October 1, 2014 by DAVID BOWCOTT
A watershed moment within the performance security industry took place several weeks ago when the first liquid surety products were accepted by some lenders as a replacement for the previous liquid instrument of choice—the letter of credit (LC).
For several years now the surety industry has been revamping their traditional North American surety offering by making it more responsive to owner claims. The traditional North American surety product responded when the surety company that issued the bond acknowledged there was a default under the bonded contract. As it respects this form, some within the owner and lender community felt that the time to investigate whether a default had occurred was not quick enough to ensure the project remained on schedule. As a result, these owners and lenders sought responsiveness by requiring LCs from the contractor completing the job.
To most contractors the requirement to post an LC can be severely constraining to their financial flexibility. The banks that issue them often have very severe security measures in order to issue these liquid instruments. As a result most contractors are extremely reluctant to post LCs to secure their performance. These are very responsive instruments so the banks that issue them for contractors are being very conservative given the immediacy of the payment. To obtain these instruments banks will often take a secured position against the contractor, and depending on the make up of the contractor’s balance sheet, they may require that cash be set aside in order to secure the LC. To other creditors, these charges and restrictions on cash impact their analysis negatively, often resulting in a reduction of credit capacity.
So, we have some owners and lenders requiring very liquid instruments in the form of LCs and we have most contractors not willing to post LCs due to financial constraints. These contractors needed a more sustainable solution. One of the obvious solutions was to turn to their surety partners to see if they could craft an instrument that satisfies liquidity hungry owners and lenders, and at the same time allows the contractor to gain better security terms. Enter the concept of liquid surety.
Liquid surety has been on the scene now for more than five years. So, why has it taken so long for these instruments to gain traction within the owner and lender community?
Well, there are a few reasons:
• Early generation forms were restrictive—Some of the early forms, though more liquid, had provisions that made them less attractive than an LC. Things like payment within 15 to 30 days versus the on-demand nature of most LCs.
• General reluctance to change—In my previous column I talked about the project finance community’s reluctance to change security packages. The “we’ve always done it this way” attitude was a major contributor to the delays in adoption.
• Lack of track record—The owner and lender community often would ask for precedence in these forms being used and also around claims using these forms. Now there is precedence.
• General mistrust of insurance products—Some might say the insurance industry as a whole has a less than stellar brand when it comes to claims payments. I’d argue these are isolated cases. Either way, this did have some impact on the slow adoption.
• Lack of motivated participants—Within some of these complex project finance deals there are a number of players—contractor, equity, financial advisor, lender advisors and lender. For these deals to move forward you need all parties motivated to do a deal.
Several of us within the insurance and construction community have spent a lot of time working to develop traction for these innovative instruments. We’ve focused a lot of our attention and energy working to get these solutions across the “acceptance” finish line. That has been accomplished; however, the work is not done. We still need to determine the framework of how these instruments will be sized, priced and secured by the surety industry. This is where the knowledge the surety industry has about the construction industry can be leveraged to create a more sustainable liquid security solution that satisfies owners and lenders, and also minimizes unnecessary constraints on the contractor’s financial position. Happy negotiating!
David Bowcott is senior vice-president, national director of large/strategic accounts at AON Reed Stenhouse Inc. Send comments to email@example.com