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Most lawyers have barely heard of surety bonds. If they know anything at all about the subject, they know that surety bonds play a role in construction projects and that every once in a while, there is a nasty dispute between sureties and developers after someone walks off the job on a construction site. What they may not know is that surety bonds — or, to be precise, the inability to buy them at a reasonable price — just forced one of America’s largest retailers, Kmart, into bankruptcy. What are surety bonds? They are like, but not quite, insurance. A surety bond is a contract in which the surety agrees to pay the debts or guarantee the contract performance of a principal to a third party — called the obligee — if the principal fails to pay its debts or perform on a contract. A common example is an appeal bond. If Jones obtains a $10 million judgment against Smith, the California Code of Civil Procedure requires Smith to post a bond in the amount of 1 1/2 times the judgment. If the judgment is affirmed on appeal and Smith fails to pay, Jones can go to the surety for satisfaction. Of course, the surety does not issue a bond for free and without recourse. The surety first will engage in a process of underwriting the bond: What is the surety’s experience in this industry and with this principal? How likely is the principal to default? What is the principal’s credit history? How risky is this bond? Second, the surety typically will insist on some sort of security to back the bond in the event of a default on the part of the principal. Sometimes, the security will take the form of collateral; other times, the security will be nothing more than the principal’s balance sheet. Surety bonds play a huge role in the American economy. Traditionally, they have been used to ensure performance of construction projects. In fact, since 1893, the United States has required all contractors on federal public works contracts to obtain surety bonds. In recent years, surety bonds have been used to back a variety of obligations, from self-insured workers’ compensation plans under which the surety will pay injured workers if the self-insured business fails to pay, to commodities contracts. And there the trouble begins. Most surety bonds are sold by insurance companies, which collectively suffered an estimated $50 billion in losses as a result of the terrorist attacks on Sept. 11, about a sixth of the available capital in the insurance industry. Just as insurers were beginning to respond to those losses by raising premiums and reducing coverage, Enron filed for bankruptcy. Enron was a disaster for the insurance industry. Enron had backed an estimated $2.5 billion of its fuel delivery and other contracts with surety bonds — contracts that Enron now is unable to perform. Claims flooded into the surety companies. The biggest claim was by J.P. Morgan Chase, which had purchased $1.1 billion in surety bonds to guarantee deliveries of oil and natural gas to an energy trading business that J.P. Morgan established on the Isle of Jersey off the coast of France. To J.P. Morgan’s dismay, the sureties not only refused to pay on the ground of alleged misrepresentations in the application for the surety bonds, but once litigation between J.P. Morgan and the sureties began, the sureties disqualified long-time J.P. Morgan counsel, Davis Polk & Wardwell and persuaded the judge to delay any payment to J.P. Morgan until after trial is completed late this year. Following the Enron bankruptcy, sureties became far more cautious in underwriting new bonds and also raised premiums substantially to make up for some of their losses. This led directly to Kmart’s bankruptcy. Kmart used surety bonds to guarantee payment of its self-insured workers’ compensation claims and other liabilities, and to comply with government regulations requiring merchants who sell alcohol and firearms to post bonds. After Enron failed, sureties reportedly required Kmart to post between $300 million and $600 million in supplemental security to back its bonds — right when Kmart was trying to pay off its suppliers after mediocre sales during the Christmas season. Kmart could not function without workers’ compensation coverage in place and bonds to back its other obligations, so Kmart decided to seek protection under the bankruptcy laws. What is next? The coming months will see a number of significant developments for the surety industry and for American businesses that are accustomed to using surety bonds to guarantee financial performance. The surety industry will experience substantial consolidation. Many of the smaller sureties have left the market in recent years or are doing so now. For example, a few weeks after Enron filed for bankruptcy, Novato, Calif.-based Fireman’s Fund Insurance Co., which had long been one of the nation’s leading sureties but which had seen its market share fall in recent years, sold its surety business to the St. Paul group. Prices will rise. Some analysts have reported increases in surety bond prices of between 50 percent and 1000 percent. This is not just because sureties face greater risks in the current economy, but also because the cost of reinsuring surety bonds has risen substantially over the past year. � Sureties will engage in more careful underwriting. Not too long ago, sureties were taking a lot of risks in order to increase market share, and they have seen some of those risks turn into claims. Now, sureties are likely to be very cautious about issuing bonds to new or existing, but financially uncertain, principals. Many sureties may limit their business to traditional types of surety bonds, like construction, appeal and performance bonds. For many principals, sureties are unlikely to be satisfied with unsecured indemnities in the event that the principals fail to pay their debts and will require cash collateral. � Many principals will seek alternatives to surety bonds to back their obligations. For example, Kmart was forced to abandon its self-insured workers’ compensation program backed by surety bonds, and now has purchased a more conventional (and more expensive) workers’ compensation program from an insurance company. Other principals may back their obligations with letters of credit. � If businesses wish to obtain financing for risky endeavors, they are unlikely to be able to use surety bonds in the future to protect their investors. And that, after Enron, may not be a bad thing. David Goodwin is a shareholder in the San Francisco office of Heller Ehrman White & McAuliffe. He is the co-chair of Heller Ehrman’s insurance coverage national practice group and represents policyholders in insurance coverage litigation and counseling.

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