“The world hates change, yet it is the only thing that has brought progress.”
– Charles Kettering
Kettering was the man behind putting electrical systems into automobiles. His goal was not to completely change how a vehicle operates, but rather make a small improvement to benefit drivers. The same applies in replacing letters of credit with surety. Utilization of surety bonds does not change what Treasury does, rather it provides them with a new avenue to help improve the firm’s financial profile. Getting an organization to shift toward broader surety utilization requires effective communication.
The 2008 financial crisis sparked international financial reform, becoming a catalyst for the surety market’s growth. These reforms led to increased bank costs, further incentivizing companies to execute on letter of credit replacement projects. Letter of credit replacement projects focus on identifying opportunities to swap outstanding letters of credit (LCs) with surety bonds, saving costs and freeing up liquidity. Though many of these reforms were developed and implemented over the last decade, numerous companies still have an opportunity to benefit from them.
Before communication begins, it is important to have an understanding of Treasury’s main functions. According to a 2014 survey done by PricewaterhouseCoopers, the most important functions of a treasury group in large organizations are financial risk management, cash and liquidity management, and funding1. Surety bond utilization can directly affect how treasury manages a firm’s cash and liquidity needs. Normally bank facilities are set up to address daily working capital (cash) needs, on-going collateral requirements, and long-term liquidity risks. Facility size and utilization directly impacts the firm’s credit profile and cost of operations. In collateral intensive industries such as Energy, hundreds of millions in LCs are issued off these facilities at any given point, costing millions and consuming a material portion of the firm’s bank borrowing capacity.
Understanding the similarities between surety bonds and LCs is vital to the discussion. Both products offer a guarantor (Surety/Bank) to guarantee one party’s (Principal/Applicant) obligations to another party (Obligee/Beneficiary), in support of an underlying contract. The Obligee/Beneficiary will typically require one of the products as part of their transaction terms to act as financial or performance assurance, mitigating their risk of loss on the transaction. Generally, both surety bonds and LCs have a maximum term of up to three to five years, and either can be structured to have an annual expiration with an auto-renewal clause. Both products are underwritten by highly creditworthy financial institutions. Banks underwrite LCs, while insurance companies (the “surety” or “sureties”) underwrite surety bonds.
In the event the Principal/Applicant defaults on their contract, leaving the Obligee/Beneficiary with a loss, the Obligee/Beneficiary can file a claim on the bond in a similar process as they would present the LC with a draw certificate to collect their losses from the respective institution. At the time of underwriting, neither banks nor sureties expect a loss to arise through the life of the instrument. In the event of a loss, both then pursue the Principal/Applicant for reimbursement of any losses incurred. Each product serves similar functions, and, are interchangeable in many scenarios.
Though similar, there are key differences between surety bonds and LCs. Surety was formalized in the United States after the Heard and Miller Acts passed in 1894 and 1935. These two acts mandated bond requirements for federally funded projects, many of which were infrastructure/construction related. As a result, surety became the standard risk mitigation tool for construction in the US. North American, Latin American and South American countries use surety widely for contractual securities. However, European countries have traditionally been markets where only LCs were acceptable. This is often a matter of education; surety can certainly fill the role of an LC in many circumstances, the obligees must first understand the functionality in order to agree to change their guidelines. It is important to note that surety has always been a guaranty of contractual obligations, and the surety’s ability to underwrite certain obligations can vary depending on country. Today, LCs are the predominant assurance instrument used across the globe, but surety is evolving every day and product popularity will continue to grow.
Governance has helped the US surety industry’s evolution in recent years. By law, surety bonds are an insurance instrument, meaning their governance is primarily on a state-by-state, country-by-country basis. Depending on the bond form, applicable governance can be subject to where the contract work is completed or addressed in a governance clause within the bond form. LCs are governed by the standardized rules and regulations published by the International Chamber of Commerce: the International Standby Practices (ISP98) or the Uniform Customs & Practice for Documentary Credits (UCP 600). Depending on the type of LC and parties involved, either ISP98 or UCP 600 is outlined in the LC language. One of the clear advantages of surety lies within the guarantor’s regulatory requirements. Basel III is a 2009 international regulatory accord introduced in response to the 2008 financial crisis. These international regulations raise capital and leverage ratio requirements for banks, directly impacting LC costs and driving surety to often times being more cost effective.
Utilizing surety effectively cannot only save costs, but also free up bank liquidity. Surety bonds are off-balance sheet or “contingent liabilities” from an accounting perspective, enabling companies to increase their liquidity profile, and the underwriting process sureties undergo provide additional downward pressure on pricing. A company’s credit facility is most often secured against their assets; however, surety is usually offered unsecured.
Sureties underwrite bonds on an individual basis, where LCs are generally issued off a broader credit facility that has been underwritten previously. During the underwriting process, a surety will review the underlying contract, bond language, updated financials, and develop an understanding of why the bond is required. By reviewing this material, the underwriter attempts to analyze all the risks associated with the transaction. For letters of credit, because the facility is often established, the bank generally will only require LC language to review. This may sound more convenient, but is also another reason surety often is more cost effective. While the banks underwriting process is complex and robust at time of the credit facility issuance, the bank’s line of sight into the actual obligations the facility will support is limited, and therefore cannot consider much of what surety underwriters can.
A common concern of treasury managers is the strategic importance of maintaining LCs to avoid negatively affecting their bank relationships. Though this can certainly be a legitimate concern, it is important to determine the drivers behind it. Several factors may be at play: a treasury manager’s experience with bonds (or lack thereof), consideration of other banking services needed, and/or the firm’s current liquidity profile. Treasury groups with broad banking needs will likely see value in surety more quickly than those who do not, because their bank relationships are often more diversified and less reliant on LCs. Organizations structured with heavy reliance on LC costs to manage their bank relationships may have significantly less flexibility. In consideration of this, it is important to communicate that LCs will still be needed from your banking partners, as only a portion of the existing LCs may be replaced.
Establishing a relationship with a surety opens Treasury to a new partnership, which aims to help support and protect the business. Part of a surety’s underwriting process includes negotiating bond language. It will look for opportunities to include language allowing for disputed claims to resolve prior to a payout. Assuming a dispute occurs and an LC is outstanding, the bank would pay out on demand and immediately look to the treasury team to organize reimbursement. That can create headaches for all involved parties and potentially be avoided through bond utilization.
Treasury and risk management working in conjunction to incorporate surety – or potentially more robust surety – is often overlooked. Why? Generally, it is due to the separation of responsibilities embedded within a firm’s org chart. A firm’s insurance department focuses on managing the numerous complexities of procuring and maintaining various insurance needs, and usually also manages the surety program. Treasury may have relatively minimal overlap with risk management as its focus is on cash and liquidity management. Often neither Treasury nor Insurance realize surety can be a key source of savings and increased bank capacity – through no fault of their own.
When internal advocacy is required, remember that surety bonds and LCs can be interchangeable, surety does not tie up bank borrowing capacity, and, with proper implementation, can very often significantly improve the overall financial picture of a company. Once Treasury and Risk Management come together, a strong surety broker can help determine the best course of action for the business.