Many political jurisdictions have statutes that require an owner or developer
of real property to post financial security to guarantee the completion of designated
improvements as a precondition to granting a construction permit or to allow
the recordation of a final parcel map. The guarantee posted by the owner/developer
assures that they: 1) will have the financial resources to pay for all the improvements;
2) the improvements will be built as required within a specified period of time;
and 3) they will maintain said improvements for a minimum of 1 year against
defective workmanship and/or materials.
Types of Guarantees
Most frequently, the owner/developer will select one of the following forms
to guarantee completion of the improvements:
- Corporate surety bonds
- Irrevocable letters of credit issued by a financial institution, e.g.
bank
- Certificates of deposit (CDs)
- Other, such as cash, certified/cashiers check or money order
- Tripartite agreement
Pros and Cons
Corporate surety bonds are far and away the most preferred option for most
owner/developers when you consider the potential disadvantages of the alternative
guarantee forms.
- Irrevocable Letter of Credit (ILOC): To
secure an ILOC, the owner/developer typically encumbers a portion of its
line of credit for a fee. The security for the ILOC may be funds on deposit
at the bank with their immediate right of set-off (seizure). If the bank
elects not to renew the ILOC, the public agency would have the right to
promptly draw down on the full amount of the ILOC. Such a drawdown of the
ILOC will create a loan, which the bank could promptly call for immediate
repayment.
- The governmental entity holding the ILOC has the right to draw on
the ILOC anytime they believe there is a breach of the owner’s obligations
and the owner would have little or no opportunity to stop the drawdown.
The ILOC is strictly a financial instrument and the bank provides no
prequalification services to assure the owner/developer has the capacity
or experience to perform.
- Certificates of Deposit (CD): It is effectively
a cash deposit that ties-up the owner/developer’s capital, which normally
can be deployed more productively. The CD is subject to forfeiture by the
unilateral demand of the public body. For the public body accepting the
CD as security, it provides no prequalification benefits. In addition, it
saddles the public body with administrative burdens to make sure they accepted
a CD that was in proper-assignable form, that they in fact had unequivocal
authority to draw down on the CD, that they don’t release it until all possibility
of nonperformance had passed, and that they hold the instrument in safekeeping
and properly return it to the owner/developer.
- Other Security (such as cash): This option
has many of the same concerns as with CDs. In addition, the public agency
would have to make some determination that the cash being deposited was
“legitimate” and not subject to possible bankruptcy preference rules.
- Tripartite Agreement: These agreements
(used infrequently) may involve set-aside letters from a bank, special escrow
accounts, and/or fund controls. Tripartite agreements typically place disbursement
of the construction funds under the direct control of the governmental agency.
Disbursement of monies may be delayed by concerns about the value of completed
work or the adequacy of monies to complete the improvements and provide
the required maintenance. Tripartite agreements are not really performance
guarantees but rather control over a fund of monies that may not be adequate
to pay for all the improvements. These type arrangements place significant
additional administrative burden on the public agency and can create liabilities
if the funds are not properly administered.
Advantages of Bonds
Corporate surety bonds generally have none of the disadvantages of the alternative
guarantees referenced above and have the following distinct advantages.
- Surety bonds provide prequalification of the owner/developer through
the underwriting process.
- Surety credit is unsecured and does not reduce or tie-up the owner/developer’s
source of funding.
- Surety’s claim department will work to facilitate a resolution of any
problem and not merely to forfeit the owner/developer’s security.
- Corporate surety bonds typically provide the public agency with a 100
percent performance, 100 percent payment, and 1-year maintenance bond.
- Irrespective of how much the owner/developer may have spent to complete
the improvements up to the time of default, the full amount of the bonds
are available to complete the work.
Important Distinction
The key difference between subdivision bonds, often also referred to as site
improvement bonds, plat bonds, completion bonds, or simply performance bonds
from regular contract performance bonds is that the owner/developer (the Principal)
has to pay the cost of building the bonded improvements rather than the public
agency (the Obligee). This is also an important point to remember if a general
contractor should agree to secure/post the subdivision bonds on behalf of the
owner/developer. Normally, the general contractor has the contractual right
to stop work if the owner does not pay him. However, if the general contractor
posts the improvement bonds in favor of the public agency, the general contractor
is obligated to complete the improvements and pay all the bills irrespective
of whether the owner/developer paid him. Therefore, a general contractor should
generally avoid posting such bonds on behalf of the owner/developer or seek
advice from their legal counsel on how best to protect him or herself.
Not All Sureties Write Subdivision Bonds
Subdivision/improvement bonds are a type of bond that not all surety companies
want to write. The reasons for avoiding this class vary. Some bonding companies
lack the familiarity or underwriting expertise. Some have had poor experience
in the past and have found that these bonds can have a very long lifespan. Some
are uncomfortable with developers whose financials may show considerable leverage
(debt) and whose valuation of land and developed properties are subject to wide
market fluctuations. Nonetheless, over time the surety industry has reported
favorable underwriting results for those companies who properly underwrite this
class of business.
General Underwriting
When an owner/developer applies for surety credit, the surety underwriter
will begin by developing the usual background and financial information to make
a general assessment of the owner/developer’s capacity/experience, their credit/financial
and their character. They should be prepared to provide three fiscal year end
financial reports on their operations, concurrent personal financial statement
on all owners, resumes on key people, list of completed projects, information
on banking relationships, business continuity plans, and copies of any trust,
partnership, or operating agreements. Most surety companies will also have their
own application form, which may ask other specific information. Once the bond
underwriter is comfortable with the account in general, they will then underwrite
each subdivision bond request.
Specific Bond Underwriting
The underwriter will require information such as the scope of the improvements
to be made, an estimate of the cost to complete the work, and information about
where the money to pay for the work is going to come from.
Scope of Work. The subdivision/improvement
bond guarantees the completion of specified improvements such as grading, storm
drains, utilities, curbs and gutters, streets, sidewalks. Therefore, the underwriter
will want details on the work or scope of the improvements to be installed.
This information will normally be spelled out in the subdivision/improvement
agreement that the owner/developer signs with the public agency. When will the
work start and be completed? What is the estimated cost of the improvements
and the amount of the bonds? Usually engineer worksheets are available that
outline the cost estimates including how the amount of the bond(s) was established.
The public body will generally include some cushion or “fudge” factor to allow
for possible escalation in the cost to complete the work. This increase factor
is not entirely unreasonable because experience has shown that sometimes the
improvements are not completed within the original time frame and the ultimate
cost months or years later could be greater.
Cost of Work. The underwriter will also want
some confirmation of the owner/developer’s estimate of cost to complete. The
preferred method is for the developer to have firm bids or signed contracts
from trade contractors to complete the work. Depending on the value of the work
and/or time to complete, the surety may want the owner to secure performance
and payment bonds from the trade contractor(s) to assure satisfactory performance.
At first blush this may seem like double bonding but the bonds from the trade
contractors run in favor of the owner/developer and not the public agency. Since
the owner is obligated to complete the improvements, it is really in the owner’s
interest to have this guarantee or they may find that they have to hire someone
else to complete the work for more money.
Funding Source. Because the owner/developer
is responsible for paying the cost of all the bonded improvements, a major underwriting
concern/question is where is the money to pay for the work? The necessary funds
should be set aside under an arrangement whereby they can only be used to pay
for the improvements as work progresses. This can be accomplished under an escrow
agreement with a lender or title company. Most often, however, the owner/developer
will have secured a development loan for the overall project. The surety will
then want to obtain a set-aside letter from the lender whereby an amount sufficient
to cover the cost of the bonded improvements will be irrevocably set aside and
held in trust for the benefit of the surety. It effectively carves out a portion
of the development loan to pay for the bonded improvements. The surety will
most likely have their own set-aside form.
Conclusion
Subdivision/improvement bonds provide the necessary assurance to allow an
owner/developer to proceed in a capital efficient manner to develop and begin
the sale of properties before all mandated improvements have been installed.
With full underwriting information and confirmation of financing in hand, the
bonding agent should be able to secure the required bonds for qualified applicants.
The bonds serve as irrevocable guarantees to those who purchase the property
that all required improvements will be installed. It also guarantees to all
who performed the work that they will be paid. The governmental body can take
comfort that the mandated improvements will not become a financial burden to
the public treasury and that they are promoting economic growth in their community.
The surety who properly underwrites this business for qualified principals will
generate profitable income for its shareholders. Subdivision/improvement bonds
can facilitate a “win-win” for all the parties.