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Legal glossary

Legal defeasance: Overview, definition, and example

Legal defeasance refers to the legal process by which a borrower can discharge or terminate their obligation under a contract, such as a loan agreement or bond, through the use of collateral or other financial mechanisms. Essentially, it involves substituting a set of assets (usually government securities or highly liquid assets) to satisfy the obligations of the borrower, thereby making the debt obligations legally null and void. This process allows the borrower to be relieved from their obligations without actually paying off the debt in full, often used in structured finance or complex debt arrangements.

For example, a borrower might use a portfolio of government bonds to defease a bond issue, ensuring that the bondholders will still receive their scheduled payments from the returns on the government securities.

Legal defeasance is important because it provides a mechanism for a borrower to escape or modify a debt obligation without defaulting. It can be a strategic tool for companies looking to restructure their finances, retire debt early, or avoid certain covenants that are tied to their original borrowing terms. It also protects creditors by ensuring that they will still be paid, even though the borrower is no longer liable under the original contract.

For businesses, defeasance can be a way to free up cash flow by eliminating liabilities or managing financial risks. For investors, it provides security that they will continue to receive payments, even if the borrower is no longer involved in the original loan agreement.

Imagine a corporation has issued a bond with a maturity of 10 years, and the company decides it wants to retire this debt early without actually paying it off in cash. The company could arrange a legal defeasance by setting aside a sufficient amount of highly-rated government securities in a trust. The interest from these securities would then be used to make the bond payments to the bondholders, effectively ensuring that the bondholders continue receiving their payments without the company being liable under the original bond agreement.

In another example, a real estate company that has taken out a large loan to finance a property might use defeasance to replace the original mortgage with a pool of government securities. As long as the securities generate enough income to cover the mortgage payments, the company is no longer responsible for making the payments directly, and the mortgage is considered defeased.

Here’s how a legal defeasance clause might appear in a bond or loan agreement:

“Upon the deposit of sufficient funds, including but not limited to government securities, into a defeasance trust, the Borrower’s obligations under this Agreement shall be considered fully discharged, and the Borrower shall no longer be liable for the repayment of principal or interest. The trustee will use the funds to make the required payments to the Lenders as scheduled.”

Conclusion

Legal defeasance is a strategic financial mechanism that allows borrowers to discharge their obligations without paying off the debt in full. By using collateral, such as government securities, to secure future payments, the borrower can effectively terminate their liability under the contract while still ensuring that creditors are paid. This process is beneficial for both borrowers and creditors, as it provides a legal and structured method for managing debt obligations and restructuring financial agreements.

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.

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