In Re Coronet Capital Co.
142 B.R. 78, 1992 WL 139629, 1992 Bankr. LEXIS 954 (1992)
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Rule of Law:
An agreement labeled as a 'loan participation' is treated as a disguised loan if the lead lender guarantees repayment of principal and interest to the participant, thereby insulating the participant from the risk of the underlying borrower's default.
Facts:
- Coronet Capital Company loaned $550,000 to SSD Properties Corp., which was secured by a mortgage on a property.
- JIB entered into an 'Assignment, Participation, and Servicing Agreement' with Coronet, paying $500,000 for a purported senior participation interest in the SSD mortgage.
- The agreement obligated Coronet to pay JIB interest at a specified rate, even during periods when SSD was not making its required mortgage payments to Coronet.
- The agreement also required Coronet to repay JIB's principal from any funds received at the mortgage's maturity before Coronet could retain any money for itself.
- SSD defaulted on its mortgage payments to Coronet in August 1990.
- Despite SSD's default, Coronet continued to make interest payments to JIB through October 1990.
Procedural Posture:
- An involuntary Chapter 11 bankruptcy petition was filed against Coronet Capital Company in the U.S. Bankruptcy Court.
- The court subsequently converted the case from a Chapter 11 reorganization to a Chapter 7 liquidation.
- A Trustee was appointed to administer the debtor's estate.
- JIB filed a Motion for Relief from the Automatic Stay, seeking permission to enforce its rights against the mortgage interest.
- The Trustee objected to JIB's motion, arguing the transaction was a loan and the mortgage was property of the estate.
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Issue:
Does an agreement constitute a disguised loan rather than a true loan participation when it contractually guarantees the 'participant' payment of principal and interest regardless of whether the underlying borrower makes its payments to the lead lender?
Opinions:
Majority - Conrad, Bankruptcy Judge
Yes. An agreement constitutes a disguised loan rather than a true loan participation when it insulates the participant from all risk of loss. The court determined the transaction was a loan because the agreement guaranteed JIB's return; Coronet was obligated to pay JIB interest even if SSD, the original borrower, defaulted. A true participation requires the participant to assume the same risks as the lead lender, meaning the participant's right to repayment arises only when the lead lender receives payment from the borrower. Here, JIB assumed no risk, which is the hallmark of a creditor-debtor relationship. This conclusion was further supported by the parties' course of conduct, as Coronet continued paying JIB even after SSD had stopped paying Coronet.
Analysis:
This decision emphasizes the bankruptcy principle of 'substance over form,' meaning courts will analyze the economic reality of a transaction rather than the labels used by the parties. By classifying an agreement with guaranteed returns as a loan, the court prevents a party from circumventing bankruptcy's creditor priority scheme. This precedent warns financial entities that they cannot disguise a loan as a participation to gain superior rights to an asset if the lead lender becomes insolvent. The ruling reinforces that a fundamental characteristic of a true participation agreement is the shared risk of the underlying borrower's non-payment.
