When The Surety Becomes Weak
By William M. Coats

There has been a group of surety failures in recent years as well as several sureties whose financial ratings by rating agencies have been downgraded. To an owner holding a performance bond from a weak or bankrupt surety for its general contractor, or a general contractor holding a subcontractor performance bond from that same surety acting for its subcontractor, there should be a considerable amount of anxiety about what might occur if it is necessary to make a bond claim.

Unlike life insurers whose risks can be actually determined with great accuracy and adequately reserved, the risks undertaken by sureties are far less likely to be adequately determined and reserved. Therefore, when trouble hits a surety, it is often the case that there are not adequate reserves available to pay all claims. In many cases of surety insolvency, no claims are paid until after a lengthy administrative process, and then claims can be payable at less than 10 cents on the dollar.

While it is impossible to completely solve the basic problem (it still being the case that you can't get blood out of a turnip), there are steps bond users can take to minimize the problem.

First, it is important that the prime contract or subcontract provision requiring a bond not only require that a performance bond be furnished, but also require that the bond be of a certain grade.
The most common standard is a reference to the "Treasury List," which is a continually revised list of sureties that are eligible to provide bonds on U.S. government projects. While this is of some comfort, it is also good practice to require that sureties acceptable to you hold a certain A.M. Best rating. (Best is a private rating agency for insurance companies.)

Of course, using a contract provision that requires a certain class of surety does no good unless you police bonds as they are submitted and determine whether the surety on particular bonds actually meet the requirements of your contract. You may need the help of your own bond agent to police this.

Second, even if the bond you originally take meets the quality standards required by your contract, that is no guarantee that the surety will still have the requisite financial strength by the time you need to make a claim on the bond. It is possible to address this problem by having your contract's bond provision provide that in the event the surety becomes de-listed on the Treasury List (or is downgraded by rating agencies), you are entitled to require that the bond be replaced with a bond from a higher rated surety.

While it is often unrealistic to expect a contractor to be able to replace its surety mid-project, such a provision would be useful in obtaining some alternate form of security in the event a contractor's surety develops problems.

Perhaps the most available form of alternate security would be funds control. If you can no longer fully rely on the surety of the bond you have taken, in the absence of a new stronger bond or some other solid form of security (e.g. letter of credit), it is reasonable to expect that the now unsupported contractor or subcontractor with whom you are doing business would allow joint check payments, or even allow a full-blown funds control regime to be put in place.

It is possible to have your contract or subcontract provide for funds control in the event of a surety downgrade. Similarly, conditional personal performance guarantees might be added to your contract, which condition the guarantee on one or more negative "triggers" relating to a surety liquidation or downgrade. Like funds control, guarantees are by no means foolproof, but may be better than a claim against a liquidating surety. If retainage can be reasonably increased based on a similar "trigger," say from 5 to 10 percent or more, that may also be of some help.

Although as stated above, none of these suggestions are wholly satisfactory, they do provide some relief. If this unfortunate problem rears it head, it would be helpful to have addressed it in advance by including clauses in your contract.

William M. Coats is a director and member of the executive committee and head of the Construction/Surety section of Houston-based Coats, Rose, Yale, Ryman & Lee PC.