What is a Death Clause?
A death clause in a loan agreement is a provision that stipulates what happens to amounts outstanding under the loan agreement in the event of death of the borrower. Some lenders will not provide loans without such a clause as it provides significant protection to them against loss of future amounts in the event that the borrower dies without settling the amounts remaining under the loan agreement.
Death clauses also provide protection to the borrower’s estate in the event that the insured event occurs. Most banks will require that the borrower take out life insurance to cover the outstanding balances on the loan agreement. The death of the borrower will mean that his or her estate will be released from any obligation to pay the amounts outstanding under the loan agreement as the bank will be entitled to claim the insurance proceeds from the insurer to settle the outstanding amount.
Insurers , however, will not pay over insurance proceeds to lenders which must be repaid in terms of a loan agreement, as the principles of unjust enrichment will prevent the insurer from paying the proceeds both to the estate and to the lender who has limited or no claim on the insured amount in terms of the provisions of the loan agreement.
How a Death Clause Applies in Loan Agreements
In the event the borrower dies before the loan is repaid, the estate of the deceased is obliged to pay the debt. Sometimes one or more of the estate’s assets will have been pledged as security for the debt at the time of the loan, in which case the lender may be entitled to recover the amount owing from the proceeds of the sale of the secured assets. However, the lender may have exercised his rights over some of the estate’s assets, and may be left with a shortfall. The lender, therefore, obtains a preference under the loan agreement. If, however, the deceased had pledged no security, or the value of the security was less than the debt owed, the lender must claim the shortfall from the heirs. The lender will take proportionate shares of the estate’s assets from each heir’s share. If the estate’s movable assets have been liquidated, the lender will take its proportionate share of the proceeds of liquidation. A lender will be entitled to claim from an heir an amount proportional to that which the heir would have inherited had the deceased died testate. Where two or more loans are made to a borrower by the same lender and the borrower has died (whether testate or not), the lender may set off the amount owed under the loans against the amount that the estate borrow from the lender may have had to repay to the lender under the Estate Debt otherwise would have been paid by the borrower’s heirs to the lender. The lender will set-off the amount owed to it by the estate against its claims under all those other loans. By way of example, the estate debt of the borrower is R 300000. The borrower has also borrowed R 2000 00 from the lender. The estate has R 400 000 available. If the R 200 000 is set-off against the estate debt, the estate will then only owe the lender R 100 000. The preference granted to the lender will be forfeited if the lender unreasonably delays in enforcing this right, causing appreciable loss to the heirs. Where the estate is insolvent, however, settlement of the lender’s claims is the priority beneficiary’s prerogative. The lender does not have an absolute right to set off the loan against estate debt.
What Do Death Clauses Mean for Borrowers and Lenders?
The inclusion of a death clause in a loan agreement can have significant implications for both borrowers and lenders. For the borrower, the death clause may result in the early onset of repayment obligations, potentially requiring the borrower’s estate or heirs to make payments on a debt that was initially designed to be manageable over a period of months or years. For example, a $5,000 loan due in six months could suddenly be payable in full upon the borrower’s death, leaving the borrower’s estate with potentially little time to raise the necessary funds or liquidate assets to pay the debt.
This death clause could be particularly problematic for a borrower whose estate would otherwise be exempt from most of the deceased’s debts under the administration of a dependent child’s estate. In such a case, a death clause would permit the lender to avoid the promise made by the borrower to defer payment of the debt until the estate is administered.
In cases of personal guarantee agreements, the death of the guarantor could result in the borrower losing access to credit (in amounts up to the personal guarantee). If the lender had relied on the creditworthiness of the guarantor as well as the borrower, the death of the guarantor could mean that the loan agreement becomes voidable at the option of the lender. In some circumstances, especially with a personal guarantee relating to a loan that was received in the form of a line of credit, the death of the guarantor would make the line of credit unavailable, thereby cutting off funding channels that had been relied upon by the borrower in the management of the business.
Similarly, a death clause could affect how administrators or executors of the borrower’s estate would deal with the loan where the collateral for the loan secured by the personal property of the borrower (including machinery, equipment, vehicles and other tools of trade) becomes an asset of the estate. The death clause permits the lender to demand repayment immediately, and it permits the inventor to take action to collect or require payment, which could involve seizing the associated personal property.
Even where the borrower’s estate is prepared to accept the transferred property subject to the encumbrance, the lender’s ability to demand repayment in full may mean that the estate may be forced to sell the property in order to make the payment, jeopardizing the estate’s interest in the property as part of the administration of the estate. In this respect, it is worth noting that the Uniform Personal Property Security Act (Canada) provides that personal property may be transferred to the estate subject to the security interest (where the security interest is registered) and that the estate thus becomes personally liable for payment of the debt out of the proceeds of any sale of the collateral where the collateral is sold within 6 months of the death.
For lenders, the presence of a death clause in the loan agreement may create the opportunity to mean financial loss on the loan agreement. The death of the borrower would trigger events of default, which could seriously derange the original lending objectives of the lender. In minimizing the lender’s risk, the death clause could also optimize the yield over the term of the loan by permitting the lender to demand repayment in full.
Of course, lenders ought to be prepared to assess the administration of the loan agreements by an administrator or executor. The extent to which a personal representative can be held personally liable and the mechanisms for dealing with loan agreements following a death could vary depending on the applicable provincial laws.
Key Legal Considerations and Legal Requirements
In addition to the informal practices, there are certain legal requirements regarding the death clause in loan agreements. The most important of these is found in the Land Registry Act. Section 52(a) states that a loan agreement with a traditional deadline does not pass title of the property until the debt has been paid off. This means that the loan agreement must have a formal deadline which passes ownership of the property from the buyer to the seller in order to be enforceable.
For example, suppose you and your partner take out a loan to buy an apartment, but with the agreement that you both own it once you have paid the loan. If you then default on the loan, the lender will not have the right to recover the flat from you. This is in direct contradiction with the goal of these clauses to make lenders feel secure that their borrowers have paid off their loans before they take ownership.
If you want to avoid these problems, the loan agreement could be worded to explicitly state that the death clause does not transfer title, giving buyers an ownership interest immediately from the start of the agreement. The threat of foreclosure can be used to secure the loan because the lender is more likely to be able to reclaim the property if it goes to the borrower’s estate instead of being passed to surviving family members or public authorities.
Changing or Negotiating Death Clauses
While the prospects of a party’s death may seem too unpleasant to consider, borrowers and lenders can—and do—negotiate the terms of a death clause. Of course, both sides to a loan agreement, including the debtor and the surety, will want the clause to be as favorable as possible. In doing so, the parties should look to impose certain obligations on the other that will not provide an unfair advantage in the event of death. And ideally, any death clause should have some reasonable period for compliance in a way that is fair to all parties involved.
Broadly, the lender will likely want some sort of notice that allows the lender to know when a particular party, whether debtor or surety, has passed away. Especially for any death clause running strictly against the debtor, the lender should want to ensure that the clause is specific and plainly states the obligation to pay , and that the clause contains no other unintended conditions in order to make the operation of the clause as streamlined as possible. For the borrower, and any surety, the parties would want the clause to provide a solution for the grieving family to carry out their obligations over time, with a remedy clearly spelled out in the case of a party’s death at any time in the future. In comparison, in the event of a debt of death, the lender would want to fall back on the estate and make special provision to work with the family to settle any obligations. In contrast to death of the debtor, if a surety dies, in most circumstances like that of a co-surety, the creditor is entitled to recover from the surviving surety even if the debt has exceeded the surety’s pro rata share. Negotiate for some limited benefit for your family.
Cases and Examples of Death Clauses
Here are some real-life scenarios to illustrate how death clauses have been applied both positively and negatively:
Scenario 1: Business Partner Agreement
In a scenario involving business partners, a death clause can serve as a legally binding agreement to protect the remaining business partner’s interest in the company. For example, a deceased partner might have left behind a widow who has a claim to deceased’s assets under the intestacy laws. Typically insurance company will provide a life insurance benefit in case of death; however in the case of death of a partner, this benefit might not be transferred to the remaining business partner. So the remaining partner might need to provide compensation (say from his own personal resources) to the widow.
Scenario 2: Real Estate Investment
In another example, real estate investors Matt and Jerry purchased several multi-unit apartment buildings. They had an operating agreement in place that included a death clause specifying that the surviving partner would acquire the ownership of the buildings if one of them died. While both partners intended to revise the operating agreement to decide upon an equitable ownership division, the terms of the document were not changed. Upon Jerry’s death, Matt inherited full ownership of the buildings—despite the fact that Matt was in a relationship that could have led to their possible marriage. The surviving partner questioned the validity of the death clause, but his request was denied by the court. Though the court found that Matt had intentions of changing the operating agreement after Jerry’s death, it ruled that the terms were clear as written and fulfilled its legal obligations in honoring them. A small portion of the ownership of the properties, however, was transferred to Jerry’s widow as part of the settlement.
Scenario 3: Divorce and Estate Planning
In a case involving spouses, divorce is an important consideration for the validity of a death clause. A couple, Ana and Jose, co-signed for a loan to purchase a sedan. Later, Ana filed for divorce and did not inform her creditors of this development. As such, Jose was unaware of the ongoing court proceedings. When Ana passed away in a car crash, her estate was held responsible for the loan payment and Jose then received over $10,000 as a result.
Scenario 4: Claims Against Estate
Less than 30 days after Anna filed for divorce, her estranged husband passed away. His creditors claimed multiple debts against his estate, which triggered an involuntary conversion (liquidation) of the assets. Anna, being the named beneficiary of her ex-husband’s life insurance policy, received $5,000 in benefits. Because Anna filed the divorce papers within 30 days of her husband’s death, she has no further claims to his estate.
Tips for Borrowers: How to Best Protect Your Estate
If a death clause is triggered, the bank will not be able to take further steps unless the surviving borrower (or the estate) takes action to have the debt acknowledged and made payable to the bank by the estate. There are a few things a borrower can do to limit the impact of this clause on other stakeholders. These include:
- Keeping your personal records organized – If you like to keep your personal financial records organized, you’ll be doing your beneficiaries a huge favor. It may seem tedious to create an index and label important documentation, but lack of preparation increases the time and cost of validating the loan after your passing.
- Naming a personal representative – A personal representative can handle your affairs after your passing with the relevant financial institutions.
- Paying off outstanding debts – Any outstanding debts should be paid off while you’re still alive. Lenders may be more likely to waive prepayment penalties in these situations.
- Reassessing your loan options – If you have paid off some of the loans, have a substantial cash reserve, and/or have other liquid assets, consider reinsuring your life CMHC or mortgage default insurance. Life insurance can pay off all or a majority of your debts, which is a viable estate planning tool. However, you may also find you no longer need as much insurance as you once did.
- Updating your beneficiaries – Some lenders will improve your credit score if you name a beneficiary as the primary-insured. Check with your lender to see what kind of policy they have in place.
Expert Advice and Myths Surrounding Death Clauses
Practitioners on both sides of the closing table offered a variety of opinions concerning death clauses. The most important factor, on both the lender and borrower side, is notification. "If the lender has no clue what’s happened to you, there’s a tendency to assume you may have fallen off a cliff somewhere," said one practitioner. Another practitioner remarked there are no uniform policies or best practices relating to notice or how long after a specific event the lender should be alerted of a death.
On the buyer/borrower side, an expert remarked that sometimes banks know before the client and may not provide notice of its rights. For example, if a guarantor died before the loan closed and the lender had notice, it would not want the deal to have the appearance of a Houdini act. It would have to decide how to proceed especially when the death has not been publicly reported.
Lenders and borrowers both can be susceptible to certain misconceptions. A key misconception for lenders is that a death has occurred. A key misconception for borrowers is that there is no prior obligation to notify a lender , so the lender does not have an obligation to give a notice. Lenders’ handling of death clauses should be driven by a rational response to the risk.
An expert on the borrower side suggested that if a seller, even a controlling shareholder, dies, it does not cause the assets to dissipate and the lender has to be armed with knowledge about exclusion and inclusion in the carve-out. If the death is caused by the delinquent borrower and the seller’s death underscores the danger to collateral, that creates an issue. But where there are multiple controlling shareholders, the death of one will not have the same effect, especially where there are multiple members/owners whose death would create a material adverse consequence.
A borrower expert stated when a buyer is using a life estate, the lender should do due diligence and make disclosures about potential problems and portfolio risks. The terms of a death clause require a notice for a death, and the clause states who must be provided, but it does not require information (it is a bare notice provision). The parties should clearly explain why they decided to include the clause so the parties understand the significance when negotiating it.