site bond

Secrets of Bonding #160: Deep in the Weeds with Set Aside Letters

In this article we will peel back the onion on Set Aside Letters (SAL) issued by banks in connection with construction loans.  What are they, when they are useful for bonding companies and when are they not?

Here is the essence of such documents:

“The agreement covering the project will provide that the funds in said impound account are … to be disbursed for payment of the (Name of Project) mentioned above and only after (Bank) has satisfied itself that the work paid for has actually been performed… In the event (Borrower) fails to complete the project described herein… all funds remaining in said impound account shall be immediately available to Surety to complete and pay the costs of said project, and in such event, (Borrower) waives any claim or interest in the remaining funds. Surety shall not in any way be obligated to repay said funds so used to (Bank).

This is an irrevocable commitment of funds which is not subject to recall or offset by (Bank).”

Pretty interesting!  This letter / agreement keeps the loan in play to fund the completion of the project  – even if the borrower (bank customer) fails / defaults.

When Are Set Aside Letters Used?

These documents are a common underwriting tool when a Site or Subdivision Bond is issued by a surety. If the bond applicant (who is also the developer and borrower) is relying on a construction loan to fund the bonded work, the SAL protects the surety by providing funds for the completion of the work in the event of a default.

What a great idea.  So why don’t we use these on everything?  Let’s look at another example.

Commercial Projects

The project owner hires a bonded contractor and a bank loan will fund the project.  The bank needs a guarantee that the asset / project (which backs the loan) will be built as intended.  A Performance and Payment Bond accomplishes this and assures there will be no Mechanics Liens against the property for unpaid bills.  These two aspects benefit the project owner and the lender.  Keep in mind, in a borrower default situation, the bank becomes the new owner of the property.

It is common for the bank to stipulate that a bonded contractor be used, and they may want to be a named beneficiary on the P&P bond – accomplished by issuing a Dual Obligee Rider.  In turn, should the underwriter require a SAL from the lender?

On Commercial projects, the normal practice is to NOT obtain a SAL from the lender.  Why not?  Why is this different?

Choose one:

a. The bank is a secured lender

b. The bank can subrogate against the borrower’s assets

c. The Dual Obligee Rider serves a purpose similar to the SAL

a. and b. are true, but the answer is c.

Welcome to the Weeds

We’re going in now. The Dual Obligee Rider adds the lender as a beneficiary with all the rights and obligations of the obligee named on the bond (the project owner).  And what are they?  Obviously they are entitled to make a performance claim and have the project delivered as indicated in the contract.

The named obligee also has obligations, one of the most primary is to PAY the builder. Important: The obligee is prohibited from making a performance claim if they have failed to pay the contractor.

Therefore, when the bank is included under a Dual Obligee Rider, they accept the benefits and obligations.  If the borrower defaults, the lender cannot make a bond claim unless they continue to pay the construction loan to the surety.  (Now the bank owns the project and the surety has become the contractor.)

Summary

Is this starting to make sense?  When a borrower defaults on a commercial project, a lender included by Dual Obligee Rider cannot make a claim unless they continue to pay the project funds to the surety.

Deeper Weeds

On Site and Subdivision there is a unique risk – the lender can take a free ride on the surety by having the bonding company pay out of pocket to complete the project.

Site and Sub-D bonds have the local municipality as obligee, not the bank.  The bank doesn’t want a Dual Obligee Rider because they automatically receive a financial benefit if the municipality makes a bond claim to demand completion of the project.  If the borrower has defaulted, the bank has the opportunity to withhold the balance of the loan (the borrower is gone), and watch the surety pay to complete a project they now own.  And they were not even the bond claimant…

This is the risk sureties avoid on Site and Subdivision Bonds by requiring the SAL that keeps the loan in play, even if the bond applicant / borrower has failed.

Admittedly, this is a pretty obscure subject, but also interesting to us “bond nerds.”  It never hurts to understand how things fit together.  These skills help us solve your complicated bond opportunities.  Take advantage of our expertise when the next one pops up.

Steve Golia is a long established surety bond provider and expert. Call us with your next bid or performance bond. 856-304-7348 

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Secrets of Bonding #122: Don’t Sign That Lien Release!

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WAIVER OF LIEN BY CONTRACTOR, SUBCONTRACTOR(S) AND SUPPLIER

We, the undersigned, acknowledge receipt of the amounts stated below as full payment for all labor, professional services, materials, or equipment furnished for use on or about the property of…”

In construction, lien releases are common. Project owners expect their general contractor to execute them. GCs demand them from their subcontractors and suppliers. They are part of the routine. If you want to get paid, you sign it. But when should you not sign it? Let’s look at what a lien release does, and when you should be cautious about executing.

The Purpose of Lien Releases
Typically, a lien release is required in connection with a monetary payment. It comes up in any of these situations:

  • Monthly payment made from project owner to the general contractor
  • Monthly payment from GC to a sub or suppliers
  • Final contract payments to any of these

The lien release enables the accounting to transition from one billing cycle to the next. It is a form of receipt that protects the Payor by acknowleging that the Payee has received funds – they relinquish the right to claim they were not paid.

danger-aheadNormally, when contractors and suppliers are unpaid, they can file a lien (a security interest) against the title of the physical property. With such a lien in place, the property cannot be sold.  The lien release / waiver gives up the right to file such a lien and possibly other legal remedies as well.

Lien releases come in two basic flavors, and it is very important to recognize the difference between them.

The Good One: Conditional

“THIS DOCUMENT WAIVES THE CLAIMANT’S LIEN, STOP PAYMENT NOTICE, AND PAYMENT BOND RIGHTS EFFECTIVE ON RECEIPT OF PAYMENT. A PERSON SHOULD NOT RELY ON THIS DOCUMENT UNLESS SATISFIED THAT THE CLAIMANT HAS RECEIVED PAYMENT.”

A release / waiver is Conditional if it waives rights once a condition (usually the receipt of payment) occurs. An example of conditional language is:

“Upon the receipt of $____, Subcontractor hereby waives and releases its lien and bond rights for labor and materials through _________ (date).”

Unless the waiver states otherwise, the conditional waiver is not effective until the condition, such as payment, occurs.

Also note, this wording includes a condition regarding time which protects the claimant’s lien rights arising in the next billing period.

The Bad One: Unconditionalcaution-proceed-carefully-md

“THIS DOCUMENT WAIVES AND RELEASES LIEN, STOP PAYMENT NOTICE, AND PAYMENT BOND RIGHTS UNCONDITIONALLY AND STATES THAT YOU HAVE BEEN PAID FOR GIVING UP THOSE RIGHTS. THIS DOCUMENT IS ENFORCEABLE AGAINST YOU IF YOU SIGN IT, EVEN IF YOU HAVE NOT BEEN PAID. IF YOU HAVE NOT BEEN PAID, USE A CONDITIONAL WAIVER AND RELEASE FORM.”

Actually it is only bad if the claimant has not yet been paid. Then it would be inadvisable to provide an unconditional release. The claimant will have no recourse if they do not receive their payment, and they will also relinquish their ability to claim against the Payment Bond.

Conclusion
The Conditional Lien Release includes conditions and wording that protects the claimant’s interests.

The Unconditional Release can be detrimental if executed unintentionally or under inappropriate circumstances.

Insurance Agents and Contractors: when tough bonding situations arise, we have the markets and the know-how to succeed even when others have failed.

Give us a call today!  856-304-7348

Not available in all states including Idaho.

Secrets of Bonding #121: Are Court Bonds Like Fruit?

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Brokers protected.  Contractors welcomed.

produce_manMostly we issue contract surety bonds (Performance & Payment) for contractors and our insurance agent / colleagues.  However, we are also an important provider of Court and Probate bonds.  We issued a number of interesting court bonds recently so here is some info on this subject.

What Are Court Bonds Are Why Are They Needed?

Generally, court bonds serve three purposes.

  1. They provide required protection for the other party in the litigation (opposite the bond applicant)
  2. They guarantee the payment of related court costs
  3. The court likes them

An Injunction Bond is a good example.  In these legal actions one party wants to limit or prevent the actions of another.  An insurance agency may request an injunction to prevent a former salesman from soliciting their clients.  The court requires the plaintiff (insurance agency) to provide a bond for the protection of the defendant (salesman) in the event it is found that (s)he has been wrongfully restrained.

A Replevin Bond is similar.  These are required when the plaintiff (a bank) wants to seize an asset (your private jet) for failure to pay your finance charges.  The bond will protect you if it is later found they wrongfully seized “Wings Over Yonkers.”  See how these work?  In different situations the bonds provide the same type of function.  The name of the bond identifies the underlying legal action.

Why Do Courts Like Them?

You may think “what’s not to like?!” That’s true. But the court may require a surety bond for a practical reason.  If the litigation involves a financial matter, they could require that an escrow deposit be placed with the court for the benefit of the other party. They would hold this money until the case is decided.

This works, but is not convenient.  Where will the funds be held?  Who is responsible for their safekeeping?  Will there be periodic accounting if the case runs for years?  Who pays the expenses associated with this?  What if the money is misplaced or stolen? 

Compare this to a surety bond: Get the bond, throw in the file. Done!

cherriesEven though the court may have the option to take cash in lieu of bond, they may demand the issuance of a surety bond simply for its convenience.

Other Court Bonds

When a money judgment is rendered, the defendant may want the matter heard by the Appellant Court. Let’s say Maynard sued Dobie for money and wins a $10,000 judgment.  Maynard figures “Ok here comes 10 big ones!”  However, Dobie wants to dispute the decision so now Maynard has to wait.

In order to bring the Appeal, Dobie must obtain an Appeal Bond which protects the interests of the court and guarantees prompt payment if Dobie loses again.  To get this bond, he’ll have to give his personal financial statement, his indemnity, and put up maybe $11,000 for the surety to hold.  Oh, and pay the bond premium!  Why is all this necessary?

Bond underwriters know that most defendants lose at the Appellate level.  They also know that the court will simply claim on the bond to pay off the judgement.  This means that underwriters expect full penalty claims on defendant’s appeal bonds – which is why they normally require full collateral for the judgment amount plus interest and expenses.nanners

Conclusion

Hopefully it is apparent that there is a thread of similarity between these different types of court bonds.  This can make it easier to understand them when a client comes a-knockin’.

Oh, so why are court bonds like fruit?  Because they have appeal!

Insurance Agents and Contractors: when tough bonding situations arise, we have the markets and the know-how to succeed even when others have failed.

Give us a call today!  856-304-7348

Not available in all states including Idaho.

Secrets of Bonding #73: Substitute Bid Bonds

Remember how much fun it was to have a substitute teacher? Well, this is a little less exciting…

In Secret #49 we talked about bidding with a check.  This is a related topic. Substitute bid bonds are an odd part of what we do as surety professionals.  Here’s how you may run into one.

It is common for project specifications to offer a number of methods to provide the bid security that accompanies a contractors project proposal.  The options may include a check made out to the obligee, or a bid bond.

A substitute bid bond may be issued after bid security has already been given with the contractor’s proposal.  This bid bond will replace, or be substituted for the existing security – thus the name.

This may arise when the contractor has no surety at the time of the bid.  They bid with a check.  Now, with a surety in place, their first request is “How about helping us get our cash back?  It’s tied up with that bid.”

What a great way to start off by helping the new client. However, sureties are not always in favor of issuing these, and some refuse to do so under any circumstances.  Why?!

1. Bid Spread: In this case, the contractor is the low bidder, but they are too low. (Read Secret #16 to learn about unacceptable bid spreads.) The contractor may be in line for the project, but the surety does not want to issue the performance bond (aka final bond).  If the bonding company provides the substitute bid bond, they become obligated to issue the final bond or face a bid bond claim (two bad options!) “Sorry, we are not able to provide a substitute bid bond for that project.”

The fallout is that the contractor may blame the surety when they lose their bid security for failing to deliver the final bond. They will also lose the expected income from the project – pretty ugly.

2. Final Bond Optional: The specs may indicate that a Performance & Payment bond is not mandatory. It is optional at the obligee’s discretion. This amounts to adverse selection against the surety.  If the obligee thinks the contractor looks capable: No bond.  If there is some doubt about their ability to perform or the adequacy of the price, better pass the risk over to the bonding company.

For this reason, substitute bid bonds may be declined if a final bond is not mandatory.  Remember, final bonds are where sureties make their money.  Bid bonds are usually free.  The contractor will not lose anything as a result of the refusal to issue the substitute and they are already eligible to win the contract.

3. Not Low Bidder: This is similar to Number 2. Here the contractor is second or third bidder. The common practice is for obligees to hold the bid security of the second and third bidders in case they need to give them the project (maybe the low bidder can’t get their final bond issued?) The bid checks could be held for months!

From the surety’s perspective there is no question about the adequacy of the second or third bidder’s number.  This may be a well-priced contract. The problem is that they are unlikely to issue a final bond.  (Projects are rarely awarded to the second or third bidders.) This has even less chance of making money for them than a normal bid bond request.

To the contractor, a substitute bid bond may seem like a great idea. For the surety, the only desirable situation is when their client is low bidder with an acceptable bid spread and a mandatory final bond. Absent that, don’t be surprised if the surety only wants to get involved after the contract award takes place and the final bond is needed.

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Secrets of Bonding #10: Site / Subdivision

Site / Subdivision: Oh what a tangled web we weave…

Feel like you’re not an expert on these?  You’re not alone!  In this article we’ll cover the basics as well as some of the tricky stuff.

Site and Subdivision (Sub-D) Bonds are both similar for the surety.  A Site Bond is needed when a business expands their facilities whereas Sub-D arises on residential development projects.

In both cases, the property owner or developer has obtained zoning board approval to proceed, but is required to build certain elements the township wants such as sidewalks, roads or lighting.  Contractors call this “site work,” thus the name Site Bond.  Site bonds do not concern the construction of the buildings.  “Improved Lots” are property where such elements have been completed.

This required work is collectively called the Public Improvements.  A township engineer will prepare an “Engineers Estimate” with an estimated current cost for each item.  The bond amount is the sum of these costs plus an added cushion in case the bond is called at a future date when construction costs are higher.

The purpose of all Site and Sub-D Bonds is to guarantee that public improvements will be built at the developer or surety’s expense, not the taxpayers.  For example, if the developer fails to topcoat the road, the township makes a bond claim and the surety must complete the work.

How Site & Sub-D differs from Performance Bonds:

  • There is no contract with the obligee (township)
  • The obligee is not paying for the work.  It is self-funded by the principal (property owner)
  • There is no definite completion date

FIRST TANGLED WEB: Since the work is self-funded, the property owner must either have cash on hand or arrange for a construction loan. If the latter, it is likely that the property in question will be collateral for the lender. This means in the event of the principals failure (such as bankruptcy), the bank becomes the new property owner but the surety remains obligated to the township.

In the borrowers absence the bank has no obligation to disburse the remainder of the loan (the purpose of which was to improve and increase the value of property THE BANK NOW OWNS) – but the surety is still required to complete the work.

Untangle this by obtaining a “Set Aside Letter” from the lender prior to issuing the bond.  This requires the bank to continue disbursing funds to the surety in the event of the borrower’s failure – with no pay back required.  In this manner, the work can be completed as intended.

SECOND TANGLED WEB: When the property owner hires a contractor to build the public improvements, it is not uncommon to require the construction firm to obtain the Site / Sub-D bond.  After all, the contractor may already have a surety relationship.  Problem: In the event of the property owner’s default, the construction contract is terminated however the Site / Sub-D bond obligation remains in force.  No more money is coming to the contractor to complete the work. The contractor is now solely responsible to the township and the surety and must self-fund the completion of improvements for property they do not own.

Untangle this one by a) requiring the developer, not the contractor, to be the bond applicant, or b) at least get the financial statements and indemnity of the developer so the contractor is not solely obligated to the surety and township, and c) a set-aside letter or escrow account (for funding by cash) could still be required.

Summary: Key questions are:

  • Who will build the public improvements?
  • If built under a construction contract, is it bonded to the developer? (Performance and Payment Bond)
  • How will the work be paid for?
  • How will the surety be funded in the event of failure by the property owner?

KIS Surety is the national contract bond underwriting department for Great Midwest Insurance Company, a national, corporate surety with an A-8 rating.  We throw all this underwriting talent at your bond opportunities and support contracts up to $10,000,000.

If you have a contract surety case that needs a fast, creative response, call us: 856-304-7348

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