Some Thoughts on the Collateral Demand
March 15, 2022
As the saying goes “a bird in the hand is worth two in the bush.” Which “roughly” translated into surety speak means it is better to get collateral up front than to rely on a promise to reimburse later. Alas, sometimes sureties don’t get that collateral up front and at some point, decides that it might need to get some collateral to protect itself. So, now the surety wants to make a collateral demand.
1. Follow the Requirements of the GAI
Everybody certainly knows to do this, but I would be remiss not to mention it – You must follow the requirements of your GAI in making the demand for collateral. You would be surprised at how many times this is not done. You really have to look at the provision in the indemnity agreement and make sure that you are following exactly what is required. If the provision says that the collateral can be demanded if you set a reserve, you have to set a reserve first. If you don’t, you’re going to be running into the issue of whether you met the condition precedent, etc. If there is written notice required for the demand, you have got to send it to whomever the GAI says it has to go to and you’ve got to send it in a manner that is required. If it says certified mail, send it certified mail. If you intend to make the demand upon the principal and the individual indemnitors, then you need to make sure that the notice or the demand is going to those individuals, as well, especially the individuals who may not be involved with the business. You want to make sure each individual indemnitor is getting their notice and their demand for the collateral, because later if they don’t provide it and you want to sue them, you want to make sure that you have complied with the GAI. Same thing with any timeframe; if you have to give them a period of time to comply with the demand, allow that timeframe to pass before taking the next step.
Basically, when making your collateral demand you don’t want to give the indemnitors’ counsel or the court any reasons or grounds to claim that the surety was acting improperly or that the surety did not follow its own agreement.
2. Make Your Demand Amount Reasonable
The best practice is to make your collateral demand reasonable. So many times the surety may simply demand the full penal sum amount of the performance and payment bond without giving thought to whether such amount makes sense under the circumstances. If the demand is too over the top given the likely exposure, the surety may face the argument that the demand was unfair, overly burdensome or punitive. Take some time to figure out what an appropriate amount for the demand should be given the facts known. Seek out advice from your consultants and counsel. Make a reasonable effort at estimating the unknown risks and factors. Sharing the basis for the demand amount in the letter might go a long way toward avoiding a dispute over the amount. At the very least, put a memo in the file as to the basis for the amount of collateral demanded so that you can refer back to it later if a dispute arises.
3. Properly Perfect Your Interest in Collateral
So, you’ve made the collateral demand, you have the collateral now and you have to make sure you properly perfect your interest in the collateral so that it is protected and preserved while you’re holding it. You may be holding that collateral for years, and you have to make sure that you have done what is necessary to perfect your security interest. To do this, you have to look at the type of collateral that you have and figure out what needs to be done. For instance, under the UCC if cash is your collateral, you perfect your interest in that cash by possession. Maybe your collateral is bank accounts. You can perfect your interest in such accounts by control of the bank accounts. If you have certificates of deposit as your collateral, that can be complicated because of the different types of certificates of deposit. Under the UCC, depending on whether it is certificated or not certificated, it could be treated like a regular deposit account or could be treated like an instrument. It really depends on the nature of the certificate of deposit. If you’ve got vehicles or movable equipment, you have to secure your interest by having title to these vehicles. For real property, of course you have to perfect your interest through the land records. There is no point to obtaining collateral if you don’t properly protect your interests in that collateral.
4. Use a Collateral Agreement
If possible, it is recommended that when you are obtaining collateral, use a collateral agreement. The GAI typically does not have very much detail as to the mechanics of how the collateral will be obtained, retained and subsequently released. The GAI typically just gives you the right and creates the obligation. There are a lot of details relating to collateral that can be spelled out in a good collateral agreement. We have had numerous occasions where issues and disputes have arisen relating to the collateral, especially with respect to when and how much collateral can be released down the road.
If you have a collateral agreement you can identify the collateral to be used, what the purpose of the collateral is, for what reason you’re holding it, and for what purpose you’re going to use it if the need arises. Certainly, you’re going to use it to reimburse yourself if you pay a loss, but you may also want to use it to pay your consultant and attorneys’ fees, or you may want to pay unpaid bond premiums and things like that. You should address those issues in your agreement. Other issues to address in the agreement, depending on the type of collateral, can include how the collateral will be held, how it will be used, how it would be sold, if there is going to be insurance on the collateral, who is going to pay the premiums, are there going to be inspection rights, and what happens to any interest or income that is generated from the collateral. As noted, another issue to address in the agreement is when and under what terms will collateral be released. There have been numerous disputes where the principal and indemnitors are claiming that since you’re holding all this collateral and the current disputes are resolved, the collateral should be released. However, the surety still has exposure and potential liability relating to its bonds that will not really go away until the statute of limitations passes. A collateral agreement can go a long way to preventing future disputes and should always be considered.
WHAT IF THERE IS NO COLLATERAL DEMAND PROVISION?
What if the issue is you don’t have a collateral demand provision in your GAI? I just read one the other day that did not have one. Of course, the commercial side of the house tends to use the short-form indemnity agreement, which barely has anything in it. What can you do if you don’t have that collateral demand provision?
1. Commercial Leverage
Initially, you may have commercial leverage. If the principal wants/needs the bond they are going to have to give the collateral. You can certainly demand that up front or maybe even midstream if they want additional bonds for other projects, you can request collateral then. It is common on the commercial side to get that collateral up front or to increase as time goes on or circumstances change. Also, on the commercial side there is more built-in leverage because commercial bonds can typically be cancelled and/or have firm expiration dates. If the principal wants to continue the bonds, then they have to give the collateral. If they don’t give the collateral, then the surety just cancels. You can’t do that on the contract side of the house because once you issue that bond for a project, you’re stuck there. Certainly, economic leverage is something to consider as a tool, even if you don’t have a provision in the GAI for a collateral demand.
2. Common Law Rights
Another approach is to use the ancient common-law rights of quia timet and exoneration. These are rights that have been around for a long time and have long been recognized as rights held regardless of what your GAI says or doesn’t say, these rights are out there and could be used under the right circumstances.
- Quia Timet
Quia timet is basically Latin and translates into “because one fears or apprehends.” It’s part of a type of writ that was known in the common law as a writ of prevention. So basically, when the surety reasonably believes it may suffer a loss in the future because the principal is likely to default, then the surety can assert the right of quia timet to be placed in funds or collateral before the surety actually incurs a loss. It is essentially a common-law version of a collateral demand provision in your GAI. Typically, the elements are you have to show that there is an obligation of the principal that is or will become due or is likely to become due, that the principal will be liable for that debt, that but for the equitable relief the surety will be prejudiced and that there is no adequate remedy at law.
- Exoneration Exoneration is very similar to quia timet and really the primary difference between the two is one of timing. The exoneration right can be raised after the debt of the principal has matured and becomes due and before the surety has paid. The surety can demand the common-law right of exoneration and have the principal pay the debt out of its own funds before the surety has to, and that was something that was recognized at common law.
- Quia Timet
The rationale here is that the principal is primarily obligated for the debt and that the surety should be allowed to force the principal to pay its debt out of its own funds before the surety is required to do so. For a further discussion of these rights, take a look at the ABA/FSLC book The Surety’s Indemnity Agreement – Law and Practice 2d., Chapter 6. Also, the Restatement of Suretyship and Guaranty, THIRD section 21 discusses the right of quia timet and exoneration and some of the comments there explain those rights in greater detail as well.
We will delve into the world of collateral demands in future posts, until then I wish you many happy collateral demands! If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (email@example.com) or any member of the Surety and Fidelity Practice Group.
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