Summary
- In the initial underwriting process, as well as on an ongoing basis, a surety should insist on full access to financial information.
- Many surety relationships require collateral to secure the risk.
We begin this article with a story that may be familiar to many professionals. We all want to feel a connection to others in our personal and professional lives. In business, the strength of that connection (which also requires excellent work) may be the difference when it comes to choosing a business or trade partner and/or choosing whether to continue or end such a relationship.
For example, in the fall of 2001, a newly licensed lawyer walked into a local bank on the corner of Fourth and Church Street in Anytown, U.S.A. at the special invitation of the bank’s manager. The young lawyer purposefully strode past the teller windows to the “back of the bank” where offices with doors are located. The bank’s manager greeted the new lawyer with a firm handshake and a broad smile, then quickly invited him into a large office and closed the door.
After exchanging pleasantries and congratulating the new lawyer on his achievements and new job with the law firm just down the block, the bank’s manager offered the new lawyer a higher-than-typical interest rate on a checking account, along with a pre-approved “new professional” mortgage with a low interest rate. The bank’s manager then introduced the new lawyer to his own “personal banker,” who would be “on call” to address all of the new lawyer’s banking needs.
The new lawyer left the bank beaming with pride, along with a new checking account and a loan commitment, the latter of which he would use to hit the housing market that weekend. No red tape. No prequalification. Perhaps more importantly, no more waiting in line to see a teller like mere mortals. This young lawyer had arrived.
The young lawyer’s relationship with the bank blossomed as the lawyer’s career blossomed. As the lawyer’s professional and personal goals evolved, the bank was there in-step, offering products and benefits that helped the lawyer reach those goals.
Just five short years later, the bank that had become the new lawyer’s trusted advisor and partner was sold to a much larger bank. The larger bank then discontinued the private banking arrangement with the young lawyer, reserving those services to high net worth individuals. Within the year, the young lawyer moved to a new bank to find better connections and service, and never returned to the original bank. While the new bank did not offer a “private banking suite” to the lawyer, it was attentive to the lawyer’s needs and made an effort to connect with the lawyer on a more personal level. Twenty or so years later, the now much older and grayer lawyer is still with the second bank. Even in an age in which the “brick and mortar” branches are becoming a thing-of-the-past, the second bank continues to reach out and provide personal service, cultivating loyalty that remains to this day. In fact, the lawyer’s ten-year old daughter now has a savings account at the bank.
The universal importance of connections/relationships holds true in the surety underwriting context. An account that is looking for a surety partner to help develop its business may look at a number of sureties that are willing to provide similar levels of bonding commitments. The surety that matches best may invariably be the one that provides the best connection and understanding of the account’s business and its operations. The surety that makes the effort to “know” its account should have an advantage over the one that relies solely on paper metrics.
Going beyond paper metrics also has its advantages when it comes to mitigating risk and managing change. It is often said: “The only constant in life is change.” For a surety, this means that an account’s bonding needs may differ from year-to-year as its business grows (or slows). Its management, corporate structure, and capital structure may also change. Market conditions can also affect the account’s business in a way that no one expects. While some of these changes may show up on paper, the truth is that most of them do not. Thus, a surety would do well to utilize all the tools available to monitor and manage its accounts. Those include, among other things, the right to information.
The request for information starts at the beginning of the relationship and should continue throughout the business relationship with the account. Requesting information and actively using that information to build the connection with an account is both good for business and good for managing risk. A well-informed underwriter may see risks in the construction market before they are seen by the contractor. The underwriter can alert the account to those risk trends, while also showing an interest in the account and its well-being and success on a more personal level. The result should be an account that is more connected with the surety and views the surety as a trusted partner and advisor rather than simply a bond vending machine.
The title “General Indemnity Agreement” or “General Agreement of Indemnity,” if you prefer, may connote an adversarial relationship. An underwriter may feel reluctant to “lead” with this document as the basis for establishing a connection with an account. But this “account agreement” is the foundational document to the surety/account relationship, and the underwriter should embrace what it provides – not what it is called. There are five common provisions in the indemnity agreement that not only help secure indemnity in the event of a loss, but also serve as the backbone of the surety/account relationship through which information is freely shared.
In the initial underwriting process, as well as on an ongoing basis, a surety should insist on full access to financial information, financials (including audited financials), and other company records. Most indemnity agreements further require the account and any indemnitors to furnish the surety free access to their respective books, records, accounts, etc. upon request until the surety’s bonded obligations are discharged. Accounts and indemnitors are generally more willing to furnish such access to sureties who, like the personal banker of yesteryear, actively use that information to help their accounts achieve their evolving goals.
Many surety relationships require collateral to secure the risk. Collateral may be required at the commencement of the surety relationship to provide security for all bonds, may be taken in relationship to a particular bond or obligation, or may be requested after a claim is made. The collateral at the commencement of the relationship should be documented in a collateral agreement governing the terms and conditions pursuant to which the collateral may be held, used, and/or returned.
Looking beyond financial metrics, a surety should “know its customer.” Unlike traditional credit transactions, surety credit not only underwrites the financial strength of the account, but also the ability of the account to perform the bonded obligations. The experience and integrity of the management team often impacts the business’s ultimate success. A surety can assess the strength of management’s character by examining the account’s relationships within its industry–particularly its banking arrangements–and any legal actions taken against it. With respect to the experience of the account’s management, the surety should investigate the account’s previous work, not only in the industry generally but also with particular projects. Even if the account has effectively completed similar work, the surety should examine whether the account has the capacity to continue its success by assessing whether its team has “the necessary technical skills, knowledge, equipment, [and] workforce” to fulfill its obligations.
Many indemnity agreements contain provisions that require the indemnitors to notify the surety if there is a change of ownership or control of the account and/or designates such to be an event of default. These provisions emphasize the importance of the account maintaining consistent ownership or control (or demonstrating to the surety that the change does not negatively impact the surety’s risk). A change in ownership is more likely to hinder, at least temporarily, the profitability of the account’s business and, by extension, the account’s ability to complete its bonded obligations when the account’s ownership or management is generational. Thus, bonding these accounts can increase the surety’s risk of exposure to bond claims. At a minimum, a change in control is a material event that creates risk (and potentially a positive impact) to the operation of the account’s business.
Indemnity agreements normally require the account and any indemnitors to inform the surety of conditions that could increase its risk of liability on a bond (or bonds) so that the surety can takes steps to prevent or mitigate loss. Two common notice obligations imposed by indemnity agreements are the duty to provide notice of changes to the principal’s business structure and the duty to provide notice of potential claims under a bond.
Surety underwriting is an exercise in risk management, but it should be more than that. Surety underwriting is really about getting to know the account, its people, its credit and other business processes, its strengths, and its weaknesses. A surety’s underwriting team should establish regular contacts, or “touch points,” with an account and its management team if for no other purpose than building and strengthening the connection with the account. A surety’s underwriting team should ask about anticipated management changes, anticipated changes in the business model, and anticipated changes in market conditions. A surety’s underwriting team can often strengthen its connection with an account by actively helping the account prepare for unanticipated management changes, unanticipated changes in the business model, and unanticipated changes in market conditions. Showing interest in the account and its success can engender loyalty and candor in communication, particularly in connection with bond requests that an underwriter believes may accentuate an account’s weakness and lead to financial uncertainty. The surety that truly knows its account and its business not only helps mitigate risk, but also adds value to both the account and the surety in the form of an enduring relationship. The question the surety should ask itself is whether it wants a teller-window relationship with an account or one that is more meaningful and in-step with the account and its business.