The indemnity agreement is the foundation of the surety bond. It’s what separates surety from insurance: the agreement functions as a mechanism to have the principal repay the surety for any claims paid out to the obligee for the principal’s default. But did you know that there’s a way beyond that agreement for the surety to protect itself in case a principal defaults?
Enter collateral security. Collateral security functions as a secondary way for the surety to protect itself and gain leverage over a principal, in addition to the indemnity agreement that guarantees indemnity from a principal if a surety has to pay claims to an obligee due to the principal’s failure to fulfill its obligations. Most indemnity agreements include language requiring the principal to deposit collateral security with the surety company if certain conditions are met. Collateral security isn’t requested in order to pay for damages, however; indemnity agreements and collateral security are distinct.
When a surety sues for indemnification and is granted an indemnification award, the surety is granted payment of money which becomes its property. Payment of collateral security is different, however. Most indemnity agreements concerning collateral security provide that collateral security is required when claims have been asserted under bonds issued by the surety or if the surety believes that collateral security is required to pay for potential future claims due to the principal’s default or breach. Once that collateral security is deposited with the surety, it is held in trust for use by the surety to pay claims concerning the default or breach of the principal or to reduce costs associated with the default or breach. Any collateral security in excess of the claims amount is ultimately returned to the principal.
Collateral security functions, really, as a way to mitigate risk for the surety. One of the main arguments against a principal paying an indemnification claim to a surety is that the surety hasn’t adequately mitigated damages. Collateral security isn’t a claim for damages so the mitigation argument doesn’t apply, however; it’s a security to pay for the already claimed damages. And in the end, there’s no windfall for the surety as any amount in excess of the asserted claims is returned to the principal.
Courts haven’t been hesitant in enforcing the surety’s claim for collateral security. Once the surety incurs the expense of the default, the courts generally allow the request for collateral security, only focusing on the reasonableness of the amount. Courts have determined that incentives of sureties to keep costs to a minimum are an adequate safeguard against invalid collateral expenditures.
Surety companies also often require collateral specifically in the case of appeal & supersedeas bonds to disincentivize abuse of the court system. The high price of making the appeal, including the purchase of the appeal & supersedeas bond, helps to discourage litigants from avoiding financial costs or trying to drive up legal costs for their opposition through the appeals process. Learn more about collateral security.
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