CFM11170 - Understanding corporate finance: raising finance: transferring debt by assignment or novation

Transferring debt

Assets

Where a debt is evidenced by a security (see CFM11140) the debt is easily transferred, subject to any limits that might be included in the terms of the security. Where a security is transferred, the borrower’s position is essentially unchanged, it is just that payments of interest and any repayment of principal that may become due simply goes to the holder at the time. Often an intermediary will manage the payments between the issuer of the debt security and the beneficial owner.

If no security has been issued and the terms of the debt are documented in a contractual agreement between lender and borrower, or more informally, the transfer is likely to involve some contractual arrangement between the lender, the purchaser of the asset and the borrower. It is possible that the terms of the lending agreement to permit a transfer of the asset, but if transfers are envisaged, it is more likely that a security will be issued and the terms of the security will be agreed in a bilateral agreement between the original lender and the borrower. Where the terms of the loan do not permit transfer, the parties will have to alter the terms of the original loan to make this possible.

If the transaction is simply the transfer of a debt security from one owner to another or a contractual transfer of the lender’s rights to another party, this is known as an assignment. Consideration for the assignment will pass from the new creditor to the old creditor.

Less often, a tripartite agreement may lead to the creation of a new debt albeit on the same terms. This is known as a novation. The consideration passes directly from the new creditor to the old. Yet another possibility is that the borrower agrees with the original lender to repay the original debt early using funds advanced by a new lender. This also creates a new debt.

Liabilities

The transfer of a debt liability by a borrower is not so straightforward. The transfer of a liability, or another obligation, is normally achieved by way of novation. Novation is a way of transferring the duties under a contract from one party to another. While it is possible to novate an asset it is much more common for the transfer of an asset to be by way of assignment.

The original debt may include provisions to enable the borrower to change in the future. These provisions might take the form of a substitution clause. Such a clause might be included at the insistence of a lender so that it is possible to transfer the obligation if there is a change in the ownership of the borrower company or a transfer of the trade of the borrower company. In this way the creditor company can protect itself from changes brought about by the borrower’s group. The obligation of the new debtor will be a new debt.

Where there is a transfer of a debt liability the change will be sufficient to bring in a new debt into existence. Where there is no prior agreement in the form of a substitution clause such a change will require the consent and agreement of all the parties to the contract. The lender, the old borrower and the new borrower must agree that the substitution can take place. The lender releases the old borrower from its obligations under the contract. The lender does this in return for getting a new asset, the new debt. The new debt is the new contract between the lender and the new borrower.

Defeasance

Sometimes a debtor will make a ‘defeasance’ payment to some other party in return for which the party will meet the debtor’s obligations under the debt, on its behalf. This does not have the same effect as a novation, because the original debtor is still legally on the hook if there is a default by the person to whom the obligation was defeased. In such a case, the creditor has not consented to the transfer of the obligation, whereas under a novation the old debt is extinguished and a new one created.