Defeasance..........................................................................................................................
S
tandard & Poor’s Ratings Services, on request,
rates legally defeased bonds and certain econom-
ically defeased bonds. A legal defeasance occurs
when the security lien of an indenture is released,
and the debt has been legally satisfied even though
the debt may not have been formally retired. In an
economic defeasance, an issuer sets aside sufficient
funds to satisfy debt obligations “in substance,” but
the debt is not legally discharged. The following cri-
teria apply for both insured and uninsured bonds.Legal Defeasance
In a legal defeasance, the trust indenture is replaced
by an escrow deposit agreement, which governs the
escrow of funds. The escrow has to be verified to
ensure its ability to make full and timely debt serv-
ice payments. Defeased bonds are eligible for ‘AAA’
ratings if the transaction meets Standard & Poor’s
criteria that addresses the legal structuring and
credit quality of the escrow. Additional criteria
must be met if a Forward Purchase Contract is
included (see “Public Finance Criteria: Forward
Purchase Contracts and ‘AAA’ Defeased Bonds”).Economic Defeasance
Economically defeased bonds of municipal issuers
and conduits may receive ‘AAA’ ratings; however,
typically, the highest rating assignable to the econom-
ically defeased debt of entities subject to Chapter 7
or Chapter 11 of the U.S. Bankruptcy Code or pub-
lic-purpose issuers (such as private colleges and uni-
versities, hospitals, not-for-profit corporations, or
other charitable institutions) is the existing rating on
the obligor’s long-term debt unless legal comfort
regarding bankruptcy issues is provided.Legal Defeasance Criteria
Standard & Poor’s reviews the following documen-
tation to analyze legally defeased transactions.
Escrow deposit agreement
Standard & Poor’s reviews the escrow agreement
to determine whether it establishes an irrevoca-
ble trust and has provisions addressing the fol-
lowing criteria:
■The escrow funds are invested in noncallable eligi-
ble securities (see “Public Finance Criteria:
Investment Guidelines”) that mature in amountssufficient to make full and timely debt service pay-
ments. The escrow agreement should specify that
reinvestment and substitution of the escrowed
securities also must be in eligible securities.
■All money and earnings are pledged to the pay-
ment of the refunded bonds.
■Provisions intended to protect the integrity of the
escrow are reviewed, such as limitations on the
active management of the escrow, whether excess
earnings and residuals revert to the issuer only
after the final principal and interest payment has
been made to bondholders and that neither the
issuer nor the obligor are responsible for funding
financial shortfalls in the escrow.
■If excess earnings or residuals are allowed to be
removed from the escrow prior to maturity or
earlier call date(s), Standard & Poor’s will look
to the rating or bankruptcy remote status of the
entities involved in substitution and reinvestment
procedures. Excess or residual earnings should
only be removed from the escrow after a bond
payment date and upon receipt of a report from
an independent third-party accountant that veri-
fies that the remaining funds will be sufficient to
pay debt service in a timely manner.
■Substitution of escrowed securities may necessi-
tate updated cash flow verification reports. If the
substitution is due to the maturity of the
escrowed security, then substitution into other
eligible escrow obligations will not require an
updated verification report. But if the substitu-
tion is of a non-maturing escrowed security, then
the substitution should be accompanied by an
independent third-party accountant’s report to
the trustee verifying the adequacy and accuracy
of the new cash flows.
■If not held uninvested, interest earnings should be
reinvested in eligible investments. However, we
will not rely on reinvestment income in calculat-
ing the sufficiency of the escrow for principal and
interest payments to bondholders.
■Only entities Standard & Poor’s considers bank-
ruptcy remote, escrow agent, or trustee may
direct reinvestment and substitution.Defeasance
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