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Participating Banks - Don't Skip the Due Diligence

Commercial Lending Bulletin

When deciding whether to participate in a loan, a bank should perform its own due diligence for the loan and not rely solely on representations from the lead or selling bank.

Reliance on the lead bank’s representations may seem logical and convenient. It is, however, fraught with risks and a lead bank’s mistake or oversight becomes the participating bank’s mistake or oversight with no way out.

The California Appellate Court showed the hazards of relying on the lead lender in Ventura Cnty. Bus. Bank v. Cal. Bank & Trust.  In this case, Ventura County Business Bank (VCBB) acquired close to a 50 percent interest in a loan from Alliance Bank to Silver Oaks Estates, L.P. for the construction of a 21-unit subdivision. Within the first year of the loan, there were signs that the loan was in trouble. Silver Oaks was unable to sell the units as anticipated and although the loan was fully disbursed, the construction was not yet finished. Ultimately, Silver Oaks was unable to make the loan payments.

As the outlook for the loan remained bleak, VCBB sought release from the participation agreement. It claimed the participation agreement should be rescinded because there was a mutual mistake by both VCBB and Alliance. In the participation agreement, Alliance represented to VCBB that Silver Oak was not in default of the loan. When Alliance made the representation, however, Silver Oak was in default of the loan – Silver Oak had previously encumbered the loan’s collateral to secure another loan from a third party, in violation of the loan requirements. VCBB argued that this mistake by Alliance and VCBB’s reliance on the participation agreement justified rescinding the contract.

But, the court rejected VCBB’s rescission argument. The court held that when a party seeks rescission for a unilateral or mutual mistake of fact, the rescinding party must establish that it did not bear the risk of the mistake. According to the court, VCBB did bear the risk that Alliance’s representation was a mistake because VCBB was required, in several provisions of the participation agreement, to perform its own independent investigation of the loan. The court reasoned that VCBB could have easily uncovered the mistake if it had ordered an updated title report. 

Although most participation agreements will have representations from the lead bank, this California case shows that representations cannot replace thorough due diligence.

This case is cited as: Ventura Cnty. Bus. Bank v. Cal. Bank & Trust, 2014 WL 540473 (Cal. Ct. App. Feb. 11, 2014)**.

**This is an unpublished opinion.

Ann Marie Mehlert is a real estate attorney at Lerch, Early & Brewer who works with real estate developers, investors, and owners on all aspects of commercial real estate. For more information on bank loans and due diligence, contact Ann Marie at (301) 907-2803 or ammehlert@lerchearly.com.

This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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