What role does collateral play in surety bonds? In this article, we take a look at the types of collateral that sureties may accept, the right time to release collateral, what happens to collateral if you change sureties, and why collateral may be necessary for riskier bonds.
Collateral refers to a security deposit the Principal (bond applicant) provides to the Surety (Bond Company) to be approved and issued a bond that is rather difficult to achieve. The collateral aims to reduce the surety's risk and exposure and makes supporting the bond more favorable.
When requiring collateral, the surety will consider the following:
- Acceptable type of collateral
- Required collateral amount
- Time of release of collateral
- Form of protection for the collateral
What are the types of collateral?
There are several types of collateral that sureties may accept.
Here are the most common forms:
Irrevocable Letters of Credit (ILOC)
Considered to be the safest form of collateral, these letters are often issued by a commercial bank. ILOC also called a Standby Letter of Credit, is awarded based on the financial standing of the bond applicant. These letters serve as a private contract between the bank and the surety, with the surety acting as the beneficiary.
Upon demand, the ILOC indicates that the bank will pay the surety up to the face amount of the letter. The payments are documented as the bond applicant’s loan. Sureties may conduct audits and review a bank’s internal financial analysis to ensure that the bank is not at risk of failure. When the surety company experiences a bond claim or loss, it can receive immediate recovery through the ILOC they hold. This collateral protects them from failure or collection (subrogation) setbacks.
Most types of collateral accepted by the surety (except ILOC) are subject to the rules of the bankruptcy courts. Under Section 547 of the Bankruptcy Code, most transfers or payments are made “on or within 90 days before the date of the filing of the petition” and may be recalled for the benefit of the bankruptcy creditors.
Certificates of Deposit (CD)
A Certificate of Deposit is used as a short- or long-term investment. Local banks may provide Federal Deposit Insurance Corporation (FDIC)-insured CDs with higher return rates than other investment options. With this collateral, the bank retains money for a specific length of time with the guarantee to repay the surety and interest to the depositor at the end of the investment term.
The CD account’s aggregate limit must not exceed the coverage provided by FDIC to ensure that the failure of the bank does not reduce the collateral below the required limit.
Fixed assets, such as real property, can be a form of collateral if they undergo professional appraisal, has adequate insurance, and free of encumbrances.
Are there any other documents required for the collateral?
Sureties may require collateral receipts that hold the principal’s name if, and when, collateral will be returned. Sureties also may call for a pledge agreement, in addition to a general indemnity agreement, to secure repayment of a debt or obligation.
A general indemnity agreement indicates that the surety is provided with acceptable evidence that it has been released from all liability under its bonds and that the surety will have sole decision-making discretion.
General indemnity agreements, collateral receipts, and pledge agreements contain specific conditions for the release of collateral.
When is the release of collateral?
Sureties will not release the collateral until they are cleared of all bond obligations. This is often a subject of disagreement between the principal and the surety as to when it is the right time to release the collateral.
In construction or fiduciary/probate duties, sureties will not partially release half of the collateral even if half of the job is finished. The job and obligation should be completed at all costs and must meet the conditions specified in the bond contract. To avoid risks and for security purposes, sureties will hold the entire collateral until the end.
“The End” is not at the end of every project or court-appointed obligation as the principal may assume. For example, in construction, there is a maintenance bond where the surety may require that collateral be held until the maintenance period has concluded. The surety is equally obligated for the duration of the lien period, which can run for 90 days after work completion.
Here are some scenarios where sureties are unwilling to issue surety credit to principal unless they receive collateral supporting the bond application/request:
- Onerous bond conditions
- Unsupportable underlying obligations
- Unsatisfactory financial strength and capacity of the principal
- Obligation period is too long
- No bond cancellation provisions
What happens if you change sureties?
Concluding a collateral relationship can prove difficult, particularly if a series of bonds (like bid, performance, or payment bonds) have already been issued. It is easier to use collateral funds with the old surety than move to a new non-collateral surety.
Even if the principal starts receiving bonds from a new bond provider, the collateral will remain in place until bond obligations are exonerated. Though more beneficial conditions are available, this can be a deterrent and may impact your surety relationship in the long run.
Importance of collateral
For riskier bonds, the sureties will often require collateral. Collateral is regarded as a “last resort” payment or credit, and you may want to avoid it. But if it’s not a burden, then it may be necessary to secure collateral in some cases. For instance, you may have a weak business financial statement, but you have other financial resources.
Surety underwriters may look into the case if the collateral requirement makes it impossible or problematic for the principal to work on a project or perform contractual or court-appointed obligations.