Collateral is often required by bonding companies when they feel a submission is not up to par. In certain circumstances, collateral is a good solution to otherwise unwritable risks. However, agents often fail to offer viable alternatives. Many agents neglect to inform their clients as to what they are actually getting into when it comes to their surety bonds the collateral retained. In this article, we will review: downfalls of posting collateral, why collateral is not always the best solution, and good alternatives.
There are many downfalls to providing collateral: tying up capital that could be used more effectively, cost of an ILOC, etc. Surety bond collateral agreements are often overlooked by the principal, leaving them in the dark on important information. The most commonly overlooked requirement is that bonding companies will hold on to the collateral until the surety has no liability on the bond. One might think that liability would end with the expiration of the bond, but this common belief if simply not true. In order for the surety to be free of liability they will require the obligee to state so in writing. In general, government workers will be hesitant to write such a letter and and with good reason too. At times, claims will take time to show up. Government red tape make claims slow to rise, therefore the expiration of the bond is not the end of liability. Some bond forms even have a “tail” on the end. A bond “tail” allows for claims to be filed X amount of year after the bond has expired. If there is a tail on the bond, the principal should not expect to see the collateral until after the tail period has ended.
Collateral is necessary in some scenarios. However, collateral is not the best decision in all situations. In general, a principal is required to post collateral if either they are considered a high risk or if the actual guarantee of the bond is a high risk. Most bonding companies will require 100% collateral in order to write these non-traditional bond risks. Below you will find several alternatives to posting the full amount of the bond:
- There are some programs for commercial bonds that only require 10% collateral. These programs write almost any bond, regardless of bond language, even for clients with bad credit.
- Higher risk construction bonds can be written by some bonding companies. However, these outside of the box thinking bonding companies are far and few in between. Some only appoint a small handful of agents nationwide. It is important that your bond agent has access to unique markets if they are available for the particular risk.
- An irrevocable letter of credit (ILOC) is a good alternative to anyone that has exhausted other methods. When it comes to obtaining a bond with 100% collateral, most bonding companies will want collateral in the form of an ILOC. This means that principal will pay a fee for their bond, a fee for their ILOC, and have capital tied up. If a principal posts an ILOC rather than a surety bond they will not have the cost of the bond. The downfall of an ILOC is that not all obligees will accept them in place of a bond.
Collateral can help guarantee an otherwise unbondable situation. Due to the downfalls, 100% collateral should only be posted when all other options have been exhausted. Keep in mind, a surety bond does not take liability off of the principal. It simply makes use of the bonding companies financial strength to make the guarantee. The principal is responsible for claim payment, whether a bond is obtained or collateral is posted directly with the state. The bond is advantageous if no collateral is required, as it frees up capital and costs about the same as a letter of credit. If you are stuck in a situation where only a bond with 100% collateral suffice, make sure you read all agreements carefully to get a good idea of what you are actually getting into. If you would like to learn more about what surety bonds are and how they work, you can read our detailed guide here.