BKs come in a couple of flavors – all nasty tasting for surety underwriters.
Chapter 7: This is a liquidation bankruptcy, which means that a trustee sells off all non-exempt assets held by the debtor so that the debts can be repaid to the fullest extent possible. Businesses generally try to avoid Chapter 7 because it is impossible to conduct business operations.
Chapter 11: Business operations continue during this process. Chapter 11, the most complex bankruptcy filing, is the one that most troubled businesses file. The debtor continues to function, maintains ownership of all assets, and tries to work out a reorganization plan to pay off creditors.
Chapter 12 is exclusively for farm operators.
Chapter 13 is like Chapter 11 but is for individuals instead of businesses.
It would be an understatement to say it is harder to qualify for surety bonds if you have a BK in your past.
Bonding companies typically use a structured method of decision making where each underwriter works within a framework. The details are described in a Letter of Underwriting Authority which may say things like “All clients must have been in business at least three years” (*why?) or “Do not approve bonds for environmental remediation work.”
A common restriction would be: “Do not bond companies that have previously declared bankruptcy.”
Such rules are handed down by senior management of the surety company and their reinsurers. They just want the field underwriters to avoid such applicants – end of story!
Why is the BK a significant black mark? Why does this one checkbox effectively end the underwriting process with many sureties? We can only guess it is because surety underwriting uses credit analysis as a key element. So the ultimate bad credit event, a BK, is an automatic deal killer with those markets.
Escape the BK
When a construction company comes out of Chapter 11, what is the next step if surety support is desired? Over the years, we have seen many cases where the owners decided to form a new company. It’s a fresh start. But is this the best step?
Every bonding questionnaire asks about prior BKs, not only for the company involved, but also the individual people. For example, ours says:
“Has the company, any affiliate or subsidiary, or any owners / spouse or companies in which they have had an ownership interest or managerial role ever experienced a bankruptcy?”
That’s pretty broad. Note that forming a new company doesn’t change a bad “Yes” to a good “NO.” Can it help at all with bonding? Actually it may do more harm than good.
As we have discussed, the prior BK is likely to be revealed through the questionnaire and also the credit reports. And what the applicant company loses is the history, which is very important to bond underwriters. The ability to say we have been in business for years and completed a long list of projects carries tremendous weight in the underwriting process. To a large extent, you throw all that away when you start a new firm.
* Remember the underwriting restriction above? Most sureties are reluctant to bond companies until they have a few successful years under their belt – so being new is always a disadvantage.
So how does a company escape the stigma of a BK? The answer is you don’t. The BK becomes a part of the company and personal credit history that may not be avoided or erased.
However, there may be a solution with the surety. The contractor and agent need to select a surety with the flexibility and expertise to evaluate the details surrounding the BK. The underwriters must be open-minded and willing to identify the strengths of the applicant, despite the BK. Key points to develop:
- Responsibility for the factors causing the BK
- Final disposition of the BK debt
- Continuity of ownership and key management
- Current financial strength and trends
- Current banking and other credit relationships
The reality is that most “prior BK” companies are not bad applicants for bonds. But agents need a surety with the ability to appreciate the value of these clients and support them without requiring collateral.
Call us with you next Contract, Site or Subdivision Bond.
FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
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