In our Defensive Banking 101 and Recession Training 101 seminars, we often advise of the potential danger in providing revolving financing to borrowers that may be secured by “bonded receivables.”
A bonded receivable, while typically a construction receivable, is any receivable resulting from the provision of goods or services under a job which is covered by a payment and/or performance bond issued by a surety. A surety bond guarantees a contractor’s full performance under a construction contract. The surety promises to undertake completion of the project or to pay out the amount of the bond to the project’s owner or developer in the event the bonded construction firm does not perform under its contract.
A lender’s underwriting for any revolving line of credit based on outstanding receivables will always depend on the strength of the receivables being financed. With respect to a bonded receivable, however, a lender faces additional pitfalls in addition to the customary concerns as to the ability of the borrower’s customer to pay what it owes and the potential danger that the customer will dispute payment of the receivable due to poor performance by the borrower under the construction project. The primary concern with bonded receivables which makes it difficult for lenders to rely upon them as collateral in their underwriting is that the rights of the surety (i.e. the bonding company) can unexpectedly prime or supersede the rights of a lender to collect the borrower’s receivables. This is true even if the lender has a first priority perfected security interest (i.e. by UCC filing) in the accounts receivable of a borrower. If a borrower does not live up to its commitments on a bonded project, the lender can lose its senior lien in the proceeds of an otherwise collectible account if the surety has declared a default under a payment or performance bond with respect to the project. That is because a surety under a defaulted bond acquires rights in the defaulting contractor’s existing and thereafter arising rights to payment as “subrogee” of the contractor and those subrogation rights take precedence over (i.e. prime) the lender’s UCC lien priority. Note that while some bonding contracts reference the right of the bonding company to file a UCC financing statement, a UCC filing by the surety is not required to establish its subrogation rights, since these rights arise outside the Uniform Commercial Code. The surety rather than the borrower is then entitled to receive payments on the project and hence the lender’s security interest no longer attaches to such receivables, unless and until the surety has recovered in full what it has expended as a result of the borrower’s default under the bond.
Where a borrower has receivables on multiple projects which are being financed by a lender, the lender likely only faces the loss of its priority security interest as to amounts becoming due on the defaulted bonded project and not as to amounts due to the borrower on the other bonded projects. This, however, is not a settled issue of law and disputes between the lender and the surety under these circumstances are likely. Sureties typically claim they are entitled to receive all payments due on any bonded project for which they are the surety to pay for not only completion costs, but also to recover more indirect expenses they incurred as a result of the default, including the expenses of monitoring and managing the project.
For these reasons, it is risky for a lender to rely upon bonded receivables when underwriting a line of credit to a contractor. Given the potential for the loss of priority in bonded receivables, lenders who do decide to include bonded receivables in their borrowing base calculation should closely monitor a contractor borrower’s performance on bonded projects and be prepared to either (i) deem bonded receivables ineligible for advance if a project starts experiencing delays or problems and then restrict advances to the borrower based on the bonded receivables, or (ii) agree upon the initial documentation of the loan to a lower (i.e., more cautious) advance rate with respect to bonded receivables in order to minimize the lender’s exposure on the bonded receivable in the event the lender is primed by the surety. An even better solution would be to obtain a subordination from the surety bonding a project, but we have not found this to be a common practice since there tends to be little motivation for the surety to agree to a subordinated position.
There are dangers to lending against bonded receivables and so lenders should proceed with caution and perhaps require secondary collateral in the event issues arise with a bonded project.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.