When construction companies and homebuilders embark on a project, they are confronted with a myriad of risks that can profoundly impact timelines, budgets, and overall project viability. One of these risks comes in the form of financial assurances, where the contractor or homebuilder guarantees performance of an underlying obligation to their client.
Surety bond agents help clients provide bonds to satisfy their financial assurance requirements. And, where allowed, construction companies also utilize bank letters of credit or cash.
This article details how a blending of some of the best aspects of surety bonds and letters of credit can offer a new, advantageous solution for contractors, homebuilders, and developers facing financial assurance requirements.
Surety Bonds vs. Letters of Credit
As detailed in Exhibit 1, there are pros and cons to surety bonds and letters of credit, usually depending on the relative position of the transacting parties. In using surety terminology, the principal is the contractor, homebuilder, developer, etc., and the obligee is their client (often a municipality).
Surety bonds are generally preferred by principals because they are typically unsecured credit instruments and backed only by a general indemnity agreement, which allows the supporting surety carrier to recover losses from corporate and personal indemnitors. Conversely, a letter of credit is typically secured through restricted cash or a draw on an existing line of credit. This reduction in liquidity or banking capacity is a strong deterrent to using letters of credit as financial assurances.
Surety bonds are also off-balance sheet financial instruments, as open bonds are not considered liabilities. On the other hand, outstanding letters of credit are reflected on corporate balance sheets and negatively impact working capital and equity calculations.
Another key aspect of suretyship is its three-party arrangement. When a surety carrier supports a bond, it does not automatically side with the claimant, as sureties have a duty to investigate all claims. When a claim occurs, the surety requests proof of default from the obligee and works with the principal to identify defenses that lessen or completely avoid losses.
Carriers generally only pay claims when the obligee has adhered to its obligations within the underlying contract or agreement. The carrier can defend and support the principal in the event of an improper default or termination. In comparison, letters of credit have on-demand payment clauses, ultimately requiring banks to pay claimants without defending its principal.
The merits of surety bonds vs. letters of credit can be reasonably debated, and there are situations that are better suited for each party. Traditionally, public project owners (such as federal, state, and city/county governments) have allowed for surety bonds, as the surety industry has done well in not just providing financial assurance for public work projects, but also by providing the expertise and resources needed to successfully complete projects with replacement contractors.
Traditional Contractors vs. Developers & Homebuilders
Construction companies are well-practiced in forming bond programs and going through the underwriting process; developers and homebuilders face a different decision matrix. First, private commercial construction can often be executed without any financial assurance, especially when it is tenant finish or in-fill development. As such, many developers do not need bond programs.
Once a developer or homebuilder expands to subdivision work — where it’s responsible for streets, sidewalks, and sewer systems — municipalities will often require security to ensure the project will be completed. A half-built subdivision is worse than undisturbed land, as it is more expensive to reallocate the land to other users.
Developers typically have robust banking relationships but are also consistently facing liquidity constraints as it looks to produce returns for investors. Developers also commonly have complex and disparate financial conditions, with single-purpose entities accounted for separately and not compiled by an independent CPA company. This deficiency in financial reporting can make it more difficult for developers to obtain a surety program.
During the Great Recession, many municipalities found the surety claims process too onerous and have opted to only allow for letters of credit or cash security. In this situation, the municipality gains protection against nonperformance, and unpaid subcontractors and suppliers are left to the mechanics lien process or the court system to find recourse for nonpayment.
Additionally, as compared to surety carriers, in recent years, more banks have failed or gone out of business. As such, some municipalities may start to rethink their approach of only accepting letters of credit.
Other Scenarios Requiring Financial Assurances
Energy & Commodity Producers
For energy and commodity producers such as oil, gas, and mining operations, the required reclamation security ensures that land disturbed from such activities is reclaimed and returned to its original state.
Due to the long-term nature of these operations, the associated financial assurances are typically noncancellable. Surety carriers are loath to underwrite such perpetual arrangements, and the availability of reclamation bonds is extremely limited. As such, energy producers will often instead post cash or letters of credit.
Large Companies
In another use case, large companies often form supplier agreements. For example, if a distributor purchases products from a supplier daily but forms a credit agreement that only requires payment for the product every week or month, then, depending on the volume purchased, these credit agreements can be quite large. Unfortunately, the suppliers often only allow for a letter of credit to back up the credit line.
International
On the international front, bank instruments are more commonly utilized for financial assurances than surety bonds, however, this trend is reversing. In 2021, the total U.S. premium for surety bonds was $6 billion; on the other hand, it was $16 billion worldwide (excluding the U.S.).
Premium volume is expected to experience an annual growth rate of 6.4% over the next five years, culminating in $25 billion of written premium by 2027. It can be expected that surety bonds will continue to grow in popularity in international economies.
Surety-Backed Letters of Credit
The surety-backed letter of credit (also known as a bank-fronted surety bond) as a financial instrument has been in existence for over a decade but has only recently garnered widespread support from surety carriers. It utilizes both a bond and a letter of credit to capitalize on some of the best attributes of both instruments.
How It Works
The principal (contractor, homebuilder, etc.) sets up a bond program with a large, reputable surety carrier and signs a general indemnity agreement. The carrier then works with a partner bank and provides a counter-guarantee for a letter of credit that the bank supports. The bank can then submit the letter of credit to the obligee (the principal’s client) by means of the Society for Worldwide Interbank Financial Telecommunication (SWIFT) or an original document.
For the obligee, the surety-backed letter of credit maintains the on-demand payment language coveted. For the principal, since the letter of credit is backed by a surety bond, there is no restricted cash or reduced banking capacity. The commitment is also not reflected on their balance sheet.
The rate structure combines charges for both instruments, which is typically 2% for the bond and 0.3% for the letter of credit.
The obligee usually requires that the letter of credit be issued by a U.S.-domiciled bank or an American branch of an international bank. The bank also needs to be highly rated and considered investment grade.
And lastly, due to the number of parties involved, the issuance of a surety-backed letter of credit can take several weeks.
The Appleton Rule
The Appleton Rule is another consideration, named after Henry Appleton, an early 20th century New York deputy superintendent of insurance.
According to the Appleton Rule, all insurers licensed in the state of New York abide by certain provisions of the New York Insurance Code, no matter where they are headquartered and doing business. Specifically, New York law provides that only monoline insurers are eligible to write financial guarantee instruments or credit enhancement products.
The Appleton Rule’s scope regulates financial guarantee instruments across state boundaries, giving New York insurance officials the authority to annul insurance licenses if any financial guarantee instrument violates New York regulations. With this rule, large multiline insurers have been put in a difficult position, as they want to avoid the potential catastrophe of losing all insurance business in New York.
Some carriers take a conservative approach to bonding any obligation that could be considered a financial guarantee. That being said, there are exceptions and ways to adhere to this regulation.
First, as long as there is an underlying performance obligation on the part of the principal (such as completing construction or delivering a product), a carrier can write a financial guarantee bond.
Further, the New York Insurance Code carves out exceptions for multiple types of financial guarantees written by multiline insurers, including appeal bonds, payment bonds, some lease bonds, and any financial guarantee instruments with an aggregate amount of less than $10 million. Use of the $10 million exception requires special language in the bond form, and it is entirely unavailable if the bond is to be issued in connection with the sale of securities, a pooling arrangement, or a credit default swap.
Use Cases
Middle-Market Homebuilders
Middle-market homebuilders that are required to post subdivision or site improvement financial assurances with municipalities that do not allow for surety bonds are ideal users of surety-backed letters of credit.
The surety-backed letter of credit combined rate will likely be higher than the rate of a letter of credit that they could obtain directly from their bank, but the tradeoff is that the homebuilder does not have to maintain cash in a restricted account.
The math that needs to be considered is the delta between a surety-backed letter of credit rate of 2.3% and the homebuilders’ standard letter of credit rate, when compared to the value of liquidity.
Entities Backed by Private Equity
Another key user would be an entity that is backed by private equity. The costs of bank debt are typically high for private equity-backed operations so replacing a standard letter of credit with a surety-backed letter of credit becomes doubly attractive.
The caveat though is that private equity-backed companies can often experience difficulties when obtaining bonding programs due to their highly leveraged balance sheets and lack of personal indemnity.
To garner more surety support, private equity-backed companies need to show a business plan that reflects stability and continual positive cash flows.
Other Considerations
Some surety carriers are simply not set up to issue surety-backed letters of credit or do not have an appetite for this type of risk. Typically, only very large carriers can provide a bank with a suitable counter-guarantee.
Further, some carriers only allow for a narrow selection of obligations to be guaranteed, such as insurance deductible financial assurances, which is concerning because that specific obligation is considered hazardous compared to other more typical bond types.
Claims scenarios with surety-backed letters of credit utilize the aspects of both financial instruments. The supporting bank will pay a claim to the obligee on demand, the surety then reimburses the bank, and finally, the surety looks to the principal for indemnification of its loss.
Surety-backed letters of credit can also be used to minimize the purchase of trade credit insurance. Credit insurance is purchased by an obligee/end user to protect against nonpayment of receivables due by the principal. While bonds, letters of credit, and surety-backed letters of credit create risk for the principal, with credit insurance, the risk of nonpayment lies with the obligee and its insurance carrier.
If the principal wants to increase its available credit facility, then it has to rely on the obligee to purchase higher limits of insurance. If the principal instead provides the financial assurance, then it can maintain more control over the available credit facility limit.
Lastly, due to the amount of administrative work involved, surety carriers are not interested in supporting surety-backed letters of credit that will have excessive limit changes. Typically, only one or two adjustments to the limit are allowed per year.
Conclusion
Surety-backed letters of credit could prove advantageous to homebuilders and developers, as well as energy producers and large commercial contractors. They provide many of the positive attributes of both letters of credit and surety bonds without some of the negative aspects.
As more surety carriers and banks develop partnerships, the use of surety-backed letters of credit will grow, and this growth will only be further driven by forward-thinking surety agents and underwriters.
Tom Patton is the President of Evergreen Surety (evergreensurety.com), an independent surety bond agency that supports clients throughout the U.S. and Canada, in Denver, CO. With relationships across a wide range of surety carriers, Evergreen Surety obtains bonds for contractors, homebuilders, developers, and energy producers. Tom has been an active member of the CFMA for 10 years, as well as a previous board member of the Associated General Contractors of Colorado and the Rocky Mountain Surety Association. He can be reached at [email protected].
