Debt reduction cover is one of the various types of insurances that business owners and businesses themselves often have in place as a precaution against the sudden or unforseen departure of key personnel from the business.
Often this insurance is held by the departing party (self-insurance) because of the tax advantages that are available.
Potential problems with commercial debt forgiveness and debt reduction cover
Take the situation where the trading entity has a bank overdraft and the agreement between the business partners (or shareholders or unit holders) is that if Partner A exits, he will pay out the business debt.
So Partner A takes out debt reduction insurance and upon his death, disability or trauma occurring, the debt is paid out through a payment made directly by the existing Partner A (or his estate) to the Bank.
Some advisors argue that this scenario results in the debt still existing because all that has changed is the identity of the creditor. They argue that whilst the bank has been paid, new legal rights arise between the business and Partner A (now argued to be the new creditor) because the payment by Partner A is similar to the repayment of a debt by a guarantor.
Alternatively, Partner A may take out debt reduction insurance and upon his death disability or trauma occurring, the amount of the insurance proceeds sufficient to pay out the bank debt of the business is agreed to be paid to the business entity, which has agreed to pay out the bank with those proceeds.
Again, some advisors argue that this scenario still means that the identity of the creditoris all that has changed and that the business still has the same overall debt. It is just that the debt is owed by the business to Partner A, instead of the bank.
The reality of such arguments
The above arguments, in our view, raise problems that do not exist. The analysis is misconceived.
The fact is that stand-alone commercial guarantees no longer exist. Every commercial guarantee which has been used in transactional work that we have seen in the past 20 years includes an indemnity as well.
All that has been done under the above scenarios is to vary the earlier obligation of Partner A to make the payment when he dies, or becomes totally and permanently disabled or suffers a trauma event, as opposed to when a default under the facility occurs.
There is no separate contractual obligation to repay the debt because it is already payable.
In the unlikely scenario where there is no indemnity (just a guarantee), Partner A has a contractual obligation to pay the money, and its payment is performance of a contractual obligation, not an issue of debt forgiveness.
If there is a payment, it is necessary for a provision to be inserted into the paperwork for the bank (if it receives the money directly) or the business (if it receives the money directly) to be bound to release Partner A (or their estate) on the payment being made. Otherwise, Partner A (or their estate) could pursue the bank or the business (as the case may be) for the amount paid by Partner A (or his estate).
Good business practice should ensure that if Partner A (or their estate) just pays their share of the business’ indebtedness, then the continuing partners (or shareholders or unit holders as the case may be) indemnify Partner A (or their estate) from any claim for the balance still outstanding.
Good legal advice requires clear legal thinking.