When conducting a surety bond, collateral is routinely utilized to protect the surety bond company from potential loss. This article will describe the different types of collateral that are typically utilized for surety bonds. Also, we will discuss some pros, cons and other issues related to using each type of collateral.
It may help to understand that all surety bonds have three parties: 1) Principal is the purchaser of the surety bond who is obligated to perform a duty. 2) Obligee is the recipient of the obligation that the Principal will fulfill. 3) Surety Bond Company provides a guarantee that the Principal will perform for the Obligee.
There are literally thousands of different types of surety bonds. Broadly speaking, the most common types of surety bonds are construction bonds, licensing bonds, and court bonds. Each kind of surety bond has its unique characteristics regarding collateral requirements. Some surety bonds always require full collateral. However, most surety bonds allow some discretion regarding the necessity of collateral.
Conventional Types of Surety Bond Collateral:
1) Cash Collateral: Cash collateral is the most common type of collateral utilized for surety bonds. Usually, the Principal will merely conduct a wire-transfer of funds from their bank to the surety bond company’s collateral account. Sometimes, the customer will write a cashier’s check to the surety bond company.
The downside to using cash collateral is that the customer loses the “opportunity cost” of using the funds for other purposes. The upside is that cash collateral is fast and simple to understand by all parties. Cash is the most secure form of collateral.
2) Irrevocable Letter of Credit (ILOC): The ILOC is a letter written by a financial institution guaranteeing the obligation of the bond. In essence, the financial institution is asserting to the surety bond company, “We’re backing the Principal for this surety bond.”
From the surety bond company’s point of view, an ILOC is a trustworthy collateral and fundamentally as secure as cash. The customer is required to have a strong relationship with their financial institution to qualify for an ILOC. As a practical matter, the average person often has a difficult time obtaining an ILOC because financial institutions want virtually 100% certainty, which is often problematic.
3) Real Estate: While riskier, surety bond companies may often be willing to accept real estate as collateral. The surety bond company essentially puts a lien on the real estate until the bond is exonerated (finished). Once the surety bond is exonerated, the surety bond company will file a “Full Reconveyance” which effectively dissolves the lien.
There are many risk considerations to contemplate when using real estate as collateral. For example, who owns the property? What is the value of the property? How much equity is in the property? Are their first loans? Second loans? Is the property in a Trust? Are their legal encumbrances related to the property? The answers to all of these questions, and more, will determine the viability of using real estate as collateral.
4) Retirement plans such as 401K plans, IRA plans. The IRS forbids retirement accounts being utilized as collateral. If you want to use retirement funds for collateral, the IRS suggests that you either take a loan from the retirement account or merely withdraw the necessary funds (which may involve an early withdrawal penalty).
5) Brokerage account (non-retirement). Individuals often maintain personal investment accounts that are generally made up of stocks, bonds, mutual funds, ETF’s and similar investments. Usually, an individual does not want to liquidate these investments, but rather, would like to use the existing investments as collateral for the surety bond.
Perhaps your financial institution can issue an Irrevocable Letter of Credit (ILOC). Or, some financial institutions may allow “securities based lending” whereby they process a loan utilizing your securities as collateral. Sometimes this can be finalized in a few days.
We suggest that you contact your particular financial institution to discuss possible options. Each financial institution maintains their unique programs.
4) Credit Card: In limited situations, some surety bond companies may accept credit cards as collateral. By using the credit card method, a “hold” is placed on the credit card; similar to the type of “hold” that a hotel utilizes to hold a reservation. The “hold” does not appear on the card holder’s monthly statement, nor is there interest charged to the cardholder. The “hold” can remain in place for months, even years.
5) Automobiles and other personal effects: Automobiles and personal effects are not acceptable collateral for most serious surety bonds. There are multiple pitfalls associated with utilizing personal items as collateral. For example, who is responsible for potential damage? Where will the personal item be stored? What about appraisal disputes? Who will pay for storage? What if the personal item is stolen? Who is the real owner of the personal item? In short, personal effects are generally sub-standard collateral.
In the surety bond industry, the most common form of collateral is cash. The second most common collateral is an Irrevocable Letter of Credit (ILOC). Utilizing other methods of collateral are generally explored on a case-by-case basis.
Surety bond companies will usually try to exhaust other options prior to mandating collateral. Generally, the first step when qualifying a customer is a review of their credit report. Those with favorable credit scores will usually receive better rates (premium) and more favorable collateral requirements. Depending on the type of bond, an underwriter might also be interested in seeing the Principal’s financial statements (balance sheet/ income statement) to determine financial capacity. Also, underwriters may be interested in the Principals specific industry experience and competence. Once the underwriter has reviewed the aforementioned items, they can determine the necessity of collateral.
We welcome any questions regarding your surety bond situation.