What Is a Defeasance Clause and How Does It Work?

A defeasance clause allows a borrower or issuer to release themselves from primary obligations related to debt. This is achieved by substituting the original collateral with new, less risky assets. It provides a mechanism for managing debt agreements and altering existing financial commitments.

Understanding Defeasance Clauses

A defeasance clause fundamentally redefines the relationship between a borrower and a lender by changing the collateral backing a debt. The term “defeasance” means to make null and void, and in this context, it refers to the process of voiding the original security interest in an asset. This is done by replacing the original collateral, such as real estate, with a different set of assets that are usually highly liquid and secure. The purpose is to maintain the lender’s expected income stream without holding onto the original asset.

The underlying principle is that the borrower or issuer effectively removes the original debt and its associated collateral from their direct responsibility. This is accomplished by establishing a new arrangement where substitute collateral is pledged to cover the remaining debt service. The legal and financial implications are significant, as the original loan agreement’s terms regarding collateral are modified to accommodate this substitution. While the debt itself is not paid off, the obligation to service it shifts to the new collateral.

For instance, if a property serves as collateral for a loan, a defeasance clause allows the borrower to swap that property for a portfolio of highly rated securities. This substitution ensures that the lender continues to receive payments as originally scheduled, but their claim is now against the new securities rather than the initial asset. This process is distinct from a simple prepayment, where the borrower pays off the loan in full and the debt is extinguished. Instead, defeasance maintains the original debt structure and payment schedule, but with different backing.

The Mechanics of Defeasance

Executing a defeasance clause involves a precise, multi-step process to ensure the lender’s continued receipt of future payments. It begins with the borrower notifying the lender of their intent. A special purpose entity (SPE), known as a successor borrower, is often created to assume the debt obligations from the original borrower. This entity becomes the new obligor for the loan.

Specific types of securities, predominantly U.S. Treasury bonds or other government-backed securities, are purchased. These low-risk securities are chosen because their cash flows can be precisely matched to the remaining principal and interest payments of the original debt. The portfolio is structured to generate an income stream that aligns with the debt service schedule through its maturity date.

Once purchased, these securities are placed into an escrow account, managed by an independent third-party trustee. The trustee holds these securities and uses their income to make scheduled debt payments to the original lender. The original debt is not extinguished; rather, the obligation to service it is transferred to the successor borrower and the income from the escrowed securities. Upon transfer of the debt obligation and establishment of the escrow account, the original collateral, such as real estate, is released from its lien.

This process involves various costs beyond the purchase of securities, including legal fees, consulting fees, and fees for the trustee and securities intermediary. These costs can range from tens of thousands of dollars to significantly more, depending on loan size and complexity. The overall cost depends on market conditions, particularly interest rates.

Where Defeasance Clauses Appear

Defeasance clauses are commonly found in commercial real estate mortgages and corporate bonds. In commercial real estate, they are especially prevalent in securitized loans, such as Commercial Mortgage-Backed Securities (CMBS). These loans often have strict prepayment penalties or “lockout” periods. Defeasance provides a workaround, allowing a property owner to sell or refinance their property even with prepayment restrictions.

For example, if a property owner wants to sell a commercial building before their CMBS loan matures, a defeasance clause enables them to release the property from the loan’s lien. The original collateral (the property) is replaced with a portfolio of government securities that continue to pay the lender as scheduled. This ensures the predictable cash flows of the CMBS remain undisturbed.

In the corporate finance sector, defeasance clauses also appear in corporate bond indentures. Companies issuing bonds might use defeasance to remove the debt from their balance sheet without repaying bondholders.

An escrow account containing U.S. Treasury securities or other highly liquid assets is established, structured to generate cash flows matching the principal and interest payments on the outstanding bonds. Once fully funded and legally established, the company’s direct obligation to bondholders transfers to the assets within the escrow. This means the debt can be removed from its financial statements.