Many users of surety credit have already discovered that surety underwriting
has tightened, bond rates have increased, and capacity or bond programs are
more restrictive. These changes in the marketplace occurred primarily because
the surety industry’s loss ratios increased dramatically, reinsurance capacity
is less and more expensive, and allocation of capital to support this volatile
line of business is more difficult to secure. The near-term outlook for the
surety line may be more of the same.
Improving Your Chances
As a contractor who depends on surety credit, what can you do to improve
your chances of obtaining the surety credit you need? It goes without saying
that nurturing the bonding relationship is always important and perhaps never
more so than now. Providing timely and complete information about your operations
and business plans is also vital. Ability to generate an operating profit commensurate
with the type and volume of work you perform is also essential. Managing risks
associated with your business and purchasing necessary insurance in reasonable
limits are also critical.
Paid-in Capital Option
Assuming a contractor is addressing the foregoing areas but is financially
not able to support the bond program it needs or would like to have, what can
the contractor do to “bulk-up” its balance sheet? The obvious answer might be
to infuse the company with additional paid-in capital.
This option may have some drawbacks, which need to be considered. If the
additional capital comes from outside/new investors, it would dilute the ownership
of the current owners. If the contractor is a “C” tax-paying corporation, any
additional paid-in capital could be “locked” in and be subject to so-called
double taxation if later paid out in the form of a dividend.
Subordinated Debt Option
In lieu of additional paid-in capital, most sureties will treat shareholder
loans to the company as both a long-term liability and as a “capital” equivalent
if the loans are subordinated to the surety. This, of course, presumes that
the shareholder(s) has the cash resources to loan to the construction company
and/or is able to obtain cash from other sources, e.g., mortgage on property.
This option avoids the potential adverse tax consequences, and the parties
loaning the money are creditors and would have priority in the event of bankruptcy
or liquidation. There is, of course, a cost to the construction company for
the interest paid on the loan, which could in part be offset by interest earned
on the borrowed monies.
Parties to the Agreement
Before entering into a subordination transaction, it is important that the
parties to the subordination agreement fully understand the purpose and provisions
of the agreement. The parties to the subordination agreement are the construction
entity, the party loaning the money, and the surety. The surety will not execute
the agreement because it, in effect, is an offering to the surety in consideration
for or as a condition to providing surety credit. The surety will want a copy
of the promissory note or other evidence of indebtedness and the executed subordination
agreement.
Types of Agreements
There are two standard subordination agreement forms that have been drafted
by the Surety Association of America (SAA), which is an industry trade group.
Both forms contain essentially the same provisions except that the so-called
general form applies to all bonds provided before and after the effective date
of the agreement, whereas the “special” form applies to bonds for a single contract.
Sureties will most often want the general form as its blanket feature makes
it the most practical form for underwriting and claims-handling purposes.
Essential Provisions
The essential provisions of the subordination agreement can be summarized
as follows.
- The creditor (the party who loaned money to the construction company)
subordinates all rights and claims against the contractor relative to the
indebtedness to any and all rights and claims of the surety on account of
any loss or expense the surety incurs by reason of having furnished any
bond to the contractor.
- The surety’s loss will be paid in full out of the assets of the contractor
before any payment on the indebtedness is made to the creditor.
- The creditor assigns to the surety its rights and claims on account
of said indebtedness in the event of bankruptcy, insolvency, etc., of the
contractor.
- The creditor and contractor agree that the indebtedness will not be
repaid until all bonded obligations have been satisfactorily completed and
said bonds released or exonerated.
- The creditor agrees that in the event of the breach of any terms of
the subordination agreement that all funds, property, or benefit received
by the creditor in connection with such breach will be held in trust by
creditor for the benefit of the surety.
Important Considerations
The surety will consider various factors before making a decision as to whether
subordinated debt is an acceptable means of strengthening the financial base
of the construction entity. Important factors include the following.
Contractor Performance. This includes the contractor’s
performance record and prospects for success. If the contractor’s financial
base has been eroded by consistent unprofitable work, then it is unlikely that
simply loaning additional monies to the company will remedy the operational
problems.
Special Situations. The surety is more likely
to consider subordinated debt as a means to strengthen the balance sheet where
it is a special situation, e.g., a temporary larger backlog than is normally
carried; the contractor’s financial base was reduced by investment in fixed
assets; stock repurchases; payment of large bonuses to shareholders and/or distributions
of profits to shareholders.
Source of Funds. Cash received from the construction
firm in the form of salary and bonuses, dividends, and distributions of profits
is often used as a source of funds in a subordination transaction. Excess cash
that the construction owner has is also acceptable. Monies borrowed from a bank
or another lender is not viewed favorably. The concern here is that the subordinated
debt will be tapped to repay the loan to the bank or other lender.
Other Considerations. In addition to the foregoing
considerations, the surety will also consider how many promissory notes are
outstanding and their due dates. Since a separate subordination has to be executed
for each promissory note, it could become an administrative burden.
Sometimes the surety will consent to partial or installment payments on one
or more promissory notes providing the repayment does not adversely affect the
contractor’s financial condition relative to the approved work program. The
surety will also be monitoring that there are no “offsetting” transactions,
such as loans to the creditor by the contractor or excessive bonuses to the
creditor by the contractor. If such transactions occur for the purpose of offsetting
the effects of the subordination transaction, the “spirit” of the subordination
agreement is violated.
Conclusion
One of the primary considerations of the surety is that the contractor have
adequate at-risk capital relative to the type and size of the work program.
This is not a static dollar figure or percentage, and each surety has their
own spin on how to judge what is reasonable and adequate.
Subordination transactions are merely one way a contractor’s financial base
can be enhanced under the appropriate circumstances. Given that the surety underwriter
today is looking for more financial muscle relative to a given work program,
the use of subordinated debt may be an effective way to secure needed surety
credit. It is an option that you may want to discuss with your professional
bonding agent.