By: Robert E. Little, Jr.
Several months ago, I was asked to present testimony before House Subcommittee on Courts, Commercial and Administrative Law on the subject of individual sureties. In that testimony, I warned that legal precedent had had little effect on policing individual sureties. Using the example in the Tip Top Construction case, I noted that despite being told by the Court of Appeals for the Federal Circuit that certain assets were unacceptable, the individual surety, in that case, proffered them again two years later to the Architect of the Capitol.
Now for the rest of the story. In that same transaction, the Architect of the Capitol had previously and properly rejected a proffered asset in the form of an Irrevocable Letter of Credit (ILOC). An ILOC (referred to in the Federal Acquisition Regulation (FAR) as an “ILC”) is a permissible asset for individual sureties provided it meets FAR-specified criteria. FAR 28.203-2(b)(5).
To provide some context, I first ran across the ILOC a few years ago as an advisor to the U.S. Special Trade Representative in connection with bilateral negotiations with Japan. I represented the U.S. side in explaining our federal bonding requirements to the Japanese. To prepare, I looked at the Japanese bonding system and discovered that they use the ILOC (ILC) almost exclusively for their public and private construction. In the Japanese system, the ILOC is typically 15% of the amount of the contract. By contrast, a bond for a U.S. project would be 100% of the contract price for each performance bond and payment bond. Consequently, your first due diligence step as a contractor would be to assure that you have two ILOCs at the face value of the contract price, each separately referencing the payment and performance bonds. In my experience, individual sureties seem to forget this point and provide only one ILOC in the amount of 100% the contract price.
If you surmount that hurdle, you must determine the validity of the ILOC for federal bonding purposes. In trying to figure this out, you will likely encounter circumstances characterized by Churchill’s description of the Soviet’s intentions in 1939. The ILOC will seem to be a “… riddle, wrapped in a mystery, inside an enigma.” In that regard, the ILOC is required to be issued by a federally-insured financial institution with the government as beneficiary and placed in a government-owned escrow account in a federally-insured financial institution. FAR 28.203-1. That essentially means that the individual named as the surety will at least have appeared to provide 200% of the contract price—essentially in cash—to secure a contractor’s performance and payments to suppliers. (This, as you may have guessed, is the enigma part. If you can get passed this enigmatic circumstance, you are ready to tackle the wrap of mystery.)
Unwrapping the mystery requires starting with the header of the document that you might receive. The name of the ILOC-issuing entity will be something like 2nd Trustee Assurance, LLC. (There are seemingly an infinite number of possible names based on roots, such as, “first,” “1st,” “trust,” “bank,” banc,” “assurance,” “fidelity,” and “surety.”) Were you to do an internet search of the issuer, you might find that such business name does not otherwise exist, or, if it does, it is not identified with the same location or phone number on the submitted document. You must confirm the entity’s existence in the database of the active legal entities in the state where the entity is located, but you might not be able to.
If you can remove the wrap of mystery by determining the entity issuing the ILOC exists, you might find that the entity is neither a financial institution nor federally insured. If you cannot determine that the issuing entity is on the Federal Deposit Insurance Corporation’s list of FDIC-insured banks, there is a very good chance that the entity is neither a financial institution nor federally insured. (All federal and some state credit unions are federally insured by National Credit Union Administration. I doubt you’ll see a credit union, however. All entities will appear to be banks or savings and loans.) On occasion, you might see an issuing entity that holds itself out as providing financial advice and/or investment services, but those firms are not necessarily financial institutions. Such firm may tout Securities Investment Protection CorporationTM (SIPC) protection, but that is not federal insurance. If you cannot establish that the ILOC-issuing entity is a financial institution and federally insured, you cannot submit the bonds if you are a bidder or accept them if you are the federal agency.
But wait, there’s more.
You, as the bidder, contractor, or agency, might be misled by the fact that the ILOC (although not issued by a federally-insured financial institution) was placed in an escrow account in an FDIC-insured financial institution. And you, as the agency, might be further fooled into thinking that the agency-as-beneficiary gives you the ability to cash out any escrowed funds (assuming there are any).
The misleading occurs because, while the federal government would be named as the “beneficiary” of the ILOC, the government might not have been given any right title and interest in—much less ownership of—the escrow account holding the ILOC. The escrow account could belong to a third party, perhaps an attorney. If so, that would violate FAR 28.301-1(b)(1) which requires the ILOC be in the name of the Government agency and placed in an escrow account in the name of (i.e., owned by) the federal agency whereby the agency has the sole and unrestricted access to and right to present sight drafts on the ILOC to the issuing financial institution. You couldn’t access the “fund” unless the owner agreed, and the owner might not—if you can find the owner.
One final note on “unrestricted.” Unrestricted means what it says: unconditional, no restrictions, e.g., no requirement that the contractor be in default. The requirement is cash on presentment of a draft to the issuing financial institution. Accordingly, if the ILOC has language, such as, “the draft must be accompanied by a certified statement that an event of default has occurred and is continuing,” the right to payment of the fund is impermissibly restricted. This becomes critical where the issuer of a one-year ILOC gives appropriate notice that it will not be extended. In such case, the owner must have the right to convert the ILOC—or any similarly limited instrument—to cash in order to protect itself and/or subcontractors, suppliers, and materialmen. Such right obviously cannot be conditioned on the contractor’s being in default.
Normally, a riddle is like a puzzle with all of the pieces present (or at least knowable) but misarranged or obscured. With ILOCs, you might find that most of the pieces are missing or not what they seem. Good luck.
Robert E. Little, Jr. is of counsel to the firm and is the former Senior Associate Counsel for the Naval Facilities Engineering Command. He is a member of the firm’s Federal Contracting Practice Group.