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Expert Commentary

Subdivision/Improvement Bonds

Also referred to as site improvement, plat, completion, or simply performance bonds, subdivision/improvement bonds help cover the owner/developer. The key difference between subdivision bonds from regular contract performance bonds is that the owner/developer (the principal) has to pay the cost of building the bonded improvements rather than the public agency (the obligee). While not all sureties write subdivision bonds, for those that do, the underwriter will require information such as the scope of the improvements, a cost estimate, and where the money is coming from.


April 2003

Many political jurisdictions have statutes that require an owner or developer of real property to post financial security to guarantee the completion of designated improvements as a precondition to granting a construction permit or to allow the recordation of a final parcel map. The guarantee posted by the owner/developer assures that they: 1) will have the financial resources to pay for all the improvements; 2) the improvements will be built as required within a specified period of time; and 3) they will maintain said improvements for a minimum of 1 year against defective workmanship and/or materials.

Types of Guarantees

Most frequently, the owner/developer will select one of the following forms to guarantee completion of the improvements:

  1. Corporate surety bonds
  2. Irrevocable letters of credit issued by a financial institution, e.g. bank
  3. Certificates of deposit (CDs)
  4. Other, such as cash, certified/cashiers check or money order
  5. Tripartite agreement

Pros and Cons

Corporate surety bonds are far and away the most preferred option for most owner/developers when you consider the potential disadvantages of the alternative guarantee forms.

  • Irrevocable Letter of Credit (ILOC): To secure an ILOC, the owner/developer typically encumbers a portion of its line of credit for a fee. The security for the ILOC may be funds on deposit at the bank with their immediate right of set-off (seizure). If the bank elects not to renew the ILOC, the public agency would have the right to promptly draw down on the full amount of the ILOC. Such a drawdown of the ILOC will create a loan, which the bank could promptly call for immediate repayment.
    • The governmental entity holding the ILOC has the right to draw on the ILOC anytime they believe there is a breach of the owner’s obligations and the owner would have little or no opportunity to stop the drawdown. The ILOC is strictly a financial instrument and the bank provides no prequalification services to assure the owner/developer has the capacity or experience to perform.
  • Certificates of Deposit (CD): It is effectively a cash deposit that ties-up the owner/developer’s capital, which normally can be deployed more productively. The CD is subject to forfeiture by the unilateral demand of the public body. For the public body accepting the CD as security, it provides no prequalification benefits. In addition, it saddles the public body with administrative burdens to make sure they accepted a CD that was in proper-assignable form, that they in fact had unequivocal authority to draw down on the CD, that they don’t release it until all possibility of nonperformance had passed, and that they hold the instrument in safekeeping and properly return it to the owner/developer.
  • Other Security (such as cash): This option has many of the same concerns as with CDs. In addition, the public agency would have to make some determination that the cash being deposited was “legitimate” and not subject to possible bankruptcy preference rules.
  • Tripartite Agreement: These agreements (used infrequently) may involve set-aside letters from a bank, special escrow accounts, and/or fund controls. Tripartite agreements typically place disbursement of the construction funds under the direct control of the governmental agency. Disbursement of monies may be delayed by concerns about the value of completed work or the adequacy of monies to complete the improvements and provide the required maintenance. Tripartite agreements are not really performance guarantees but rather control over a fund of monies that may not be adequate to pay for all the improvements. These type arrangements place significant additional administrative burden on the public agency and can create liabilities if the funds are not properly administered.

Advantages of Bonds

Corporate surety bonds generally have none of the disadvantages of the alternative guarantees referenced above and have the following distinct advantages.

  • Surety bonds provide prequalification of the owner/developer through the underwriting process.
  • Surety credit is unsecured and does not reduce or tie-up the owner/developer’s source of funding.
  • Surety’s claim department will work to facilitate a resolution of any problem and not merely to forfeit the owner/developer’s security.
  • Corporate surety bonds typically provide the public agency with a 100 percent performance, 100 percent payment, and 1-year maintenance bond.
  • Irrespective of how much the owner/developer may have spent to complete the improvements up to the time of default, the full amount of the bonds are available to complete the work.

Important Distinction

The key difference between subdivision bonds, often also referred to as site improvement bonds, plat bonds, completion bonds, or simply performance bonds from regular contract performance bonds is that the owner/developer (the Principal) has to pay the cost of building the bonded improvements rather than the public agency (the Obligee). This is also an important point to remember if a general contractor should agree to secure/post the subdivision bonds on behalf of the owner/developer. Normally, the general contractor has the contractual right to stop work if the owner does not pay him. However, if the general contractor posts the improvement bonds in favor of the public agency, the general contractor is obligated to complete the improvements and pay all the bills irrespective of whether the owner/developer paid him. Therefore, a general contractor should generally avoid posting such bonds on behalf of the owner/developer or seek advice from their legal counsel on how best to protect him or herself.

Not All Sureties Write Subdivision Bonds

Subdivision/improvement bonds are a type of bond that not all surety companies want to write. The reasons for avoiding this class vary. Some bonding companies lack the familiarity or underwriting expertise. Some have had poor experience in the past and have found that these bonds can have a very long lifespan. Some are uncomfortable with developers whose financials may show considerable leverage (debt) and whose valuation of land and developed properties are subject to wide market fluctuations. Nonetheless, over time the surety industry has reported favorable underwriting results for those companies who properly underwrite this class of business.

General Underwriting

When an owner/developer applies for surety credit, the surety underwriter will begin by developing the usual background and financial information to make a general assessment of the owner/developer’s capacity/experience, their credit/financial and their character. They should be prepared to provide three fiscal year end financial reports on their operations, concurrent personal financial statement on all owners, resumes on key people, list of completed projects, information on banking relationships, business continuity plans, and copies of any trust, partnership, or operating agreements. Most surety companies will also have their own application form, which may ask other specific information. Once the bond underwriter is comfortable with the account in general, they will then underwrite each subdivision bond request.

Specific Bond Underwriting

The underwriter will require information such as the scope of the improvements to be made, an estimate of the cost to complete the work, and information about where the money to pay for the work is going to come from.

Scope of Work. The subdivision/improvement bond guarantees the completion of specified improvements such as grading, storm drains, utilities, curbs and gutters, streets, sidewalks. Therefore, the underwriter will want details on the work or scope of the improvements to be installed. This information will normally be spelled out in the subdivision/improvement agreement that the owner/developer signs with the public agency. When will the work start and be completed? What is the estimated cost of the improvements and the amount of the bonds? Usually engineer worksheets are available that outline the cost estimates including how the amount of the bond(s) was established. The public body will generally include some cushion or “fudge” factor to allow for possible escalation in the cost to complete the work. This increase factor is not entirely unreasonable because experience has shown that sometimes the improvements are not completed within the original time frame and the ultimate cost months or years later could be greater.

Cost of Work. The underwriter will also want some confirmation of the owner/developer’s estimate of cost to complete. The preferred method is for the developer to have firm bids or signed contracts from trade contractors to complete the work. Depending on the value of the work and/or time to complete, the surety may want the owner to secure performance and payment bonds from the trade contractor(s) to assure satisfactory performance. At first blush this may seem like double bonding but the bonds from the trade contractors run in favor of the owner/developer and not the public agency. Since the owner is obligated to complete the improvements, it is really in the owner’s interest to have this guarantee or they may find that they have to hire someone else to complete the work for more money.

Funding Source. Because the owner/developer is responsible for paying the cost of all the bonded improvements, a major underwriting concern/question is where is the money to pay for the work? The necessary funds should be set aside under an arrangement whereby they can only be used to pay for the improvements as work progresses. This can be accomplished under an escrow agreement with a lender or title company. Most often, however, the owner/developer will have secured a development loan for the overall project. The surety will then want to obtain a set-aside letter from the lender whereby an amount sufficient to cover the cost of the bonded improvements will be irrevocably set aside and held in trust for the benefit of the surety. It effectively carves out a portion of the development loan to pay for the bonded improvements. The surety will most likely have their own set-aside form.

Conclusion

Subdivision/improvement bonds provide the necessary assurance to allow an owner/developer to proceed in a capital efficient manner to develop and begin the sale of properties before all mandated improvements have been installed. With full underwriting information and confirmation of financing in hand, the bonding agent should be able to secure the required bonds for qualified applicants. The bonds serve as irrevocable guarantees to those who purchase the property that all required improvements will be installed. It also guarantees to all who performed the work that they will be paid. The governmental body can take comfort that the mandated improvements will not become a financial burden to the public treasury and that they are promoting economic growth in their community. The surety who properly underwrites this business for qualified principals will generate profitable income for its shareholders. Subdivision/improvement bonds can facilitate a “win-win” for all the parties.


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