Sub-stance over style: true nature of "sub-participation agreement" examined

Introduction

The question of whether an arrangement which was termed a sub-participation agreement, and which took the form of an adapted template sub-participation agreement, actually amounted to one was considered in the recent case of Yieldpoint Stable Value Fund, LP v Kimura Commodity Trade Finance Fund Ltd [2024] EWCA Civ 639. In this case, the Court of Appeal dismissed the claim that the arrangements were effectively a hybrid sub-participation incorporating a fixed term loan, and confirmed the parties had entered into a sub-participation agreement as that term is commonly understood.

Transfers of a loan or part of it by sub-participation can be an attractive option for a lender who wishes to remain "lender of record" and to preserve its relationship with the borrower, but to pass on a large portion of the risk involved to a different entity.

The double credit risk in sub-participations is well understood (with the participant taking the risk on the borrower repaying sums it has borrowed to date plus on the existing lender or "seller" passing those sums on), and with this being leverage for the sub-participant negotiating its "reward" – a share of the margin commensurate with such risk plus in some cases a sizeable fee. This risk/reward structure to which the sub-participant is exposed is a hallmark of sub-participations, allowing the participant to share in the downside (default risk by the borrower) and the upside (interest/revenue sharing/price participation) and case law suggests in a true sub-participation agreement, clear and strong language would be needed to depart significantly from it. Aside that the term "sub-participation" itself is not a legal term of art, but the manner in which a sub-participation agreement works in the context of loan transfers is commonly understood in the market, with various forms of funded participation agreement produced by the Loan Market Association to assist with drafting.

Relevant facts

On 30 March 2021, Yieldpoint Stable Value Fund (Yieldpoint) agreed to pay US$5 million to participate in Kimura Commodity Trade Finance Fund's (Kimura)'s 50% share of an existing loan facility (the Loan), which was made available to Minera Tre Valles SPA (MTV), a Chilean mining company. Yieldpoint's return was to receive interest quarterly at a rate of 3-month plus LIBOR plus 7.5% and a pro rata share of Kimura's monthly price participation entitlement under the Loan based on the price of copper.

The two main documents involved were:

A master participation agreement for trade transactions entered into between Kimura and Yieldpoint in February 2021 (the MPA).
(i) The MPA was drafted in contemplation of the parties entering into sub-participation arrangements in the future, and indeed included a template form of supplemental sub-participation agreement. The arrangement set up by the MPA (including via the drafting of the template) was a conventional sub-participation arrangement including the usual hallmarks in terms of recourse – a participation was expressly made without recourse on the part of the participant to the seller, with the seller expressed to have no liability or obligation to the participant, and with recourse to the seller's rights against the counterparty given to the participant by way of equitable assignment, post funding.
(ii) If the MPA were read together with an agreed sub-participation agreement on the terms of the template, Yieldpoint would not have recourse to Kimura, but would have a direct proprietary cut through to MTV. The parties were however permitted to deviate from the terms in the template in their agreed form sub-participation agreement, with such agreed terms expressed to prevail over any conflicting terms in the MPA.
The sub-participation agreement agreed between Yieldpoint and Kimura and entered into in March 2021 (the MTV Agreement).
(i)The terms of this were indeed modified from those in the template in the MPA and there were inconsistencies between it and the MPA.
(ii) Two particular departures from the template which were considered to be incongruous with the true nature of a sub-participation agreement were the inclusion of (1) a fixed term for the participation, with an option to renew on the maturity date of 31 March 2022 (the Maturity Date) and (2) special conditions for the giving of notice by Yieldpoint if it wanted to renew.

MTV had defaulted in its obligations under the Loan by 31 March 2022, and the senior lenders (including Kimura) granted MTV a forbearance in respect of the instalment due in March 2022. MTV was then declared bankrupt by the Civil Court of Santiago in February 2023. Yieldpoint commenced proceedings, claiming repayment of USD$5 million together with unpaid interest and monthly price participations.

In determining whether Yieldpoint was due these sums (which effectively required a determination as to how responsibility for a default on the part of MTV prior to the Maturity Date should be addressed between the parties), the analysis of the drafting of each of the MPA and the MTV Agreement, the way in which their provisions operated together and in particular what the true character of the arrangements created by them was, were crucial:

If the arrangement took effect as a sub-participation agreement, Yieldpoint would be exposed to the underlying risk of default by the borrower and Kimura would not be responsible for any sums resulting from that.
If it were determined to take effect as a fixed rate loan then the capital sums were due to have been repaid by Kimura to Yieldpoint on the Maturity Date.

Stephen Houseman KC, sitting as a judge of the High Court (the Judge) considered in May 2023 that the participation was in fact a form of fixed term loan and not a true sub-participation, albeit "with some discomfort", and Kimura then appealed the decision.

Applicable principles considered by the Court of Appeal

Previous case law, textbooks and papers in which the nature of sub-participation agreements was considered were discussed by the Court of Appeal:

The Privy Council considered a sub-participation agreement in Lloyds TSB Bank plc v Clarke [2002] UKPC 27 [2002] 2 All ER (Comm) 992, with Lord Hoffman noting that "the term "sub-participation agreement" is not a legal term of art like "assignment" or "trust". It is however a term commonly used in the market".
Philip Wood's work: International Loans, Bonds and Securities Regulation, was referred to, in which various ways in which a lender may grant another bank "participations" were described including novations, assignments and sub-participations. A sub-participation is described as an arrangement in which "the participant places a deposit with the lead bank in the amount of its participation and the lead bank agrees to pay to the participant amounts equal to the participant's share of the receipts by the lead bank from the borrower, if and when received…the lead bank does not assign or declare a trust of any part of the original loan in favour of the participant. The participant is a creditor only of the lead bank and not the borrower. If the lead bank becomes insolvent, the participant is an unsecured creditor of the lead bank. Therefore the participant has a double risk – the risk of the borrower and the risk of the lead bank."
The description of sub-participation in the paper: "Loan, Transfer and Securitisation BSD 1989/1" was also referred to in which sub-participation was described as a "back-to-back non-recourse funding arrangement" which creates a debtor-creditor relationship without giving the participator any interest in the underlying loan.

Court of Appeal decision

The Court of Appeal (with the primary judgment delivered by Lord Philipps, with Lady Justice Falk and Lady Justice Andrews concurring), in considering whether this arrangement would rightly be determined to constitute a fixed term loan, noted that it was inherently unlikely that the parties intended it not to replicate a conventional sub-participation, as was anticipated by the MPA. Had the parties wanted to draft a fixed term loan, they would have been likely to draft this as a separate loan agreement incorporating the usual and expected terms and conditions .
The Court of Appeal recognised the incongruence and the "temporal disconnect" (using the description given by the Judge) between the Maturity Date and the sub-participation structure, noting that the consequences of both operating in tandem would be unclear, but noted that the entire structure of the sub-participation arrangement could not be overturned simply by the inclusion of the Maturity Date.
The Court of Appeal referred to the need for the contractual wording used in all applicable documents to be read together "in order to reach a coherent interpretation of the entire contract which conforms with commercial sense". Only if a coherent interpretation could not be reached would further analysis then be required as to which provisions take priority and which need to be given a modified reading or overturned altogether need to be made. Applying that to this case the Court of Appeal found it difficult to see how this arrangement could be seen as something other than a conventional sub-participation arrangement with early redemption.
The non-recourse nature of a true sub-participation agreement was discussed, noting that giving Yieldpoint recourse to Kimura for the failure of MTV to repay the loan on the Maturity Date would not be consistent with the true non-recourse nature of a sub-participation agreement. The recourse that would typically be available to a participant would be to enforce rights of recourse against the counterparty, rights which Kimura had agreed to transfer to Yieldpoint in proportion to its participation.
The appeal was allowed with the Court of Appeal firmly of the view that the MTV Participation was a conventional sub-participation and that Yieldpoint's argument that it was permitted to be repaid its US$5 million investment in repayment of a fixed term loan should fail.

Useful points for lending transactions

There are a number of useful takeaways from this case, both for sub-participation arrangements and generally:

Sub-Participation Agreements

Default: The Court of Appeal made a useful observation that "parties discussing a trade often focus on what will occur if all goes to plan, without addressing what they no doubt consider to be the unlikely situation of default or non-performance, leaving that to the written terms". A keener focus at negotiation stage on what happens on default, particularly for a bespoke arrangement, is likely to assist, with the parties ensuring the drafting is clear on this point, and noting that pre-contractual discussions are very unlikely to be admissible based on the parol evidence rule.
Interaction between documentation: The interaction between the MPA and the MTV Agreement was critical in this case and highlights the importance of careful drafting to provide clearly how such documents should relate to each other, and if precedence is to be given to one, in what circumstances.
Use of template documentation: Weight was given to the fact that the parties had used the template sub-participation agreement to document their arrangements, and that if they had wanted to document a different type of arrangement, this would have been supported by their using the appropriate template as a starting point. This is a useful reminder on starting with the right base document and adapting as necessary if the commercial structure changes.

Generally

The name chosen for the arrangement is not conclusive: This case reiterates a point made previously in relation to the characterisation of fixed and floating charges, namely that the name the parties ascribe to a particular document is not determinative of how it takes effect at law. The rights and duties established and nature of the arrangement between the parties is a question of law, and a matter of construction of all relevant documentation by the court. The Court of Appeal noted that the operative clauses of the sub-participation arrangement with MTV clearly identified the arrangement as a sub-participation, as it is commonly understood.
The commercial sense of the structure of the transaction will be relevant: A court will consider the commercial sense of the transaction, and if one party's interpretation of the arrangements results in the undermining of the sense of the structure used, that should be taken into account. If Yieldpoint's interpretation was correct, Kimura would have agreed to (and in fact) transfer(red) most of its benefit from the USD$5 million without Yieldpoint exposing its capital.
Court's overall approach to interpretation: As explained above and as was crucial to the decision by the Court of Appeal, the right approach to interpretation where there is more than one document to be considered, was to read all of the contractual provisions together, in order to reach a "coherent interpretation of the entire contract which conforms with commercial sense". It is only if that is not possible that a court will need to determine which provisions should be given priority/a modified reading or overridden. This approach at first instance would have been likely to result in the MPA and MTV Agreement together being read as a conventional sub-participation agreement with early redemption.