Security for Contract Performance

Originally published in The John Liner Review, Vol. 24, No. 2 (Summer 2010)

The world has come to reject surety bonds and to embrace IFAs, and American businesses ignore these instruments at their peril.

A time-honored method of providing security for the performance of a contract is the surety bond. Two parties enter into a contract, and a third party, the surety, promises to perform the obligation if its principal fails to do so.1

Despite its distinguished history, the surety bond has come to be derided by many parties. "A surety bond is just a license to sue," is one of the pithier denunciations often heard.2 Yet for all the denunciations (and undeniable shortcomings), surety bonds continue to be employed extensively in the common law world.

A surety bond claim is not, in the first instance, about the bond; it is about the "other" contract in the transaction.3 Thus, a claim under a surety bond depends upon a default under the primary obligation, and entails a "mini-trial" of that issue.

Typology of Failure

The process of determining that collateral security for a contract is appropriate and selecting a suitable form of security can be viewed as an exercise in risk management. Proper risk management begins by recognizing the risks that are presented.

Contract failures can be classified depending on when the failure emerges.

Tender Risk

This category addresses the failure of the counterparty, after being awarded the contract, to deliver the executed contract (and other required documents, such as insurance certificates or performance bonds). In United States public contracting practice, the tender risk is addressed by requiring bidders to deliver a "bid bond" or equivalent security.

Performance Risk

This second category subsumes the risk that a contractor will not deliver the bargained-for performance. It includes untimely delivery, delivery of defective work, short delivery, and faults in the manner of delivery.

A surety bond is a contract, separate from the underlying agreement, under which a third party, the surety, guarantees the performance of the underlying agreement.

Litigation Risk

This family of loss exposures refers to the process of converting a claim into cash in hand in an amount sufficient to make the aggrieved party whole. It can be parsed into two further categories: the judgment risk, i.e., the risk of securing a legally enforceable decree that one party make payment to the other; and the execution risk, the risk that the contractor is insolvent.

Surety bonds excel at addressing the execution risk because they assure the obligee that, upon reducing a claim to judgment, there is a solvent party — the surety — that will take on the burden of payment. However, a performance bond does not remove the judgment risk. The surety does not owe the obligee an immediately performable duty to pay until and unless the claim of breach has been reduced to judgment. In short, a surety bond is not a "pay now — fight later" instrument, which dilutes its value.

Securing the Transaction

Secured transactions are made up of two parts. The primary transaction, sometimes called the "value" transaction, is the commercial deal that drives the entire exercise, such as a construction contract. The secondary, or "collateral," transaction serves to provide assurances to one of the parties in the primary transaction that the other will provide the agreed-upon return. When the discussion is focused on the collateral security, the primary transaction is sometimes referred to as the "underlying" transaction.

One approach to secured transactions is to hold an interest in collateral security that can be used as a fund to cover the expenses caused by a default. That collateral fund can be created through an outright grant, or it can be created by withholding a portion of the payments that are otherwise due to the counterparty. The latter method is commonly employed for construction projects and in that context is called "retainage."

Possessory Security Interest

There are many kinds of collateral security. Perhaps the simplest of them is the pledge, which is the delivery of property to the creditor, who may make itself whole in the event of default by taking the collateral (if it is cash or near-cash) or selling the collateral and applying the proceeds to the debt. Pledges have the virtue of simplicity and directness. Disadvantages include the custodial and administrative burden of holding and preserving the collateral property and the fact that the collateral remains the property of the counterparty, at least until there has been a default and a formal resort is had to the collateral.

Suretyship

As an alternative, some parties use surety bonds to supply additional assurances of performance. A surety bond is a contract, separate from the underlying agreement, under which a third party, the surety, guarantees the performance of the underlying agreement. The tenor of these bonds generally is that the surety agrees to be liable for a stated sum of money (the "penal sum") related to the underlying contract, but if the principal (i.e., contractor) performs the contract, then the surety is exonerated from all liability on the bond.

The surety's liability is thus dependent on the principal's default. Note that the term "surety" consistently signifies only dependent, accessory, or "co-extensive" liability. While claims are often asserted that an instrument creates only accessory liability (because the issuer of the instrument wishes to resist payment and wishes to set up the value transaction as a defense to payment under the security instrument), the intended use of accessory instruments appears principally in the construction industries of the United States, Canada, and the United Kingdom.4 If the instrument contains terms viewed by the courts as importing accessory liability, the issuer will generally decline to pay until a lawsuit has been commenced and prosecuted, regardless of the other terms of the instrument.5

Moreover, the liability of a surety is fragile, and said to be strictissimi juris.6 Any modification of the underlying contract made without the assent of the surety will exonerate the surety, as will any act that diminishes the surety's recourse against the principal.

Surety bonds, when enforced through court proceedings, generally entail activity that prolongs rather than expedites the resolution of any real disputes over the performance of the work and the payments for it.7

Independent Financial Assurances

In contrast to the foregoing, much of the world outside of the United States has come to rely on instruments that mandate payment of the sum of the instrument "on first written demand." These instruments are issued by banks and function as independent obligations of the issuer, irrespective of the actual right of the beneficiary to declare a breach of contract, the willingness of the principal that the payment be made, or any other matter or thing. In Europe and throughout Africa, Asia, and the Middle East, these instruments are known as "independent bank guarantees," and they have become critically important in a wide variety of commercial transactions.

Banks in the United States do not issue instruments of this kind. Until 1999, commercial banks in the United States were prohibited from guaranteeing the obligations of their customers. However, United States banks were not precluded from establishing letters of credit, which were not seen as guarantees but as payment facilities. Over time, other payment mechanisms evolved under which the letter of credit, now...