Securing Construction of Public Highways and Other Municipal Services: Surety Bonds v. Irrevocable Standby Letters of Credit (Part 2)

By: Quinto M. Annibale, Loopstra Nixon LLP

October 2015

In Part 1 of this 2-part series we examined the various tools that are available to municipalities in securing the construction of services and infrastructure in the development process. It was noted that the most common form of security that is used by municipalities for this purpose is the irrevocable standby letter of credit. In Part 2 we will examine the advantages and disadvantages of the two main forms of security available to municipalities: surety bonds, and irrevocable standby letters of credit. By looking at examples from the United States and a recent case study from an Ontario municipality we will explore the benefits of using surety bonds in a modified form.

The Use of Subdivision Bonds in the United States

In the United States, public authorities in a number of state jurisdictions are provided with a wide range of options with respect to the form of security which may be accepted to enforce obligations undertaken by developers for the construction and maintenance of infrastructure pursuant to a Subdivision Agreement.1

One widely used form of security is the so-called subdivision bond.2 As is the case with conventional construction bonds, subdivision bonds represent a tripartite surety contract executed between an obligee, a principal, and a surety.  In practice however, subdivision bonds operate somewhat differently than ordinary construction or public works surety bonds, reflecting the different nature of the parties involved and the particular obligations that the bonds are meant to enforce.

The differences arise principally due to the subdivision agreement which operates in a very different manner than a traditional construction contract. Under the subdivision agreement it is the developer (i.e. principal under the bond) that must pay for, and then arrange to construct the municipal services guaranteed under the bond. In a traditional construction contract the principal would most likely be a contractor directly responsible for the construction and the obligee would in that case pay for the improvements being built. Here though, the obligee does not pay for any of the construction of the infrastructure (indeed, the purpose of the security is to ensure this is the case) and the consideration provided for the construction is not money, but rather the right granted in the subdivision agreement for the developer to develop the lands in question.

One practical impact of this is the manner in which the obligation of a surety has been interpreted where default is alleged by the obligee. A number of courts have taken a very practical approach to defining this obligation, strictly limiting recovery under the bond to the actual damage sustained. In Westchester Fire Insurance Co. v. City of Brooksville3 for example, the municipality sought to collect against the face value of the bond, maintaining it would use this money to complete the servicing improvements covered under it. This was a case where the developer had gone bankrupt and construction of homes in the development had not begun in earnest. The court sided with the surety and ordered that no payment under the bond was due. This is because even if the services were constructed by the municipality there would be no homeowners to service and therefore there was no damage actually sustained by the municipality. Thus any payment under the bond would constitute a windfall and would not be in the nature of a performance bond.

There is large variation between subdivision bonds used in various jurisdictions and depending on the way these are structured or the language used they may have features of penal, payment, or performance bonds.

Which Instrument is Appropriate for Use in the Context of Municipal Services?

If accepted in their traditional forms, there is no question that Irrevocable Standby Letters of Credit (“ISLOC”) are the preferred method of security for the construction of municipal services acquired through the development process.  However, there is no reason why Performance Bonds cannot incorporate language which includes most, if not all of the protections contained in UCP 600 (at least those that are applicable to the municipal context).  After all, UCP 600 and its predecessors were developed to aid international trade.  The public policy basis for the creation of an international standard has little direct application to or bearing on the public policy protections necessary to ensure that municipal services are delivered.  There are no international barriers, no protectionism, no nationalism to worry about, no conflicts of law problems to solve, and no different banking systems to worry about when securing municipal services.  As long as the terms of the Surety Bond are the same as those in an ISLOC, and there is comfort in the financial stability of the Surety, then Performance Bonds (amended to contain the same provisions as ISLOCs) are every bit as good as ISLOCs.

Case Study – Friday Harbour in the Town of Innisfil

The Town of Innisfil recently launched a pilot project to test the usefulness of bonds as security for the completion of municipal services in a project called “Friday Harbour” on Lake Simcoe.  The Town of Innisfil (as do most municipalities) had plenty of previous experience using Performance Bonds in projects that it tendered on its own for the construction of municipal services.  Historically performance bonds have been accepted by municipalities in the context of the construction of tendered municipal services, but there has been a reluctance to accept them for works constructed within a development plan.  The municipal staff reviewed the legal basis for bonds vs letters of credit and concluded, in a report to council, that bonds would be acceptable, on a trial basis, for the completion of works which were external to the subdivision.  The report identified the following as reasons supporting this decision:

  1. The Surety in this case was prepared to amend its standard form of performance bond so that it contained most, if not all of the protections contained in UCP 600. It contains the following important clauses;
    1. The obligation to pay is on demand, without regard to the equities between the parties and the payout is in cash up to the aggregate amount of the bond;
    2. The Bond is automatically renewed after one year and stays in effect unless the Surety provides notice that it will not renew (in which case the municipality is given the right to draw on the entire bond);
    3. Partial Drawings are permitted;
    4. It is standby;
    5. It is irrevocable;
    6. Drawings are permitted upon presentation of a sight draft;
    7. The Bond references the specific agreement for the construction of the municipal services; and
    8. Partial reductions are permitted in the bond amount
  2. The municipality had a track record of accepting Performance Bonds for tendered project on municipal roads and services already;
  3. The financial stability of the Surety was reviewed and found to be acceptable as an issuer. The Surety is a personal and commercial insurance company and is therefore subject to financial and reporting requirements that must be made publically available, despite being a private company.
  4. The Surety provided the Town with their previous years’ annual financial reports for review and they were found to be strongly capitalized, with shareholder equity substantially greater than the annual premiums generated by the company.  Their assets are predominantly liquid, consisting of cash, cash equivalents, bonds and debentures and stocks of publically traded companies.  They are rated as “A” (Excellent) by A.M. Best and as “A-“ by Standard and Poor’s;
  5. As a property and casualty insurer, Surety is regulated by the Office of the Superintendent of Financial Institutions (“OSFI”), the Canadian federal regulator that also regulates Canada’s banks and life insurance companies.  The Guarantee Company is required to comply with OSFI regulatory requirements which include minimum capital requirements;
  6. While the industry obligation to maintain capital is fairly low, (common practice is to maintain capital in the “mid-200’s”, the Surety had typically maintained 300+ meaning that it is well capitalized.  It is regarded in the industry as a “top tier” personal and commercial insurance company. The company is considered to be well run and its governance is strong;
  7. Bonds have been an acceptable form of municipal subdivision services security in the US for many years. Several Canadian municipalities have now adopted policies to allow bonds to be accepted.  Notably, the City of Pickering has adopted such a policy.  The City of Calgary, the City of Grand Prairie, The Regional Municipality of Durham and the City of Greater Sudbury have all accepted some form of surety bond for the construction of municipal services; and
  8. In the agreement and as a condition of accepting the bond, the municipality has stipulated that the Town is permitted to require a replacement security if the credit rating of the Surety falls below a level that is unacceptable to the municipality.  This is to ensure that the security for the service will continue even if the financial stability of the Surety changes.

Conclusion

As the example from Friday Harbour demonstrates, in cases where a surety company is open to such arrangements, incorporating terms and language that is typical of letters of credit into the surety contract can offer significant advantages to all parties involved.

On the one hand, the municipality gets the flexibility and peace of mind offered by an ISLOC. If the developer defaults on its obligations it is unnecessary for the municipality to go through a drawn out negotiation with the surety company and the risk of non-performance is thereby drastically mitigated. As well, with amended language, the modified bond provides just as much protection to a municipality as an ISLOC. Meanwhile, the developer benefits, because although the modified bond now operates in many ways the same as an ISLOC would, the developer’s liability with respect to the surety remains in the nature of an indemnity. Under an ISLOC the developer would be required to provide dollar for dollar direct security and potentially tie up resources in the form of its line of credit with the issuing bank thereby decreasing the cash available to complete construction. This potentially reduces the risk of default which is an advantage for both the developer and the municipality. As well, the overall cost of borrowing for the developer is lower. Where the parties involved are open to more flexible and creative arrangements it is likely that we will see more and more municipalities accept Surety Bonds as security for subdivision services in future.

 

FOOTNOTES

  1. See for example CAL. GOV’T CODE § 66499 (California); FLA. STAT. ANN. § 177.091 (Florida); 55 ILCS 5/5-1041 (Illinois); MASS. ANN. LAWS ch. 41, § 81U (Massachusetts); MICH. STAT. ANN. §§ 5.3004 and 26.430(182);
  2. Although the use of subdivision bonds is not unprecedented in Canadian jurisdictions (see for example York (City) v Wellington Insurance Co. 1998 CarswellOnt 3541, 41 O.R. (3d) 750, 75 O.T.C. 33) it is much more common for an ISLOC to be used.
  3. 731 F. Supp 2d 1298 (M.D. Fla. 2010)

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