When the public-private partnership (PPP; P3) model was introduced to the US in 2007, it was borne out of European and Australian frameworks. Various adaptations of these models have served to deliver some of the largest projects in the infrastructure space over the past nine years. But one facet of P3 contracts causing consternation among US construction firms is a common requirement for bank letters of credit to be issued as project guarantees.
In P3 contracts outside the US, letters of credit have become a traditional recourse mechanism. They provide a financial guarantee that if a contractor defaults on a project, the obligee will receive compensation from the bank holding the letter of credit within a short, specified time period.
In contrast to its European counterpart, the US construction industry has rather been built around the concept of surety, backed by a municipal bond market. While it is often confused with something akin to insurance, surety is a three-party agreement between the surety company, the obligee, and the principal that includes performance and payment guarantees. Unlike a letter of credit, which is focused on a single project, a surety guarantee is something that comes with an understanding that if a contractor defaults on their obligation, the surety will step in and take action to minimise loss.
So when letter of credit-backed contracts translated to the US, it naturally seemed to local constructors to be something of a square peg versus round hole situation. As time went on, P3 letter of credit requirements were becoming overly burdensome for US contractors as they aggregated, to the point that further participation threatened to affect core business lines.
To secure a letter of credit, a contractor must set aside the amount of liquidity specified. So, on an $890 million project with a 10 percent letter of credit requirement, the US contractor would have to set aside $89 million into a credit facility to be drawn upon by the obligee in the event of default – and the contractor has no recourse to this. That means that too many letters of credit could stretch a business too thin, becoming a default risk of a different kind.
So a new adaptation of the local construction market’s tradition was tailored and implemented through the work of Bill Ernstrom, vice president of major strategic projects at Walsh Group, and Stan Halliday, chief underwriting officer of bonds and special issuance for Travelers, the surety that has underwritten all of Walsh Group’s bonds for more than 50 years.
This is the story of how surety was introduced to the US P3 market through the $900 million Pennsylvania Rapid Bridge Replacement Project, which is set to replace 558 structurally deficient bridges across the north-eastern state in 36 months – and what that could mean for the future of the market.
A PROGRAMMATIC APPROACH
Halliday explains that whereas a letter of credit is strictly a financial remedy, surety provides “a much broader guarantee [through its] programmatic approach”.
“In our world, we could certainly pay money if we felt that was the best solution, but with a sophisticated contractor, really we’re going to continue to make sure that they perform on the job, make sure the job is staffed, make sure they finish the job in a timely manner, and then bear the additional financial consequences of doing that. Because more than likely the project is going to be done at a loss and we’re funding part of that loss,” Halliday explains. “It’s more like how a contractor would view their business.”
Surety companies are able to provide this service – taking on a great deal of risk on behalf of their customers – because even before granting the first bond to a contractor, they review its entire business line and outlook. They then utilise this intelligence along with ongoing financial monitoring to determine strengths and capabilities.
“Our exposures are intertwined and our fates run together, so we constantly update,” Halliday says. “If there was a major default event with a contractor, we would have multiple projects with multiple issues [on the line], where ratings agencies get sort of hyper-focused on one project.”
In other words, while agencies are often focused on a single project, Ernstrom and Halliday argue that a programmatic guarantee covering an entire business line is much more effective than a simple cash guarantee to ensure stakeholders are all able to weather the default event. What’s more, since surety is programmatic it doesn’t put the same strain on a contractor’s balance sheet as a letter of credit, freeing up much-needed liquidity.
In the lead-up to deployment, Ernstrom and Halliday went on a ratings agency road show to find out how to bring surety into the P3 marketplace.
During their conversations with the ratings agencies, Ernstrom noted that it was a learning process for both sides. For his part, he said that he had always believed the ratings agencies were primarily concerned with a contractor’s liquidity, when in reality, payment certainty was their primary focus. Because at the end of the day, the ratings agencies’ concern is whether or not investors will get what they were promised.
On the other side of the coin, Ernstrom said the ratings agencies were under the impression that surety would act similarly to insurance, meaning there would be a long, hostile claims process involved in reconciling a project default. Here, Halliday was able to show them that was not the case. “What we set about on with the bond was how to create a new form that made the resolution of the issue, whatever it was, be more certain in a specific timeframe,” he said.
Once it became clear the agencies were after an expressly stated coverage of liquidated damages and a quick resolution guarantee, those were implemented into the Walsh bonds. “Within those 15 days we’re going to do one of two things: one, we’re going to tell you that you’re right, we have a default and we’re on it; or two, we’re going to tell you that we’ve investigated and we don’t think so. Everyone likes number one but they don’t necessarily like number two, so what do we do about number two? Well here’s where the innovation comes in,” says Halliday.
Halliday explains that Travelers established a pre-arrangement with internationally-recognised arbiter JAMS that calls for the surety to register a case within three days of the close of its investigation. JAMS will hear the case within a 30-day window and make a ruling. If they rule that the contractor is indeed in default and that the default is covered by the bond, then the surety will honour that decision and make the required payment. If the payment or decision of the arbiter is disputed by either party, it can be brought to a general court. But until the JAMS decision is reversed, both parties are required to abide by it, according to the bond form.
“When S&P looked at it, I think they counted about a 60-day period that would allow them to recover the same amount of money as a letter of credit, but it would also provide a much larger limit of coverage because a bond can be secured at a much larger amount than a letter of credit,” he said. “As a result of that, on the Pennsylvania Bridge bonds, our S&P rating got notched up two points.”
With a nod from S&P, the project moved forward with successful issuance of $890 million in performance and payment bonds. “They were seeking a 10 percent letter of credit, so there was a lot broader coverage,” said Halliday. “So S&P for the first time rated a project with this performance bond as it would have if it was a letter of credit – and that helped the Walsh Group.”
AN INDUSTRY SOLUTION?
Looking ahead, Halliday says he sees the dispute resolution bond as a potential industry solution. He notes that the bond form had been discussed in conversations about the Maryland Purple Line project, though whether it will ever be utilised is yet to be seen. Nonetheless, it is worth noting that it was even brought up at all in that project and other projects that Ernstrom and Halliday could not discuss.
“We’d like to see long-term some standardisation of it and certainly all sureties should be comfortable with it and be able to write it if they can.”