What Small And Emerging Contractors Need to Know Understanding Collateral © Copyright 2017 NASBP

What Is Collateral? Collateral is an asset that is pledged by a contractor to secure a surety bond. It is a form of asset that is readily convertible to cash, pledged for the surety’s protection. Surety companies sometimes require collateral from a contractor in order for the contractor to qualify for surety credit. Collateral may be in several forms, such as a bank account or a bank’s irrevocable letter of credit. 2

Why Does A Surety Company Require Collateral? A surety company sometimes requires collateral for bonds written for a principal that is considered a higher risk, according to the surety’s underwriting standards. Collateral pledged to a surety company is a reimbursement guarantee to the surety if a loss occurs. A higher risk principal might have insufficient personal and corporate assets to the surety and/or questionable personal and corporate credit history. 3

How Collateral Benefits Small and Emerging Contractors If a surety underwriter is unable to approve a bond request based on the qualifications given by the principal, depositing some form of collateral may assist the principal in qualifying for a bond. If a contractor is financially challenged or does not possess credible financial information, a surety may require collateral as a condition to issue the requested bonds. Be sure to read all agreements carefully to ensure you understand the terms and seek legal advice, when appropriate. 4

How Does the Collateralization Process Work? The terms and conditions for pledging of collateral on a bond obligation are set forth in the surety company’s collateral security agreement. The dollar value of the cash collateral required by the surety can be based on a percentage of the bond penalty or on the full value of the bond. Collateral is typically held by the surety for the complete duration of time for which the bond is in effect or during which the obligee could make a claim on the bond. Generally, sureties require proof of the bond’s cancellation or written release by the obligee in order to initiate the collateral release process. 5

Forms of Collateral Generally Accepted by Sureties: Cash Collateral in the form of cash is typically filed with the surety company in the form of a cashier’s check. Usually, the surety deposits the collateral in an FDIC-insured bank in an interest-bearing escrow account on behalf of the principal. 6

Forms of Collateral Generally Accepted by Sureties: ILOC An irrevocable letter of credit (ILOC) is a demand instrument that the bank will pay upon presentation of certain required documents by the surety. An ILOC is an instrument issued by a bank or financial institution. It functions similarly to an open line of credit, and the only entity that can withdraw funds is the surety company. Most lending institutions charge a fee for issuing an ILOC. ILOCs cannot be cancelled. 7

Forms of Collateral Sometimes Accepted by Sureties: Real Estate Because of the uncertainty in today’s real estate market, collateral in the form of a deed of trust against real estate is a less desirable form of collateral to sureties. Most sureties will not accept a commercial or undeveloped parcel of land as a means to collateralize a bond obligation. Sureties review developed, residential properties based on current equity position, which is calculated by its current assessed value less all encumbrances (liens, (mortgages, home equity lines of credit balances, etc.) The surety often charges fees for appraisal costs of the property, for filing the deed of trust, and for filing the re-conveyance upon release of the property as collateral. 8

Forms of Collateral Generally Not Accepted by Sureties Certificates of deposit (CDs) are accepted by fewer sureties because the maturity dates of CDs rarely coincide with the bond terms. This mismatch causes collateral to be either held longer than needed or prematurely liquidated, with penalties incurred. Government securities, stocks and bonds, and gold and silver bullion have in the past been considered acceptable collateral; but market fluctuations have made them unreliable security for most sureties. Physical assets such as cars, boats, and construction equipment may not be acceptable due to lack of liquidity, fluctuation in value, and cost of storage. 9

SuretyLearn.org provides valuable resources and information on growing your small construction business and on positioning your business to qualify for surety credit. 10