The Surety’s Right to Demand Collateral Security
Once a surety determines that it will issue bonds on behalf of a construction firm, the surety generally requires the contractor, its principals, and their spouses to execute an indemnity agreement that gives the surety extensive, enforceable rights to maximize its chances of incurring no losses. We all know that the most important provision of any general agreement of indemnity (GIA) is the indemnification provision, which provides that the indemnitors agree to hold harmless or indemnify the surety against all liability, loss, costs, and/or expenses that the surety might incur as a result of having issued bonds on behalf of the principal. Less well-known, but an important provision nonetheless, is the collateral security provision (also known as the collateral deposit provision and the “place in funds” provision).
The collateral security provision in a GIA provides the surety with the right to demand and obtain collateral from the principal and indemnitors to secure it against potential liability for claims and expenses. Under this provision when a surety receives a demand on its bond, the principal and indemnitors must deposit with the surety, upon demand, funds or other collateral sufficient to secure the surety against the claim. A sample collateral deposit provision follows:
|Immediately upon demand, the Undersigned will deposit with Surety, as collateral security, money or other collateral satisfactory to Surety, equal to (1) the liability of Surety, if established; (2) the liability asserted against Surety; or (3) the reserve established by Surety, or any increase thereof, to cover any liability for any loss or expense for which the Undersigned may be obligated to indemnify Surety under the terms of this Agreement. Surety shall have the right to use the collateral, or any part thereof, in payment or settlement of any liability, loss or expense for which the Undersigned is or would be obligated to indemnify Surety under the terms of this Agreement.
This language provides that the surety has a right to use the collateral to pay any and all liability under its bonds. The principal’s and indemnitors’ failure to meet a surety’s collateral demand is a breach of the GIA.
Numerous courts (although not all) throughout the United States have upheld collateral deposit provisions in GIAs by granting the surety a preliminary injunction, even in cases where the principal or indemnitors assert defenses to the underlying bond claims or to their indemnity obligations. The courts have also held that sureties lack an adequate remedy at law for a breach of a collateral security provision.
Bond producers are highly encouraged to urge their contractors and subcontractors seeking bonds to read and understand the provisions of the surety’s GIA and to seek legal assistance, if needed, before executing it rather than to receive later a potentially unpleasant “surprise” when the surety seeks to enforce its contractual rights. Producers should impress upon their contractors and subcontractors that the GIA is a powerful legal contract that provides the surety issuing bonds with many enforceable rights against the indemnitors and that the courts will, with few exceptions, enforce unambiguous provisions in a GIA. Contractors should be reminded and cautioned that contractual rights of a surety, such as the collateral security provision, that are written into the GIA are just that: contractual rights that courts will almost always enforce as written. The GIA is not a document to be lightly signed and then blithely forgotten, as an administrative step to obtaining bonds.
Contractors and subcontractors—and their bond producers—should remember the following concerning GIAs:
- Always review and understand the provisions in the GIAs you are asked to execute, prior to execution. Please note that sometimes the same surety company will have various forms of GIAs, so always review any GIA you are asked to execute.
- If necessary, have the GIA reviewed by knowledgeable legal counsel.
- The language of GIAs varies from surety to surety, but most GIAs contain certain typical clauses, such as the collateral deposit provision.
- Different jurisdictions might interpret the same provisions of a GIA differently.
- Do not rely on the impact of a statement, whether oral or written, that is not specifically incorporated into the executed GIA.
- Always consider whether any provision in the GIA is too onerous or too risky to your business (sometimes a specific GIA contains terms and conditions that are not typical and put the principal at risk of enterprise failure).
The author of this article is Martha Perkins, General Counsel at NASBP. Martha Perkins can be reached at firstname.lastname@example.org or 202.686-3700.
This article is provided to NASBP members, affiliates, and associates solely for educational and informational purposes. It is not to be considered the rendering of legal advice in specific cases or to create a lawyer-client relationship. Readers are responsible for obtaining legal advice from their own counsels, and should not act upon any information contained in this article without such advice.