Surety as a Risk Management Resource

Surety is required in public works contracts by legal statute, but often considered a necessary evil by contract administers and a barrier to opportunities for many companies, particularly small business or companies engaged in emerging technologies.

For administrators the complexity of making a claim and the unresponsiveness of the surety given the burden of proof to document a default often has surety ignored as a viable risk management tool when not required by law.  For those that seek opportunities where surety is seen as an obstacle, the underwriting requirements that support only “pig iron under water” make the surety experience a frustrating endeavor.

As the quality and access to data continues to improve as a result of data interoperability (see box), along with the emergence of data interoperability enabled performance measurement and predictive analytics, so too does the ability of the surety industry to develop innovative products and services like Surety Based Risk Management that not only address some of the perception issues, but can significantly contribute to the due diligence and financial viability of entering into contracts as a viable risk management resource.

XBRL Extension for Construction, Energy and Transportation  

Distinction of Surety as a Risk Management Resource
The objective for risk management departments, and lenders, is to identify risk factors that create a material financial exposure and to seek ways to mitigate if not remove the risk.  This is accomplished by enacting policies and procedures that reduce the potential of a loss due, plus purchasing insurance to reimburse for exposures that are outside the ability to control, such as fire, theft and unanticipated liability exposures.

One area that creates a material financial exposure that is generally outside the ability to control is counterparty default under a contract, where the impact of a default creates delays to critical capabilities and negative financial ramifications, such as construction of a new facility or the delivery of needed raw materials, and imposes the necessity to assume the contract where there is insufficient internal expertise to cure the default, or to re-let the contract causing extensive cost overruns. 

As a lender financing companies that have counterparty risk for contract default the ability of the borrower to absorb and manage a counterparty default is an underwriting and due diligence consideration.  The more a borrower can insulate themselves from counterparty risk the better.

A distinction is that surety manages counterparty default risk far beyond just a financial payment.

Surety is not insurance, which is risk transfer and provides for reimbursement of a loss.  Surety is a credit product where the surety becomes a co-signer and relies on risk retention by the entity being bonded, where a loss is subject to recovery action.  As co-signer the surety is provided rights and remedies that enable them to assume the contractual obligations under a default to step in and complete the contract. 

Having a counterparty bonded is risk transfer to the beneficiary of the bond because it can provide stakeholders with financial resources and expertise that will not only respond to a counterparty default, but manage that default more efficiently given the various legal structures that facilitate a surety’s rights and remedies as it relates to assumption of the underlying bonded contract for the purpose of curing the default.

The surety obligation to cure a default is unique and different from other forms of financial guarantees, such as the traditional letter of credit.  While the “on demand” nature of a letter of credit has the benefit of liquidity, it also has the burden of responsibility and exposure to a banks foreclosure action against the counterparty.

The surety assumes the responsibility and obligations of the defaulted counterparty to cure the default, and they also relieve the contract administer of the many issues and challenges that accompany a default.

In the event of counterparty default the surety cures the contract, and the bank forecloses on the counterparty.

Surety is appropriate where a counterparty default creates an internal need to cure the default with a level of expertise and activity that is outside the normal scope of operations.

Surety is not generally appropriate or available where a counterparty default is simply a matter of a financial payment obligation with no option to cure and/or the underlying contract is not assumable, such as credit enhancement or pure financial guarantee.

Considerations for Risk Management Departments
Does the additional underwriting and qualification process of a surety contribute to the due diligence effort for contracting with a counterparty?

If there is a counterparty default does your entity have the expertise to assume the prime contract to completion and deal with the various third party claims?

Is the counterparty on the prime contract subject to second tier contractor or vendor default beyond their ability to assume those obligations without affecting the prime contract?

If the counterparty defaulted on the prime contract would their subcontractors, materialmen or vendors have lien rights or other causes of action against your entity or property?

If the counterparty defaulted would the preferred outcome be a qualified replacement to assume the contract to completion, or would the activity be discontinued.

In the event of a counterparty default would it be preferred to administer funds received under a letter of credit draw, and protect those funds from other creditors, or to tender the issue to a surety to let them handle completion, creditors and third party claimants.

Considerations for Investors and Lenders
Does the additional underwriting and qualification process of a surety contribute to the due diligence effort for underwriting the investment or loan?

If your borrower has a counterparty default do they have the expertise to assume the prime contract to completion and deal with the various third party claims?

Could your borrower be exposed to second tier subcontractors, materialmen or vendors having lien rights or other causes of action against the entity, asset or property that secures the loan?

If the borrowers prime contract counterparty defaulted would the preferred outcome be a qualified replacement to assume the contract to completion, or would the activity be discontinued.

Is the revenue required to pay the loan, or provide a return on investment, subject to the successful completion of a prime contract that is being funded by the loan or investment?

How Risk Management Programs Can Implement Surety
The risk of counterparty default can be addressed with Surety Based Risk Management where failure points are identified all along the supply chain.  If the prime contract is dependent on a lower tier contractor or supplier for success and the default of those lower tiers will negatively impact the prime contract, then those failure points should be bonded. 

By bonding the critical points in the supply chain the risk to the prime contractor is mitigated, particularly if the default of one lower tier contract could cascade into problems that affect other tiers or the completion schedule.

Contracts should be drafted to take advantage of the services and products the surety offers, and structure the surety as stakeholders whose mutual interest is effective and proactive mitigation of risk factors that could lead to a default.

Contracts should have clear default and cure provisions, with notification timelines that allow a surety to understand the situation and to coordinate a response in collaboration with their client.

Contracts should not try to impose different or unilateral obligations on the surety, or different timelines to cure a default.

Regular communication (monthly progress billing) of contract progress should be accessible to stakeholders in a data standard that utilizes data interoperability to enable performance measurement and predictive analytics by the surety.

Written communication to contract stakeholders that deal with a potential default should include the surety, provide an overview of what the expectation is for resolution, and benchmarks to track progress.