S&P - Public Finance Criteria (2007). - The Global Clearinghouse

DefeasanceDefeasanceStandard & Poor’s Ratings Services, on request,rates legally defeased bonds and certain economicallydefeased bonds. A legal defeasance occurswhen the security lien of an indenture is released,and the debt has been legally satisfied even thoughthe debt may not have been formally retired. In aneconomic defeasance, an issuer sets aside sufficientfunds to satisfy debt obligations “in substance,” butthe debt is not legally discharged. The following criteriaapply for both insured and uninsured bonds.Legal DefeasanceIn a legal defeasance, the trust indenture is replacedby an escrow deposit agreement, which governs theescrow of funds. The escrow has to be verified toensure its ability to make full and timely debt servicepayments. Defeased bonds are eligible for ‘AAA’ratings if the transaction meets Standard & Poor’scriteria that addresses the legal structuring andcredit quality of the escrow. Additional criteriamust be met if a Forward Purchase Contract isincluded (see “Public Finance Criteria: ForwardPurchase Contracts and ‘AAA’ Defeased Bonds”).Economic DefeasanceEconomically defeased bonds of municipal issuersand conduits may receive ‘AAA’ ratings; however,typically, the highest rating assignable to the economicallydefeased debt of entities subject to Chapter 7or Chapter 11 of the U.S. Bankruptcy Code or public-purposeissuers (such as private colleges and universities,hospitals, not-for-profit corporations, orother charitable institutions) is the existing rating onthe obligor’s long-term debt unless legal comfortregarding bankruptcy issues is provided.Legal Defeasance CriteriaStandard & Poor’s reviews the following documentationto analyze legally defeased transactions.Escrow deposit agreementStandard & Poor’s reviews the escrow agreementto determine whether it establishes an irrevocabletrust and has provisions addressing the followingcriteria:■ The escrow funds are invested in noncallable eligiblesecurities (see “Public Finance Criteria:Investment Guidelines”) that mature in amounts■■■■■■sufficient to make full and timely debt service payments.The escrow agreement should specify thatreinvestment and substitution of the escrowedsecurities also must be in eligible securities.All money and earnings are pledged to the paymentof the refunded bonds.Provisions intended to protect the integrity of theescrow are reviewed, such as limitations on theactive management of the escrow, whether excessearnings and residuals revert to the issuer onlyafter the final principal and interest payment hasbeen made to bondholders and that neither theissuer nor the obligor are responsible for fundingfinancial shortfalls in the escrow.If excess earnings or residuals are allowed to beremoved from the escrow prior to maturity orearlier call date(s), Standard & Poor’s will lookto the rating or bankruptcy remote status of theentities involved in substitution and reinvestmentprocedures. Excess or residual earnings shouldonly be removed from the escrow after a bondpayment date and upon receipt of a report froman independent third-party accountant that verifiesthat the remaining funds will be sufficient topay debt service in a timely manner.Substitution of escrowed securities may necessitateupdated cash flow verification reports. If thesubstitution is due to the maturity of theescrowed security, then substitution into othereligible escrow obligations will not require anupdated verification report. But if the substitutionis of a non-maturing escrowed security, thenthe substitution should be accompanied by anindependent third-party accountant’s report tothe trustee verifying the adequacy and accuracyof the new cash flows.If not held uninvested, interest earnings should bereinvested in eligible investments. However, wewill not rely on reinvestment income in calculatingthe sufficiency of the escrow for principal andinterest payments to bondholders.Only entities Standard & Poor’s considers bankruptcyremote, escrow agent, or trustee maydirect reinvestment and substitution.www.standardandpoors.com57