In recent months, the term "defeasance" has often been used inappropriately, particularly by the media, to describe the contribution or sale of doubtful real estate receivables to an unconsolidated entity, thereby deforming the original meaning of the term. Defeasance is the annulment of a contract; in-substance defeasance is defined by the National Accounting Board (Conseil National de la Comptabilité) as a financial engineering technique enabling a company to obtain a result equivalent to the extinguishment of a debt appearing in its liabilities by means of a transfer of securities to a separate legal entity responsible for servicing the debt, (without any risk to the creditors), but this transaction does not legally free the company from its initial obligation.

This technique, as yet little used, as only approximately six such transactions are known to exist, was analysed by the National Accounting Board in its opinion No. 76 of December 1988, defining the conditions to be applied in order to ensure the security of the creditors.
  • - The transfer to the separate legal entity must be irrevocable,
  • thereby obliging the latter to repay the loans transferred.
  • - The assets transferred, assigned solely to the purpose of
  • servicing the debt, must be free of risk with regard to their
  • due date, the payment of the principal and interest and permit,
  • with the flows generated, to fully cover the servicing of the debt.

This technique is viewed as optimising indebtedness capacity and can frequently generate exceptional income or loss resulting from the difference between the face value of assets and liabilities simultaneously removed from the balance sheet (profit in the event of interest rates being higher than the rate of the loan issued).

It should be pointed out however, that this technique can sometimes be more costly than the mere repurchase on the market of the bonds since the guarantee to creditors requires the constitution of a risk-free asset portfolio, such as state or state-guaranteed bonds. Such bonds cost more to purchase, with the same level of return, i.e. the required rate allowing cover of the defeased debt.

For more information, please contact Olivier Drion or Ghislaine Mattlinger on 33 - 1 42 91 08 16.
For further information contact Olivier Drion on +33 1 4291 0606.
Copyright Mondaq Ltd +44 171 820 7733.