Expert Commentary

Enhancing Your Financials

Today, surety underwriters are 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. Subordination transactions are merely one way a contractor’s financial base can be enhanced under the appropriate circumstances.


July 2003

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.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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