Covenant defeasance: Overview, definition, and example
What is covenant defeasance?
Covenant defeasance is a legal provision in a contract, often found in bond or loan agreements, that allows a borrower or issuer to be released from certain covenants or obligations under the agreement, typically by setting aside a sufficient amount of funds or assets in a trust to cover the obligations. In a defeasance structure, the borrower or issuer effectively "defeats" the covenant requirements by ensuring that there are sufficient funds or assets to satisfy the debt or obligation without requiring further compliance with the covenants.
Covenant defeasance is commonly used in bond transactions or complex financing arrangements. It provides a way for issuers to reduce their obligations under the agreement, particularly if they have met certain financial requirements or if they want to avoid the restrictions imposed by the covenants.
Why is covenant defeasance important?
Covenant defeasance is important because it provides flexibility to the borrower or issuer while still ensuring that the contractual obligations are met. By setting aside assets in a trust, the borrower may avoid the restrictive requirements of certain covenants, such as maintaining specific financial ratios or meeting other performance-based metrics.
For issuers, defeasance can provide a means of freeing up resources or reducing operational restrictions once they have demonstrated their ability to meet the financial requirements. For investors, covenant defeasance offers reassurance that the bond or loan will be honored despite the release from certain covenants, as the assets set aside in trust provide security for the debt.
Understanding covenant defeasance through an example
Imagine a company that issues bonds with several financial covenants, including maintaining a debt-to-equity ratio below a certain threshold. After several years, the company has accumulated enough cash and other assets to cover the remaining principal and interest payments on the bonds. The company enters into a covenant defeasance agreement, where it sets aside the necessary funds in a trust to ensure the bonds will be paid off.
As a result of the defeasance, the company is no longer bound by the restrictive financial covenants because the debt is fully secured by the assets in the trust. The company is effectively relieved from the operational burden of maintaining specific financial ratios, but the bondholders’ interests remain secured by the funds in the trust.
In another example, a real estate investment trust (REIT) issues bonds with covenants requiring regular property maintenance and debt levels within certain limits. After a successful sale of several properties, the REIT sets aside enough proceeds into a defeasance trust to ensure future bond payments. This action releases the REIT from the covenants but secures the bondholders’ interests.
An example of a covenant defeasance clause
Here’s how a covenant defeasance clause might look in a bond or loan agreement:
“Upon the deposit of sufficient funds or government securities into a trust account, the Issuer shall be relieved from compliance with the financial covenants specified in Sections 5.1 through 5.4 of this Agreement. The trust shall be managed by an independent trustee and shall be sufficient to satisfy the remaining obligations of the Issuer under this Agreement. Once the defeasance conditions are met, the Issuer shall be deemed to have satisfied its obligations under the Agreement and shall no longer be bound by the covenants.”
Conclusion
Covenant defeasance is a valuable tool that allows borrowers or issuers to be released from certain covenants once they have met the financial requirements or set aside sufficient assets to secure the obligations. This flexibility can reduce operational restrictions and provide the borrower with more freedom, while still ensuring that creditors or bondholders are protected. By including covenant defeasance provisions, parties can structure agreements that accommodate future financial changes and provide clarity on how obligations will be fulfilled.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.