The Nebraska Supreme Court recently rendered an opinion in the case of Community First Bank v. First Central Bank McCook, 310 Neb. 839 (2022), involving the issue of whether a contract between two banks was a participation agreement or whether it created a debtor – creditor relationship (loan) between the two banks.
In Community First, the lower court had granted the motion of First Central for summary
judgment and dismissed Community First’s complaint in which its “causes of action” were all based on a claim for breach of contract. The Supreme Court, concluding that the contract between the parties was ambiguous, determined that a genuine issue of material fact existed regarding the provisions of the contract between the parties as to whether their contract was a participation agreement or a loan and that neither party was entitled to judgment as a matter of law at that stage of the proceedings. Accordingly, the Supreme Court reversed the lower court order granting summary judgment in favor of First Central and remanded the cause to the district court for further proceedings.
Community First alleged that First Central approached it in 2017 "about providing $300,000 in financing." The offer was accepted, and the parties entered into a contract dated June 1, 2017, pursuant to which Community First's interest matured on August 1, 2017. The contract between the parties consisted of a document entitled "Participation Agreement," into which a June 1, 2017, letter between the parties was incorporated. Four separate extensions of the maturity date were requested and granted, the last of which extended the maturity date to December 15, 2018. Following maturity, payment was requested by Community First, and Community First alleged that First Central refused to pay what was owed under the contract and its extensions.
The arrangement between Community First and First Central related to the refinancing
of a $861,000 loan of a customer of First Central which would have allegedly exceeded
the regulatory lending limit of First Central. Community First claimed that the June 2017
contract created a debtor-creditor relationship between the parties, whereas First
Central contended that the Agreement was a participation and not a loan. Subsequent
to the maturity date of contract, First Central’s borrower filed bankruptcy.
The court acknowledged that Nebraska case law does not appear to address the standards for determining whether a given arrangement constitutes a true participation
agreement, or whether it is instead a disguised loan.
The Supreme Court analyzed the traditional components of a loan participation in which
“the wide spread majority” of cases hold that the participated loan device results in the
sale of the designated percentage of the loan to the participating bank with the lead bank acting as the participant’s agent to collect and forward the appropriate repayments
and to service the loan.
The court further noted “participations are not loans; they are contractual arrangements
between a lender and a third-party, in which the third-party, or participant, provides
funds to the lender…the lender in turn uses the funds from the participant to make loans
to the borrower.”
The court further indicated:
“In the typical participation, the lead lender transfers to the participant not only the benefits to be received from a share in the underlying loan (i.e. a pro rata share in the principal and interest payments) but also the risk of the borrower’s default. The lead lender makes no warranties or guarantees about the borrower’s ability to repay the loan or about the worth of the collateral in the event of default. If the borrower does default, the participant is entitled to a pro rata share of any monies received upon liquidation of the collateral, but it has no right of recourse against the lead lender.”
In distinguishing between a true participation and a disguised loan, the court cited the
following factors that indicate that a transaction is a true participation:
By contrast, the court noted the following factors that indicate that a purported
participation may in fact be a disguised loan:
The court further held “Factors which may cause a transaction to be other than a true
loan participation include anything that indicates the participants are not subject to the
normal risks of ownership, such as guaranteed returns by the lead institution, or
required repurchase agreements.”
The Supreme Court ultimately determined that the contract relating to the transaction
between the parties was ambiguous. While several provisions of the contract tended to
support a determination that the agreement included the features of the participation,
other provisions, such as “guarantee of repayment by the lead lender to a participant”
and especially “participation that lasts for a shorter or longer term than the underlying
obligation” may indicate the transaction is a disguised loan.
In Community First, discrepancies between the “maturity date” for Community First’s
funding commitment (August 1, 2017, later extended to December 15, 2018) and First Central’s funding obligation (December 15, 2030) created an ambiguity within the
contract regarding the term of the underlying indebtedness.
Being unable to discern whether the maturity date was August 1, 2017 (later extended
to December 15, 2018) or December 15, 2030 and whether First Central was
guaranteeing payment to Community First of all principal and interest on August 1, 2017
(later extended to December 15, 2018), independent of the First Central borrower’s
obligations and performance under the promissory note, the Supreme Court determined
that genuine issues of material fact existed and remanded the action for further
Participation agreements have historically been the source of extensive litigation and
lenders should exercise due diligence in preparing contract documents and documenting these types of transactions.
Action for Conversion
In Ogallala Livestock Auction Market v. Leonard, 30 Neb. App. 335 (2021), a cattle and livestock broker (Leonard) purchased cattle and other livestock for third-party buyers on a commission basis. Leonard's "arrangements" with his bank (Pinnacle) involved an account which consistently had a negative balance. Typically, checks would be drawn upon a negative balance on the account, Leonard would verify that deposits were forthcoming, and the checks would be honored by the bank.
In 2015, Leonard purchased 1,584 head of cattle from Ogallala Livestock, delivered them to buyers and drew checks on his account totaling nearly $3 million. Five deposits were made into Leonard's account as payments to Leonard from the third-party buyers. Upon presentment, Pinnacle dishonored the checks drawn on Leonard's account and utilized the deposited funds to set off outstanding fees and interest Leonard owed on his account. Leonard thereafter failed to make payment to Ogallala Livestock or return the cattle.
The complaint filed by Ogallala Livestock against Pinnacle was dismissed by the District Court for failure to state a claim for relief. On appeal, the Nebraska Court of Appeals reversed the lower court ruling in part and remanded the cause for further proceedings.
In the trial court, Ogallala Livestock asserted a cause of action for conversion. Pinnacle defended on the basis that Ogallala Livestock had no right in funds represented by a check and no right to sue the drawee on a dishonored check.
Neb. U.C.C. §3-408, provides that a check or other draft does not of itself operate as an assignment of any funds in the hands of the drawee available for its payment and that the drawee is not liable on the instrument until the drawee accepts it.
In order to state a claim for conversion, Ogallala Livestock was required to allege sufficient facts to establish that it had an ownership interest in the funds deposited into Leonard’s account.
The Court of Appeals noted that “a deposit of funds in a bank to the credit of the depositor ordinarily is termed a “general deposit.”” In such cases, the title to the funds deposited passes to the bank, and the relation of debtor and creditor exists between the bank and the depositor. The presumption is that a bank deposit made in the usual course of business is a general deposit and not a special or trust deposit. However, Ogallala Livestock asserted that deposits paid into Leonard’s account were an exception to the general deposit rule and that they were special deposits or deposits for a specific purpose.
The Supreme Court has previously articulated that special deposits occur where the property, securities, or funds are left with the bank for safekeeping only, and the specific property or fund is to be returned to the depositor. In such a case, the bank is a mere bailee. Title to the deposit does not pass to the bank, but remains in the depository.
The Court went on to note that “[w]ith respect to deposits made for a specific purpose, this occurs where funds are deposited in a bank for the purpose of paying a specific obligation. The burden is on the claimant to show that the deposit was received by the bank with the express or clearly implied agreement that it should be kept separate from the general funds of the bank and that it should remain intact. In the case of a deposit for specific purpose, the bank acts as the agent of the depositor, and if the bank should fail to apply the deposit as directed, or should misapply it, it may be recovered as a trust deposit.”
Citing prior precedent, the Court held that “a bank may not set off funds in a depositor’s account in payment of the depositor’s indebtedness to the bank when the bank knows or should know that the funds being set off belong to another. A bank that appropriates the deposit made by a customer to reduce his or her indebtedness to the bank, knowing the deposit, or a part thereof, to be a trust fund, is liable to the true owner for conversion of his money, and an action at law to recover the amount can be maintained…”
Finding that Leonard had plead sufficient facts to suggest the existence of an agreement between Ogallala Livestock and Pinnacle and/or that Pinnacle knew or should have known that the purpose of the deposits was to cover the checks that Leonard had written to Ogallala, the Court of Appeals remanded the cause for further proceedings, returning the case for further action by the trial court.