Practical Advice to a Surety to Protect Collateral in Bankruptcy

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By Elliot Scharfenberg

It borders on the cliché to begin an article by musing that suretyship is among the most ancient contracts known to law and that undertaking a suretyship contract has been fraught with risk ever since its inception. While this is undeniably true, I assume that everyone reading this article is no stranger to these well-trodden platitudes. Instead of ruminating on legal theory or recapitulating a legal brief from a case the author recently was involved in, I’d like for this article to be among the precious few that give practical advice to commercial surety underwriters in their daily practices. At the stage when the surety has decided to take collateral, the role of the surety bond producer is more remote and focused on ensuring communications between the client and the surety.   

Although the bulk of my legal practice consists of representing sureties in the claim process, I’ve had the privilege to work with many underwriters during work outs and pre-bankruptcy planning, long before a claim is made and while the principal and indemnitors are in the midst of financial turmoil. It will come as no surprise that the goals of the representation and the methods for making decisions are often different when my client contact is an underwriter as opposed to a claim professional.

Commercial surety underwriters make consequential decisions for their companies on a routine basis. Whether it be the decision to write a new account, to exit an account, or how to structure a business deal during a contentious work out, each may have the potential to generate millions of dollars of profit or loss for their companies. Among those consequential decisions are whether to demand collateral, how much, from whom, in what form, when, and under what conditions. The decision to take collateral is not one made easily, and I understand that there are many business, strategic, and legal considerations that go into the decision to take collateral. While those considerations pose interesting issues, they are also beyond the scope of this article. Instead, this article is more limited: once the decision to take collateral is made, how does the underwriter make sure that the collateral is legally protected if the party depositing the collateral files for bankruptcy? For those who are pressed for time, there is a cheat sheet in the conclusion.

I.      What Language Should Be in the Indemnity Agreement or Collateral Agreement?

As I am a lawyer, this topic is near and dear. I recently finished refreshing the indemnity and collateral agreement forms used by one of my surety clients. During that process, I realized that, especially in high-dollar commercial surety underwriting, the rights that a surety can bargain for in the indemnity agreement are far more limited in scope than in contract surety and often do not include security agreements. This makes sense because many of those large companies are not willing to grant security interests to the surety and those companies are good credit risks even without a security agreement. Nonetheless, a security agreement is important when taking collateral; and the underwriter should pay close attention to the language of the indemnity agreement and perhaps obtain a separate collateral agreement.

The basis of the surety’s rights to collateral will be in an indemnity agreement—or possibly a separate collateral agreement—without which the surety may be left with little or no collateral security rights. But are all indemnity agreements created equal? No, they are not. While I recognize that the business realities of underwriting a commercial surety account may dictate a less inclusive indemnity agreement, the following are a few provisions that should be considered when taking collateral security. Failure to include some of these provisions could affect the surety’s rights to the collateral when the principal declares bankruptcy.

First, the surety should have the right to be placed in funds at any time. Ideally, this provision would allow the surety to demand the form of the collateral, that is, an irrevocable letter of credit, and would give the surety the right to set the amount of the collateral in the surety’s sole discretion. Unless there is a compelling reason to limit its scope, the collateral should secure all surety bonds and should expressly allow the surety to use the collateral to pay loss and expense, hold as a reserve against future claims, pay premium, and pay the costs of the surety’s professionals.

Second, the indemnity agreement or collateral agreement should expressly state that it is a security agreement and may be filed as a financing statement for purposes of the Uniform Commercial Code. An agreement that meets these criteria may make the surety a secured creditor for certain types of collateral that may be listed in the agreement. When a surety perfects its security interest, this type of provision may also provide the surety with a secured position in the principal’s bankruptcy proceeding.

Finally, keep in mind that a good indemnity agreement or collateral agreement is the first step, but not the only step, to securing rights to collateral. The surety will want to timely perfect its security interest under the UCC, which may take some effort if the collateral being taken is not subject to perfection by possession. An attached but unperfected security interest is generally not worth much even before a bankruptcy filing, and it is especially flimsy after the principal files for bankruptcy.

II.    What Form of Collateral Should the Surety Take?

The answer is either incredibly straightforward or a bit more complex. The straightforward answer is that the surety should take whatever form of collateral the surety can get its hands on. As they say, beggars can’t be choosers. But what if the surety has more leverage—for example, the surety is taking collateral as a condition to issuing bonds—and the principal has the financial means and inclination to give the surety its preferred form of collateral? Under those circumstances, the best option is typically an irrevocable letter of credit, with appropriate language, from a reputable financial institution. There are many types of collateral that could be taken, and each has costs and benefits; but the two most common forms of collateral in commercial surety underwriting are letters of credit and cash.

        A.     Letters of Credit

Sureties are intimately familiar with the bank-issued letter of credit, which is a type of commercial paper governed by the UCC where, at the request of an applicant (here, the principal), an issuer (usually a bank), on its own account, guarantees to the beneficiary (here, the surety) the payment of a sum of money upon a documentary presentation by the beneficiary. A letter of credit provides the surety with several advantages. The proceeds of a letter of credit are liquid, and no sale or transfer of property is required. There are no fees, expenses, or transaction costs required in order to obtain the proceeds. Also, like cash, they have a fixed and known amount of proceeds that do not fluctuate over time due to market conditions.

Finally, in the bankruptcy context, letters of credit are incredibly helpful. Letters of credit may be able to give the surety ammunition if the trustee or debtor-in-possession tries to claw back the collateral as a preferential transfer. Because most courts have held that letters of credit and their proceeds are not property of the debtor’s estate, these same courts also hold that preference avoidance powers do not apply to letters of credit or their proceeds. However, there are several courts that have held otherwise.

        B.     Cash

Sureties also regularly take cash as collateral. Cash is often the most straightforward collateral a commercial surety underwriter may obtain. It has much of the same benefits as a letter of credit, in that it is liquid; has little transaction costs; and its value does not fluctuate due to market conditions. However, once a bankruptcy petition is filed, the surety’s rights to use the cash become prescribed. The surety cannot use the cash collateral without first requesting relief from the automatic stay. Cash is generally considered property of the debtor’s estate, regardless of where the cash is located or who has possession or control.

Instead, when a surety is holding cash collateral, the surety is a secured creditor, with its secured interest equaling the amount of the cash collateral. A surety’s only option when the depositor of collateral is in bankruptcy is to file a motion for stay relief and obtain leave from the bankruptcy court to use the cash collateral. This general rule is subject to some exceptions, for example when the cash collateral is earmarked funds or trust property, which may not be property of the debtor’s estate. However, that discussion is beyond the scope of this article.

III.   What Happens When the Depositor of the Collateral Files for Bankruptcy?

The moment the depositor of the collateral files for bankruptcy, a new legal regime is imposed on all parties, including the surety. The surety must carefully comply with the provisions of the Bankruptcy Code prior to exercising its rights against the principal’s collateral. Just because a surety had a pre-bankruptcy right to use the collateral does not mean that the surety has that same right after the bankruptcy is filed. Without getting into too much depth on any given topic, an underwriter should be aware of the following bankruptcy concepts.

A. Property of the Estate

The commencement of a case under the Bankruptcy Code creates an estate, which includes all legal or equitable interests in property as of the commencement of the bankruptcy case. Section 541(a) of the Bankruptcy Code has a broad scope, covering all kinds of property, including tangible property, intangible property, and causes of action. That being said, the filing of a bankruptcy proceeding does not expand a debtor’s interests in an asset or its rights against others.

B. Automatic Stay

Probably the best-known effect of a bankruptcy filing is the imposition of the automatic stay under section 362. The debtor’s filing of the petition operates as an automatic stay of almost all actions to enforce a debt or foreclose on the debtor’s property. Therefore, once a bankruptcy case is commenced, a surety may not immediately enforce its rights against the collateral without risking a violation of the automatic stay. The automatic stay remains effective until the principal’s property is no longer the property of the principal’s estate. Violations of the automatic stay are taken very seriously and can result in sanctions, assessment of damages, attorney’s fees, and even punitive damages.

That being said, a surety is not without remedies; but it should ask for permission and not forgiveness. A surety may seek to enforce its rights against property of the estate by moving for relief from the automatic stay. While it may be a complicated process and may take longer than the surety would like, the surety can generally make use of the collateral after a series of filings in the bankruptcy case.

C. Avoidance and Preferential Transfer

The avoidance powers granted under the Bankruptcy Code are case in point that a surety should not wait until the last minute to perfect its security interest. While sureties tend to hesitate to file a UCC-1 financing statement until a loss is imminent or has been incurred, this delay may give rise to a preference issue under the Bankruptcy Code that could be detrimental to a surety’s position as a secured creditor. If the surety attempts to perfect its security interest by filing a financing statement in the ninety days prior to a bankruptcy filing, the trustee or debtor-in-possession may move to avoid the lien as a preference under section 547 of the Bankruptcy Code. Regardless of when the security agreement (typically contained in the indemnity agreement or collateral agreement) was executed, any action taken to perfect the surety’s interest in the indemnitor’s property within that ninety-day period will likely be viewed as a transfer that may be avoided.

Careful consideration should be given when encountering these and other bankruptcy issues, and it would be wise to seek legal counsel to protect the surety’s interest.

IV.    Conclusion and Practical Tips

While business considerations often do and should drive a commercial underwriter’s decision to take collateral, having an understanding of how the surety’s contractual rights may be altered by bankruptcy law should assist an underwriter in making that ultimate decision.

And now for the promised cheat sheet to protecting collateral in bankruptcy: (1) ensure that the security interest is appropriately documented in an indemnity agreement or collateral agreement and that the security is perfected; (2) if you have the choice, letters of credit generally give the surety more rights in bankruptcy than other forms of collateral; (3) move fast because the longer the surety waits to exercise its collateral security rights, the more tenuous its position; and (4) once the principal files for bankruptcy, make sure to carefully vet every move the surety makes so as not to unintentionally violate bankruptcy law or lose rights to the collateral. A fifth and final piece of advice is to consult with a lawyer to ensure that you are protected to the full extent that the law allows. Perhaps that final suggestion is a bit self-interested, but I stand by it as sound advice.

Find Out More

Access a free NASBP Podcast on this topic here: https://bit.ly/35zCEuI. Access free NASBP Podcasts here: https://letsgetsurety.org/episodes/. Access a NASBP Virtual Seminar on this topic here: https://learn.nasbp.org/p/CommercialSuretyBankruptcy. Access NASBP Virtual Seminars on similar topics here: https://learn.nasbp.org/.

Elliot Scharfenberg is a partner in the New Orleans office of Krebs Farley & Dry. The majority of his practice consists of representing sureties in all manner of disputes, both as a transactional attorney and litigator. He has a niche in representing sureties on complex plug and abandonment bond issues, including bankruptcy proceedings. He can be reached at escharfenberg@krebsfarley.com or 504.299.3583.