Discharge of indenture defeasance: Overview, definition, and example
What is discharge of indenture defeasance?
Discharge of indenture defeasance refers to the process by which a borrower or issuer of a debt security (such as bonds) legally releases itself from its obligations under an indenture agreement by setting aside a sufficient amount of funds or assets to satisfy the debt in full. This process is typically done by placing the required funds or securities in a trust or escrow account, effectively "defeasing" the debt. Once the funds are set aside and secured, the borrower is no longer responsible for repaying the debt, and the indenture is considered discharged.
For example, a company that issues bonds may create a defeasance trust to deposit sufficient funds to pay off the bondholders at maturity, thereby discharging the indenture and relieving the company of its debt obligations.
Why is discharge of indenture defeasance important?
Discharge of indenture defeasance is important because it provides a legal and financial mechanism for an issuer to be released from the debt obligations without actually having to make the full payment in cash immediately. This allows businesses to manage their finances more efficiently by securing the necessary funds upfront, while also protecting bondholders or creditors by ensuring they will be paid according to the terms of the indenture.
For companies, defeasance can be an effective way to remove debt from their balance sheet, potentially improving their financial position or creditworthiness. For investors, it guarantees that the debt will be paid off even if the issuer is no longer able or willing to make the payments directly.
Understanding discharge of indenture defeasance through an example
Imagine a corporation, ABC Corp., that issued $10 million in bonds. Over time, ABC Corp. has accumulated enough assets and liquidity to discharge the indenture through defeasance. The company creates a defeasance trust, where it deposits a combination of cash and government securities worth $10 million to pay off the bondholders when the bonds mature. By doing so, ABC Corp. is released from the obligation to make future payments on the bonds, as the funds are secured in the trust for the benefit of the bondholders. The indenture is now considered discharged.
In another example, a municipality may issue bonds to finance infrastructure projects. After completing the project, the municipality might choose to defease the bonds by placing funds in an escrow account that are earmarked for the bond payments. This action discharges the municipality's obligations under the indenture and provides bondholders with assurance that the debt will be paid at maturity.
An example of a discharge of indenture defeasance clause
Here’s how a clause like this might appear in a bond indenture:
“The Issuer may, at its discretion, discharge this Indenture by defeasing the Bonds by irrevocably depositing sufficient funds or government securities into a trust, thereby fulfilling all of its payment obligations and relieving itself of any further liability under the terms of this Indenture.”
Conclusion
Discharge of indenture defeasance is a critical financial tool that allows a borrower or issuer to free itself from the obligations of a debt security by setting aside funds or assets to ensure payment. This process benefits both the issuer, by removing the debt from its books, and the bondholders or creditors, by securing their payment. Understanding defeasance helps businesses make informed decisions about managing debt and improving financial health, while providing investors with security that their investments will be honored.
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.