Hazardous provisions in bond forms: how to help mitigate underlying risk

While bond form wording is standard in many cases, commercial surety bond forms may contain language that could be hazardous or, in some cases, completely unacceptable. Even wording that appears reasonable could potentially be interpreted in unintended ways if not viewed in the entire context with any underlying agreement.

But if you know what to watch for, you can anticipate and could mitigate these hazards. Here are four types of wording in surety bond forms to keep an eye on and how to try and mitigate any potential risk. A surety bond is traditionally entered into by the principal, typically a business; the obligee, usually a government entity; and a surety.  

Example

“Full payment shall be made under the bond within thirty (30) days’ receipt of the department’s declaration of forfeiture by the surety.” Or stated another way: “Forfeiture of all or a portion of the bond shall be made by the surety upon demand by the obligee…”

Explanation

In short, you may need to pay the obligee a portion or the entire penal sum of a bond within 30 days according to the provisions of the bond form. If a contract or underlying agreement is involved, the provisions of that document will apply as well. And all of this could occur with little or no opportunity for the principal to investigate the claim or present a defense. The red light here — and everywhere — is “forfeiture.” 

Example

“Within seven (7) business days of surety’s receipt of a demand for payment under this bond, surety shall pay obligee the amount of such demand.”

Explanation

This is known as a “pay-on-demand clause” and contains several potential risks. First, making a payment in seven days is near to impossible in many cases and it’s often too short a window to prepare any defenses. And if the obligee demands payment, the surety is obligated to make it. The surety is likely to then try to get reimbursed by its principal, placing it in a difficult position with its own customer.

Example

“The principal and the surety further agree that execution may issue upon judgment so confessed for the full amount of money and accrued interest that is owing from the principal and/or surety to the Commonwealth, with costs and collection fee upon filing information in writing in the court when such judgment shall be entered.”

Explanation

This is known as a “confession of judgment clause,” and it’s important to understand the risks for both the surety and principal. This type of clause potentially means that the surety accepts the liability and amount of damages as claimed by the obligee and allows the obligee to enter judgment against the surety. This could place the surety, and by extension the principal, at risk to not only have its and the principal’s defenses ignored, but also potentially liable to make a payment immediately under the bond. This is a lose-lose for both parties.  

Example

“In the event the surety’s or principal’s credit rating is downgraded by one level or to below investment grade by S&P or Moody’s, then this bond may be subject to a demand for payment by the obligee.”

Explanation

This clause is known as a “ratings trigger” and should not be accepted in any bond form or contract. The trigger in this case is the credit rating of the subject company: if it drops below a certain level, the obligee may then demand a replacement security or payment. For this reason, senior underwriting officers are required to sign off on this wording before execution, extending approval times and sometimes even negating possible consideration.

The above examples illustrate how bond form wording that may appear relatively innocuous can entail hidden liabilities and obligations. So how can these kinds of bond risks be mitigated?

It’s important to have available cash and sufficient bank lines for reimbursement if the surety has to make a payment. This can give the surety confidence that it can recover payment in the event a partial or total penal sum of a bond is demanded. Your surety provider can assist in determining the level of liquid assets needed to stay ahead of potential financial pitfalls.

In addition to acceptable cash balances and bank lines, it is important for the principal to demonstrate overall financial health. This includes showing that the company has been in business for a number of years, is financially stable, and is able to weather any difficulties that may develop over the long term. The principal may also need to show that both management and their legal support team have been made aware of the risks taken on by the provisions of the bond and are able to protect themselves and the surety from undue exposure concerning the bond in question. In some cases, taking collateral may be the additional security needed to mitigate a pay-on-demand clause or long-term risk.

If the bond form refers to an underlying agreement, this document — as well as the bond form — may govern the overall risk and must be reviewed closely. Bond provisions providing greater coverage than required by the contract may apply, while bond provisions providing less coverage may be disregarded. There are also cases in which the bond obligation can be modified from the conditions set forth in the underlying agreement by the insertion of a clause in the bond form. This should be signed by the obligee indicating acceptance of the changed provisions.

Bond forms can be confusing — especially with potential and unexpected risks contained in their wording. Mitigating these risks should focus on either avoiding bond forms with these hazardous clauses or working to negotiate acceptable bond language for all parties.

Here is where your surety can help, providing advice and counsel to steer you through the approval process. The ideal scenario is where everyone is comfortable with bond form language, difficult as it may be. Partnering with your surety provider is a great way to get the assurance you need.

Liberty Mutual Surety provides bonds with a tailored approach to commercial surety across many industries. Find out more about our range of offerings here.