The Surety — Last-Resort Financing

By Hafez Daraee

Almost all federal and state public construction projects require the general contractor to provide payment and performance-surety bonds. A surety bond is essentially a financial guarantee that the principal, usually the contractor, can and will perform the work promised under a construction contract. If the contractor fails, the surety is jointly liable with the contractor for the owner's damages and for subcontractor and supplier claims. The surety's liability is limited by the amount stated in the bond (the penal sum), which is usually equal to the full contract price.

The surety's exposure to loss is covered by the indemnity agreement, by which its principal (contractor) promises to hold the surety harmless from any loss arising out of its default. The indemnity agreement is usually secured by property, equipment, cash, personal guaranties, and assigned contract proceeds. If the surety pays anything on account of a contractor default, including defense costs, the surety will expect a full recovery out of this security.

Although the surety's obligation is to protect the owner and contract vendors, a surety may find that helping the contractor avoid a default serves its own economic interests. The surety thus takes on another role — as a source of financing needed to help a contractor stay in business or to complete a project. There are both advantages and disadvantages to the surety.

Advantages to the surety include:

• The availability of other collateral owned by the contractor that can be offered as additional security to the surety.
• Continuing the project by the contractor who is most knowledgeable about it is often more cost-effective than bringing in a replacement contractor.
• Helping a contractor stay on the project helps ensure that the project continues, and potential damages associated with a job shutdown may be avoided.
• Financing a contractor can help the project toward completion, which in the long run will limit the surety's exposure to claims.

But disadvantages also exist. For example:

• Financing a contractor does not lessen the penal limit of the surety bond. In fact, assisting the contractor with financing may expose the surety to an even greater financial risk.
• The outcome of the project is often uncertain when a contractor is in distress, regardless of the financing source.
• The costs and complexity of the financing process itself are often a barrier.
• Financing can weaken the indemnity provisions between the surety and the contractor.

Because a surety bond default is not an event that happens suddenly, but rather one that rises and ripens over many months, by the time a request for financing is made, the surety is probably aware that some level of distress exists.

The process of considering a contractor's request for financial assistance begins with the surety's request for a voluntary letter of default under the indemnity agreement. This letter typically contains the principal's express admission of its inability to perform its remaining obligations under the contract. The authority for the surety to assist with the financing of a project is generally found in the text of the indemnity agreement. Ultimately, the decision to financially assist a contractor is solely up to the surety. Because a surety is protected by an often heavy-handed indemnity agreement, the contractor should consider the surety a source of absolute last-resort financing.

Contractors should understand that as part of the assessment criteria, the surety will look to the cash, capacity, and character of the contractor's principal. If a contractor is seeking financing from its surety, it should be prepared to answer some basic questions, like:

• Do I have any cash or other credit facility available? Have I tapped all potential sources of cash and credit, including advances from credit lines, receivables from unbonded contracts, real or personal property that can be liquidated, or cash from indemnitors?
• Do I have the technical ability to perform the work? Do I have the available management, supervision, personnel, and equipment to perform the work?
• Do I have the managerial and organizational competence to perform the work? Are my trade subcontractors willing and able to perform?
• Does my history of honesty, integrity, trustworthiness, and commitment to completing work support a positive decision to finance?
• What additional collateral can I provide?

When the decision to assist a contractor is made, numerous financing options become available to the surety, the most common of which are:

• The surety can lend money directly to the contractor.
• The surety can guarantee a loan made to the contractor by a third party.
• The surety can backdoor-finance the project — directly paying the obligations of the contractor.

Although the surety's lending decision often involves a complex cost-benefit analysis, the increased risks to the contractor should not be overlooked. The indemnity agreement is prepared so that in the event of any default, the surety has access to all the contractor's assets, as well as to all the assets of any personal guarantor. Thus the breadth of the indemnity agreement and the relentlessness with which a surety will pursue those who owe it an indemnity obligation are often sufficient to deter contractors from considering a surety as a potential funding source. But in times of economic distress, every possible source of financing should be considered, even with the additional risks it presents.

Published Summer 2008

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

BACK TO TOP | BACK TO ARTICLE INDEX | PRINTER-FRIENDLY PAGE