Performance bonds: how to avoid collateral

This is an annoying topic. Not because surety bond collateral is inherently bad, but because it is a subject of great fear for contractors and their underwriters/guarantors. For example:

  • Why does the bonding company take money from me if they can see Am I in a weak cash position? I need it to successfully execute the new project.

  • Won’t you pay me interest on the money? Why not?

  • When the job is half done, you don’t release part of the collateral?

  • You do not release the collateral upon acceptance / completion of the contract?

  • You only release the collateral when the warranty period expires?

  • etc. A lot of aggravating phone calls and emails.

With all this annoyance ahead, why are some bond companies asking for collateral? The reason is to protect itself in the event of a bond claim.

When a breach of contract occurs, the claims department hopes to have two reliable sources of financial recovery:

  1. The unpaid balance of the contract goes to the security deposit when they complete the work

  2. The guarantor summons the applicant/company and its owners to recover the damage

Collateral requirements arise when the guarantor wants to have it security. When a problem arises, they don’t want to find out that the customer has run out of money, or they’ve gone bankrupt…or left the country. If they have to write the bond, they want one guaranteed way of financial recovery.

Keeping in mind that collateral is a high price for a bond, let’s look at an alternative approach that helps the guarantor but doesn’t take a big bite out of the contractor!

“Retainage” is money that the project owner withholds (keeps) to ensure the final completion of the project and the payment of related bills. If the retention is 10%, the contractor will receive 90% of the money owed to him as the job progresses. At the end, the contract owner/creditor will still hold 10% to keep the contractor interested in achieving full, satisfactory completion. In this way, the retention money protects both the creditor and the surety – making a bond claim less likely.

“Surety Consent to Release of Final Payment” is a voluntary procedure that obliges may use as a courtesy to the surety. The last bit of contract money can be a useful lever to get the contractor moving for final contract adjustments. There may be cracks in the building, broken glass, faulty light bulbs, painting mistakes – little things that the creditor cares about but the contractor finds tedious to correct. The surety clearance is another way for the bonding company to avoid a claim. “Resolve this issue or we won’t agree to release your final payment.”

How can these two useful tools be integrated to ensure they help the surety and thus replace the need for collateral?

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The answer is to add a condition to the bond (obliged compliance required by the creditor) stating that there shall be no release or reduction of the advance or final payment without the surety’s prior written consent. Now the bond company is guaranteed to have a financial resource available and the amount is known in advance – just like collateral. But the contractor didn’t have to drain the company’s bank account to achieve this: Win win!

What if the contract terms do not provide for a retention procedure? One can be added by contract change. If Funds Control (an escrow agent) is used to handle the contract payouts, a retention procedure can be added to the Funds Control agreement.

Keep this alternative procedure in mind if your bond insurer needs help being more creative with the insurance solution.

Speaking of fund management, check out our article “Performance Bonds: How to Avoid Fund Management” next week.