Financial players in the distressed market in Spain are commonly using the LMA sub-participation agreement. However, “sub-participation” is not a concept that has been traditionally recognised under Spanish law. This has given rise to borrowers resisting enforcement, arguing that such an arrangement should be recharacterised as an assignment of claims. Such recharacterisation would be detrimental for distressed debt investors.

The use of English law governed LMA sub-participation agreements since the financial crisis, and especially in the distressed debt market, has significantly increased in Spain.

In a sub-participation 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 only a creditor of the lead bank and not the borrower and if the lead bank becomes insolvent, the participant is an unsecured creditor of the lead bank.

The key drivers for the success of this type of contract in the Spanish market are that (i) the lead bank can remove distressed debt from its balance sheet; (ii) international investors obtained a credit position without having to deal directly with the debtor and without having to pay stamp duty or any other type of notarial costs for the transaction; and (iii) it allows the lead bank to transfer risk without entering into an assignment which could be costly and, sometimes, is forbidden by, or limited by, the underlying loan agreement.

However, Spanish legislation does not specifically regulate this type of transaction. This gives rise to a risk of recharacterisation under Spanish law. In recent cases, debtors are starting to argue that a sub-participation is in reality an assignment of claims. The consequences of being an assignment of claims include the following:

− Litigious credit (article 1,535 of the Spanish Civil Code): A debt becomes “litigious” (also known as a litigious credit) from the point in time that a debtor files its formal defence to a creditor’s payment demand. Where a litigious credit is assigned to a third party, the debtor has the right to extinguish the claim (within nine days from the date on which the transferee demands payment from him) by reimbursing the price paid by the transferee to acquire the litigious credit (along with court costs and interest on the price from the day it was paid).
− Loss of security on the basis that the assignment did not include the assignment of security rights, so the participant cannot benefit from the security, especially when they are Spanish law security rights which in most of the cases need registration or public deed.
− Any restrictions or ban on assignment in the underlying loan is breached, so the borrower may try to dispute the validity of the sub-participation (vid. Bank of America v TP Ferro which has appeared in the press).

This means that a lead bank which uses a sub-participation agreement whilst at the same time commencing enforcement may have difficulties with enforcement. If the borrower discovers the sub-participation, and resists payment on the basis that the debt is disputed (a crédito litigioso) or on the basis that the real creditor has lost the benefit of the relevant security, he may ask the court to stop the enforcement of the security on the basis that the sub-participation should be recharacterised as an assignment, and that such assignment did not include the relevant security. Similar issues could also arise on insolvency.

In a recent case which remains confidential in which Allen & Overy LLP acted for the successful party, the Spanish courts considered the nature of a sub-participation for the first time. The bank submitted expert evidence from an English legal expert that an LMA sub-participation is not an assignment of the loan, and none of the terms of the sub-participation purport to assign any of the bank’s existing rights against the borrower, so as a matter of English law the bank remains the lender in respect of the loan and thus the party entitled to bring an action against the borrower for non-payment under the loan.

The Spanish court accepted that the credit was not assigned and the pledge was enforced. The court was greatly swayed by the fact that the lead bank is the only entity that could exercise any right against the borrower, which made it impossible to recharacterise the sub-participation.

Whilst the bank was successful, the dispute caused delay in enforcement which could have been avoided if, as is usually the case, the sub-participation had been confidential as between lead bank and sub-participant.