A loan participation conveys an undivided percentage ownership interest in the underlying loan to the participant (transferee). That interest entitles the participant to receive proceeds from the loan (i.e., collections on the loan) consistent with its ownership interest. However, the transferor remains the sole legal owner of the loan. As such, a participation does not convey to the participant a right to directly enforce the provisions of the underlying loan. That right remains with the transferor. The participant has enforceable rights only against the transferor in accordance with the terms of the participation agreement or based on other principles of law.
Transfers in the form of loan participations are considered to involve only a portion of a loan and are therefore subject to the participating interest guidance. However, in limited circumstances, this presumption may be overcome.
Question TS 2-1 discusses the application of this guidance.
Question TS 2-1
An entire financial asset is considered to have been transferred once all portions of the asset have been transferred.
How should the phrase "once all portions have been transferred" be applied? Can this condition be satisfied only once the transferor has conveyed full legal title to the entire underlying financial asset to another party or may this condition be met if the transferor has sold an ownership interest in all of the cash flows from the underlying financial asset to one or more parties (e.g., using participation agreements), but retains legal title to the entire underlying asset?
PwC response
If the "all portions" concept could only be met when accompanied by a conveyance of full legal title to a transferee, the guidance in
ASC 860-10-40-4E would arguably be unnecessary. We believe that an entire financial asset can be considered transferred even when the transferor retains legal title to the underlying asset, provided both of the following conditions are met:
- A 100% ownership interest in the underlying asset’s cash flows has been sold to a third party (or, if there are multiple transferees, a 100% ownership interest in the aggregate)
- Other than retaining a servicing fee that satisfies the conditions in ASC 860-10-40-6(b)(1), the transferor has no other economic interest in the underlying asset’s cash flows, either directly or indirectly
Our view is that, if these conditions are satisfied, a transferor has effectively transferred the equivalent of an entire financial asset and consideration of the participating interest guidance is not necessary.
Example TS 2-5, Example TS 2-6, and Example TS 2-7 further illustrate this concept.
EXAMPLE TS 2-5
Transfer of interests in a loan–all portions have been transferred condition not satisfied
Bank Co originates a five-year $50 million loan to Industrial Corp on January 3, 20X1. On January 31, Bank Co sells a 50% interest in the loan to Transferee A and a 40% interest to Transferee B using participation agreements. Bank Co remains the legal owner of the loan and retains servicing at an at-market rate. Bank Co deducts its servicing fee from the periodic interest payments received from Industrial Co. Otherwise, Bank Co is obligated to remit 90% of all cash collections received from the loan to the two transferees, and keeps the other 10%.
If an event of default occurs under the loan agreement with Industrial Corp, Transferee A is entitled to receive first any collections or proceeds received on the loan until its participation interest is fully repaid (i.e., Transferee A’s right to cash flows from the loan become senior to the interests held by Transferee B and Bank Co).
How should Bank Co account for the transfers to Transferee A and Transferee B?
Analysis
Since Bank Co retains a 10% ownership interest in its loan to Industrial Corp, it cannot assert that "all portions" of the loan were transferred. When evaluating the appropriate accounting for the interests sold to the two transferees, Bank Co must first evaluate whether those interests have the characteristics of a participating interest.
Because the participation sold to Transferee A is senior to the interests owned by Transferee B and Bank Co in the event of Industrial Corp’s bankruptcy or default, the pari passu condition of a participating interest is not satisfied. As such, Bank Co must report the two transfers as secured borrowings.
EXAMPLE TS 2-6
Transfer of interests in a loan–all portions have been transferred
Bank Co originates a five-year $50 million loan to Industrial Corp on January 3, 20X1. On January 31, Bank Co sells a 50% interest in the loan to Transferee A and a 40% interest to Transferee B using participation agreements. On February 28, Bank Co sells the remaining 10% interest in its loan to Industrial Corp to Transferee C through a participation agreement for a cash payment of $5 million. After this exchange, Bank Co has no involvement with the loan (or with any of the interests sold) other than as the loan’s legal owner and servicer. Servicing is performed at an at-market rate.
If an event of default occurs under the loan agreement with Industrial Corp, Transferee A is entitled to receive first any collections or proceeds received on the loan until its participation interest is fully repaid (i.e., Transferee A’s right to cash flows from the loan is senior to the interests held by Transferee B and Transferee C).
Does the transaction with Transferee C on February 28 impact the accounting for the transfers of participations to Transferee A and Transferee B?
Analysis
Yes. As a result of the transaction with Transferee C, Bank Co has sold a collective 100% ownership interest in the loan to the three participants. For purposes of the
ASC 860 derecognition analysis, Bank Co may consider "all portions" of the underlying loan to have been transferred as of February 28.
On a standalone basis, the three participations sold do not satisfy the criteria to be participating interests. However, since Bank Co has transferred all portions of the loan, it is not required to further consider the participating interest criteria. Consistent with the guidance in
ASC 860-10-40-4E, Bank Co should perform a sale accounting analysis upon the transfer of its final 10% ownership interest to Transferee C.
ASC 860-10-40-4E indicates that the sale requirements are to be applied to the entire financial asset presumably establishing that as the appropriate unit of account. However, the legal structure of the transfer was accomplished using participation agreements. This raises the question of how the requirements in
ASC 860-10-40-5 should be applied. In these fact patterns, we believe for Bank Co to achieve sale accounting,
all of the three participations must satisfy the derecognition criteria in
ASC 860-10-40-5. To illustrate, assume that Bank Co’s transfer of the senior interest to Transferee A does not meet the legal isolation criterion in
ASC 860-10-40-5 so that one of the transferred participations does not qualify for sale accounting. Accordingly, Bank Co cannot assert that all of the transferred portions satisfies the conditions for sale accounting. As a consequence, Bank Co would continue to recognize the entire financial asset on its balance sheet and account for each transferred participation as a secured borrowing.
This conclusion is consistent with
ASC 860’s principle that the unit of account is the entire financial asset and an entity may not account for a transfer partially as a sale and partially as a secured borrowing.
EXAMPLE TS 2-7
Transfer of interests in a loan–all portions have not been transferred
Bank Co originates a five-year $50 million loan to Industrial Corp on January 3, 20X1. On January 31, Bank Co sells a 50% interest in the loan to Transferee A and a 40% interest to Transferee B using participation agreements. On February 28, Bank Co sells the remaining 10% interest in its loan to Industrial Corp to Transferee C through a participation agreement for a cash payment of $3 million. In addition, Transferee C pays $2 million additional consideration consisting of a credit-linked note executed between the parties. The note obligates Transferee C to remit to Bank Co certain amounts it receives from its participation interest in Bank Co’s loan to Industrial Corp. The note is nonrecourse; the only source of repayment is from collections that Transferee C receives from its participation with Bank Co.
Can Bank Co assert that it has transferred "all portions" of the Industrial Corp loan to the three transferees?
Analysis
As a legal matter, Bank Co has sold a 100% ownership interest in the proceeds (collections) from its loan to Industrial Corp through the three participation agreements. However, through its note with Transferee C, Bank Co continues to have an indirect economic interest in its loan to Industrial Corp. If the loan to Industrial Corp were to become worthless, so too would the note from Transferee C, thus exposing Bank Co to loss. In our view, to meet the "all portions have been transferred" condition in
ASC 860-10-40-4E, a transferor may not retain any economic interest in, or exposure to, the cash flows generated by underlying entire financial asset (either directly or indirectly) other than that arising from a servicing fee.
Example TS 2-8 and Example TS 2-9 illustrate how a transferor’s contingent obligation to fund a make-whole payment to a transferee should be evaluated when identifying the unit of account under
ASC 860.
EXAMPLE TS 2-8
Transfer of 50% interest in a loan–consideration of transferor’s make-whole obligation
On July 1, Bank Co sells to Transferee A, for cash, a 50% interest in a $100 million loan previously made to Manufacturing Corp. Transferee A and Bank Co participate equally in cash collections received on the loan on a pari passu basis. However, the participation agreement obligates Bank Co to make a limited make-whole payment to Transferee A in the event that Manufacturing Corp prepays its loan at any point during the first two years of its term. Bank Co will augment the prepayment penalty that Manufacturing Corp must pay in accordance with the underlying loan agreement.
How should Bank Co account for the transfer to Transferee A?
Analysis
Bank Co retains 50% of the loan’s cash flows. As such, Bank Co cannot assert that "all portions" of its loan to Manufacturing Corp have been sold. Bank Co must evaluate whether the participation sold to Transferee A meets the definition of a participating interest.
As discussed in
TS 2.4, the make-whole provision is inconsistent with the attributes of a participating interest; therefore, Bank Co and Transferee A would each report the participation agreement as a secured borrowing.
EXAMPLE TS 2-9
Transfer of 100% interest in a loan–consideration of transferor’s make-whole obligation
On July 1, Bank Co sells to Transferee A, for cash, a 50% interest in a $100 million loan previously made to Manufacturing Corp. Transferee A and Bank Co participate equally in cash collections received on the loan on a pari passu basis. However, the participation agreement obligates Bank Co to make a limited make-whole payment to Transferee A in the event that Manufacturing Corp prepays its loan at any point during the first two years of its term. Bank Co will augment the prepayment penalty that Manufacturing Corp must pay in accordance with the underlying loan agreement.
On August 1, Bank Co sells to Transferee B, for cash, its remaining 50% ownership interest in the loan with Manufacturing Corp. No make-whole arrangements exist in the participation agreement executed between Bank Co and Transferee B; Bank Co is obligated simply to remit to Transferee B 50% of any prepayment penalty paid by Manufacturing Corp in accordance with the loan agreement.
How should Bank Co analyze the transfer of its 50% ownership interest in the loan to Transferee B, and what are the implications of that transfer on Bank Co’s accounting for its participation agreement with Transferee A?
Analysis
As a result of the participation agreements executed with Transferee A and Transferee B, as of August 1 Bank Co no longer has any economic interest in the cash flows from its loan to Manufacturing Corp. The participation agreements, viewed together, obligate Bank Co to remit all of the cash collections from the loan to the two transferees. Bank Co has transferred "all portions" of the underlying loan to the two transferees. Consistent with the guidance in
ASC 860-10-40-4E, Bank Co should perform its sale accounting analysis as of August 1
st by applying guidance in
ASC 860-10-40-5 to the entire financial asset using the approach noted in Example TS 2-6.
The make-whole arrangement with Transferee A should not jeopardize Bank Co’s determination that all portions of the loan to Manufacturing Corp have been transferred. The make-whole simply obligates Bank Co to supplement, in limited circumstances, the portion of the prepayment penalty paid by Manufacturing Corp that Bank Co must remit to Transferee A. The arrangement does not require Bank Co to make a payment to Transferee A in the event that Manufacturing Corp fails to pay interest and principal when due. Similarly, the make-whole does not entitle Bank Co to keep any portion of any prepayment penalty paid by Manufacturing Corp, as Bank Co has sold a 100% ownership interest in all cash inflows from the loan. The make-whole arrangement would need to be considered by Bank Co in its evaluation of the condition in
ASC 860-10-40-5.
This example did not stipulate a servicing fee arrangement. However, the conclusion reached would not change were Bank Co to charge the two participants a servicing fee provided the fee approximates a market rate and is not structured to provide credit support to the two investors.