Surety Bonds: Case for Collateral


Surety Bonds: Case for Collateral

A surety bond is a type of risk management tool; it is an agreement where the surety, a bank or an insurance company, provides their financial backing of the principal (the party responsible for fulfilling an obligation) for the benefit of the beneficiary (the party to whom the principal owes the obligation). Although surety bonds may take the form of performance guarantees, advance payment guarantees, bid bonds and letters of credit, they have two things in common. First, they are the oil that lubricates trade, whether domestic or international. Second, they enable parties who hardly, or do not, know each other in the business sense to transact in the confidence that the amount stated in the bond will be paid in accordance with the bond terms, by the surety, bila maneno (without let or hindrance).

Yet going by the number of disputes ending up in courts for enforcement of surety bonds and the defenses put forward by the sureties, it is obvious that a substantial number of sureties do not understand the purpose and implication of the surety bonds. Once a demand is made, sureties try everything possible to avoid honouring them. Quite a number only pay after the court has passed a judgment, usually with costs and interest, which could have been avoided.

For instance, in the construction industry, performance bonds are provided as useful means of creating financial security for the Employer (the developer) for the contractor’s failure to perform his contractual obligations. The contract requires a bond usually to a level of 10% of the contract sum. The bond guarantees the contractor’s performance of the contract with an undertaking to be bound in a specified sum until such performance is achieved. Upon the contractor’s failure to perform his functions, the Employer is entitled to call the surety to take good the loss up to the maximum amounts of the bonds.

Whereas the construction contract and the bond are interrelated, since the bond is a tri-partite transaction involving the parties to the construction contact and bond, the bond is nonetheless a separate and wholly independent legal document enjoying autonomy from the construction contract.

There are two types of bonds; conditional and unconditional bonds. The conditional type, on the one hand, is where the surety agrees to pay if and when a specified condition e.g., default by the contactor occurs. In this type, proof of default is necessary. Unconditional bonds, on the other hand, entitles a beneficiary to call upon the surety for payment whether or not there has been default under the contract, provided only that the calls not fraudulent. It is a pledge by the surety to indemnify the beneficiary merely when demand is made.

In one of the cases of the bank undertook to pay “on your written demand in the event that the contactor fails to execute the contact in perfect performance”. Although this looked like a conditional bond, the court interpreted it as unconditional because the initiating event was the demand and it would not have been intended that the bank would be concerned with the assessment of whether or not there had been perfect performance.

To mitigate the exposure risks sureties are well advised to insist on a collateral. The collateral would do so by providing the surety with funds on hand to use towards settling the claims that risk of issuing the bond to be too high without some form of collateral in place.

It is important to emphasize that a performance bond is not an insurance policy. The latter is normally a contract of indemnity under which the insured is indemnified in event of loss. This because, apart from the number of parties involved in each, three in the former and two in the latter, a bond, once is issued, cannot be recalled until the stated date of discharge or until the construction has completed satisfactorily. An insurance policy can however be cancelled before the expiry date.

What we have discussed as regards performance bonds applies to other types of surety bonds with necessary adaptations.

Sureties should therefore harken to the advice usually given to newlyweds; not sign a surety bond lightly or in-advisedly otherwise it may turn out to be a poisoned chalice.

Daniel Musyoka