Loan Participation Interests And The Sale Of Depositary Receipts

Loan participation interests and the sale of depositary receipts over such interests as an alternative to some limitations imposed to local borrowers by the Mexican tax regulations regarding the quality of lenders from whom those borrowers could obtain funding, and the possible insolvency of the arranger of the transaction

Introduction

Mexican tax laws discourages local borrowers from raising funds internationally through financial intermediaries the same laws don't consider 1st tier lenders. If a Mexican corporation is only able to get foreign funds from a bank local tax laws do not consider first tier, the borrower is forced to pay, depending on the category of the bank, either 15% or 30% over the nominal amount borrowed. This presents a problem for small or mid sized Mexican corporations, given the risk weighting rules that govern the entities considered 1st tier lenders in Mexico it is very difficult for those Mexican corporations to get financing. For reason of size, capital, past credit history, etc. small or mid sized Mexican corporations don't meet the general credit qualifications first tier banks require to extend. As we all know, such banks have very strict rules as to the quality of the credit of their borrowers and deny financing to potential borrowers who fail to meet the banks' strict credit conditions. Whenever a small Mexican corporation meets the requirements of one of the banks considered 1st tier in Mexico, the conditions said bank imposes on the small or mid sized borrower will be so strict that it will make the loan almost economically unfeasible. This leaves the borrower with the dilemma of getting financing at a very high prices with banks that local authorities consider 1st tier, if that is possible, or getting loans from banks considered 2nd tier at decent prices, but paying a tax that would make the loan sometimes even more expensive than paying the almost prohibitive prices 1st tier banks charge.

Some brokers the Mexican authorities do not consider 1st tier formulated a solution by which they could raise funds for those corporations from investors (definitively not considered 1st tier by Mexican tax laws) willing to take the risk small Mexican corporations for the return offered by the investment in the respective borrowers. This could be accomplished by engaging the services of financial institution considered 1st tier in Mexico as a fronting bank. The fronting bank would make a loan to the Mexican Corporation and sell a 100% participation in the loan to the broker who originated the transaction, which would convert the participation in clearing eligible depositary receipts. At the same time, the depositary receipts would be sold to the investors who had initially funded the loan. The first tier bank does not damage the quality of its loan portfolio since a sale of a 100% participation eliminates the risk from its books, the broker, although it does not have the capital to fund the loan, obtains it from investors willing to bear the associated risk. The fronting bank considered first tier in Mexico gets a fee for acting as lender of record before the Mexican taxing authorities. The fronting bank will have to maintain the credit on record and report it accordingly to the Mexican banking authorities even if it is not taking the risks associated with the respective second tier credit. This gives the Mexican Corporations we have mentioned many advantages since they do not have to pay a high tax and can get financing at a competitive rate without paying the required tax for dealing with a 2nd or 3rd tier financial intermediaries. Problems arise when the broker who originated the transaction and buyer of the participation becomes insolvent before the maturity of the loan and the depositary receipts mentioned in the example above. If that were to occur who would be entitled to the repayment of the loan: The holders of the depositary receipts or the estate of the bankrupt broker?

The intention of this note is to comment on a decision of the Supreme Court of The Bahamas that resembles notably the facts surrounding the structure described above. We are also briefing the relevant factual background to help you compare it to the facts surrounding the DR receipt structure explained above to be able to receive funding from 2nd tier or 3rd tier lenders without paying the associated tax the Mexican authorities impose. We are going to base our note on a transaction that took place between a small Mexican corporation, a US broker and a European bank, already absorbed by another bank, who was considered 1st

tier by the Mexican taxing authorities. The documentation they used for the deal will be discussed infra.

The Mexican Transaction

For illustration purposes, we will base the content of this note in a real transaction that took place three years ago. However, we feel that the current holders of the Depositary receipts and receiver of the estate of the broker who originated the transaction would not let us disclose the names of the parties involved in that operation. For purposes of this note we could say that based on available documentation, in 1998 a European bank considered 1st tier by the Mexican authorities (the "Fronting Bank") made a guaranteed loan (the "Loan") to a Mexican corporation (the "Corporation"). The basic documentation used for this transaction was a loan agreement, a participation agreement to sell the Loan, a deposit agreement to convert the participation in a clearing eligible instrument and an information memorandum describing the depositary receipts and the transaction. The Fronting Bank was then supposed to act as lender of record of the Loan before the eyes of the Mexican authorities. The fronting bank was supposed to carry the Loan in its books, but was allowed to transfer the risks associated with the Loan by way of participating out the Loan to investors willing to fund it. A US broker not considered 1st tier by Mexican tax laws (the "Originating Broker") arranged the entire transaction, including the Loan. At the same time, the Fronting Bank sold and transferred 100% participation interest in the Loan to the Originating Broker by executing a participation agreement (the "Corporation Participation Agreement"). Said 100% participation interest in the Loan was represented by a participation certificate (the "Participation Certificate"). The Participation Certificate was sold to the Originating Broker for a full consideration identical to the principal amount the Fronting Bank had advanced to the Mexican Corporation under the Loan.

The sale of the Participation Certificate was made without recourse against the Fronting Bank and without responsibility from the seller bank with respect to the Loan. The respective participation agreement makes clear that all actions or decisions in respect to the Loan can only be made after "consultation with, and receipt instructions from, each person or entity at the time holding a participation in the Seller [the Fronting Bank]'s interest in the Loan, including the Purchaser [the Originating Broker]" (we emphasized). The Mexican Corporation Participation Agreement goes on to say that in the event of a disagreement between holders of said participation, the Fronting Bank would act in accordance with the wishes of the parties holding a majority interest in the principal amount of the Loan. In the same document, the Fronting Bank waived all the rights that a normal lender would have in favor of the holders of the relevant participation, including the Originating Broker. Please note that despite being only one Participation Certificate, the Mexican Corporation Participation Agreement assumes that the Participation Certificate may be transferred to more than one holder because it provides the solution in case of a disagreement between various parties.

When the Fronting Bank gave up its rights and control over the Loan to the Originating Broker it also made clear that it would not be responsible, inter alia, for the effectiveness, enforceability, genuineness, validity or due execution of the Loan and the participation on the part of the Mexican Corporation. Once the Participation Agreement was perfected the owner of the Loan was Originating Broker. The Mexican Corporation Participation Agreement declared that it constituted a sale of 100% of the Loan and that in no way it could be construed as a loan by the Originating Broker to Fronting Bank, or as a pledge of any interest in the Loan by the Originating Broker to Fronting Bank. The Fronting Bank indeed did not have any obligation to repurchase the Loan from the Originating Broker upon default or otherwise. Then, the Fronting Bank's functions were limited to receiving funds from the Originating Broker to grant a credit facility to the Mexican Corporation. The control and risk associated with that facility would immediately be transferred to the original provider of the funds and bearer of the risk associated with the financing, the Originating Broker. The Fronting Bank acted indeed, as it is established in the information memorandum of the Mexican Corporation DRs (the "Information Memorandum") and the deposit agreement between the Originating Broker, the receiptholders and a the relevant depositary ("The Mexican Corporation Deposit Agreement"), as a "Lender of Record". For its services in relation to the Loan the Fronting Bank charged a Facility Fee.

On the same date the Loan and the Participation Agreement were executed, the Originating Broker, the participant and owner of the Participation Certificate under the Mexican Corporation Participation Agreement, entered into the Mexican Corporation Deposit Agreement with the Fronting Bank offshore (a subsidiary of the Fronting Bank, hereafter defined as "the Fronting Bank Offshore") and the holders from time to time of any beneficial interest in the Global Receipt to be issued under the Mexican Corporation Deposit...