Defeasance: Overview, definition, and example
What is defeasance?
Defeasance refers to a legal concept or clause used in financial contracts, typically in relation to bonds or loans, that allows the borrower to cancel or void the obligation to repay a debt by setting aside sufficient assets or securities. In essence, defeasance involves providing an alternative arrangement to satisfy the debt, usually by depositing funds or acquiring specific securities that are used to cover the debt payments. This can effectively "discharge" the debt without actually paying it off in cash. The defeasance clause typically outlines the conditions under which the borrower can exercise this option and what assets or securities must be set aside.
Why is defeasance important?
Defeasance is important because it provides a way for borrowers to release themselves from debt obligations without physically paying off the loan or bond. This can be particularly useful in situations where the borrower has the financial means to settle the debt but prefers to use assets or securities in a way that meets the terms of the contract. Defeasance allows for flexibility in debt management and can be part of a larger strategy for refinancing or restructuring financial obligations. It can also offer benefits to the lender by ensuring that the debt is still covered and repaid, even though the original repayment terms are not being followed.
Understanding defeasance through an example
Imagine a company has issued a bond with a 10-year maturity and an interest rate of 5%. The company decides it would like to cancel its obligation to pay interest and principal over the life of the bond. To do so, the company enters into a defeasance arrangement, where it deposits enough funds into a special escrow account or purchases government bonds that will generate the necessary funds to cover the debt payments. By doing this, the company effectively discharges its debt obligation because the funds or securities held in the escrow account are guaranteed to cover the bond's future payments, releasing the company from further liability under the bond.
In another example, a homeowner with a mortgage may want to defease the loan. Instead of paying off the mortgage directly, they might deposit enough funds or purchase bonds that generate sufficient income to meet the mortgage's repayment terms. This arrangement satisfies the lender's expectations, even though the homeowner has not directly repaid the loan.
An example of defeasance clause
Here’s how a defeasance clause might appear in a loan or bond agreement:
“The Borrower shall have the option, at its discretion, to defease this loan by depositing sufficient funds or purchasing qualifying securities that are designated to meet all future principal and interest payments due under this Agreement. Upon such defeasance, the Borrower’s obligations under this Agreement shall be considered satisfied, and the Lender’s recourse shall be limited to the deposited funds or securities.”
Conclusion
Defeasance is a useful financial tool that allows borrowers to cancel their debt obligations through an alternative arrangement, typically by setting aside sufficient assets or securities. This option provides flexibility for borrowers who may wish to free themselves from debt without paying it off in the traditional manner. Defeasance clauses help ensure that the lender’s interests are still protected while offering the borrower an effective way to manage their debt obligations.
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.