffer
Extraordinary events in recent days have prompted many of you to inquire about how certain of your interests would be treated in the event that Bear Stearns files for bankruptcy. The area of greatest inquiry has related to the treatment of participation interests, in loans, granted by Bear. It appears that the worst case scenario will be avoided and that JP Morgan will buy Bear. This would mean that JP Morgan will guaranty or assume Bear Stearns’ counterparty risk. It may be prudent, in any case, to keep in mind some of the more important points with respect to structuring participation agreements to ensure that in a bankruptcy, your interest, as participant/grantee (“Participant”), would remain outside the bankruptcy or receivership estate of the transferor/grantor (“Transferor”). Likewise, it may be a good idea to examine existing participation agreements to evaluate their effectiveness in light of recent events. 
Parties to a participation agreement should ensure that the documentation accomplishes a true sale of an interest in the underlying asset. For transactions settled on the form of the LSTA Participation Agreement for Distressed Trades, which was released in October 2007, or for trades that settled on documents substantially in the form of the LSTA Model Participation Agreement, published in April 2002, this should not be a concern. However, the risk may be real for distressed trades that settled prior to October 2007 and for any transactions settling on alternative participation documents. Failure to accomplish a true sale could result in a court concluding that the economic substance of the transaction is that the Participant has extended credit, in the form of a secured loan, to the Transferor. In such a case, the underlying asset would be part of the bankruptcy estate of an insolvent Transferor and the Participant would be in line with other secured creditors. However, in a true sale the Participant’s interest in the underlying asset and the proceeds therefrom would not be considered property of the Transferor and, therefore, would remain outside the bankruptcy estate and would not be available to creditors of the Transferor.
To accomplish a true sale, among other things:
  • the Participant should not have recourse to the Transferor (except for the Transferor’s breach of representations and warranties made in the participation agreement);
  • the participation agreement should have the same term as the underlying asset;
  • the Transferor should not commingle proceeds received on the underlying assets with other funds; 
  • the participation agreement should require the Transferor to directly pass on proceeds received in respect of the underlying asset to the Participant; and
  • the participation agreement should provide a sufficient recitation that the parties intended that the transfer constitute a true sale and not an extension of credit.

Questions regarding this advisory may be directed to John J. Hanley (212-238-8722,, or Karl Schaffer (212-238-8659,

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
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