Following a meeting of the Financial Accounting Standards Board (FASB), U.S. loan participations likely will continue to receive sales accounting treatment under amended FAS 140 so long as the transfer constitutes a “true sale.” Prior to reaching any formal decision on the issue, FASB will consider whether to provide implementation guidance on the factors that may be necessary or advisable for such a transfer to constitute a true sale and to ensure that there is sufficient guidance to enable accountants to exercise sound judgment. FASB is expected to reach a final decision on this issue in mid-September.
FASB’s decision on this issue is of critical concern to the Loan Syndications and Trading Association(LSTA) because of the adverse impact that a change to the FAS 140 standards could have on the loan participation market. Both originating lenders and secondary market buyers of loans rely on loan participations to manage credit exposure and diversify their portfolios.
The difference between an outright “assignment” of a loan and “participation” is that an assignment has the effect of substituting the assignee/buyer as the lender of record, while a participation transfers to the participant/buyer the right to re-payment - leaving in place the relationship between the borrower and the original lender. Outright assignment often requires borrower consent, which is not always available for all types of loans or in all markets.
“We are delighted that loan participations are likely to continue to qualify for sales accounting treatment under GAAP,” said Allison Taylor, executive director of the LSTA. “The LSTA believes this is the proper treatment for these instruments, as long as they are true sales. The LSTA also believes that practices for some lending institutions may improve as a result of the FASB inquiry. Assuming FASB formally adopts the proposed “true sale” standard, the LSTA will publish a standard form of participation agreement designed to assist the market at large in meeting this standard.”
If FASB had decided that participations did not qualify for sales accounting, there would have been adverse consequences for the management and dispersion of credit risk within the financial system generally, as well as a reduction of the availability of credit in certain markets and competitive inequities for community banks.
In January 2003, FASB began the process of amending FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to address various issues related to transfers of financial assets. During this process FASB questioned, among other things, whether a loan participation should be accounted for as a sale. A simplified example helps illustrate FASB’s original concern:
1. Company X borrows $100mm from Bank A
2. Company X has $5mm on deposit with Bank A
3. Bank A sells the $100mm loan to Bank B by participation, in an effort to reduce its exposure to Company X’s credit
4. Bank A becomes insolvent
5. Company X offsets its deposit with Bank A against the loan, reducing the outstanding loan balance to $95mm
6. Bank B’s claim through the participation against Company X for repayment of the loan has been reduced to $95mm from $100mm, because Company X applied its deposit at Bank A against the outstanding loan amount (this is known as the exercise of a “setoff” defense)
7. Bank B would have a $5mm claim against Bank A, which would be subordinate to claims of Bank A’s depositors
The question FASB was asking was whether the borrower’s (and the lead lender’s) ability to reduce the amount the borrower owed on the loan by way of this “setoff” amounted to the asset not having been removed from the reach of Bank A and its creditors. If so, the original lender, Bank A, would not be permitted to treat the loan as having been transferred from its balance sheet.
For the last four months, the LSTA has encouraged its members, various industry groups, legal and accounting organizations and regulatory agencies to respond to FASB’s formal request for information, and retained the law firm of Cleary, Gottlieb, Steen and Hamilton to assist in these efforts. Cleary Gottlieb prepared a memorandum outlining the statutory and case law addressing setoff defenses (which the LSTA shared with other organizations to assist them in their responses) and a comment letter responding to FASB’s formal request for information. On the basis of the LSTA’s comment letter, FASB invited the LSTA to participate in two public roundtables to discuss the issues. At FASB’s request, the LSTA also submitted a supplemental letter and legal memorandum answering additional questions posed by the board.
The staff at FASB played a critical role in presenting the information to the board and recommending approaches. Patricia Donoghue of the FASB staff indicated that “the roundtable process was a real learning experience for the FASB staff and board, and we appreciate the role of the trade associations and their counsel in helping us understand the complicated issues surrounding setoff rights.” FASB expects to publish an exposure draft of its proposed amendments to FAS 140 in the first quarter of 2005.