Subdivision bonds – not your typical contract bond
Subdivision bonds operate differently than traditional contract performance and payment bonds, and these differences impact the approach in which subdivision bonds are underwritten. Here, Daniel Young, Contract Underwriting Officer, briefly explores how subdivision bonds stand apart from other contract bonds.
Unlike typical construction ownerships, which can involve an entity owned by an individual or small number of individuals, real estate development entities can assume a wide variety of ownership structures. These can include—but are not limited to— LLCs, limited partnerships, general partnerships, individuals, non-profits, government entities, and trusts.
Dan explains that often in the Subdivision space, underwriters will see development projects owned by multiple project-specific entities. “Commonly we’ll see project-specific entities as LLCs, but in some cases owned by other LLCs, partnerships, or corporations between the development entity (bond principal) and the individuals that ultimately own it,” he says.
He further explains that the first step in underwriting subdivision bonds starts with a review of the ownership structure of the developer and the relevant operating agreements, partnership agreements, etc. needed to understand and document the ownership of these often-complex entities.
Due to the varying ownership structures that can be involved, Subdivision underwriters typically place emphasis on personal indemnity of the individuals that own the business entity and less on the business entity itself. “This is another important distinction. While personal indemnity may be required to support traditional contract surety business, it isn’t the primary basis for support,” says Dan. “Where other contract surety underwriters are generally looking for the business entity to financially support the surety needs of the account, we’re more interested in personal indemnity of the owners of the business entity.
There are multiple reasons for this. First, as developers tend to form new entities for each new project, often the developing entity holds limited assets, all related to the project at hand. Those assets typically include land, work-in-progress, and are usually encumbered by a lien for the benefit of a project lender, leaving little as security for the surety. Additionally, project-specific entities may be “wound down” prior to the release of all the bonds required for the project.
Last but certainly not least, explains Dan, is to determine who is responsible for paying for the improvements. Under a traditional contract obligation, the contractor receives payment for the work completed from the project owner. Contrast that with a subdivision bond, in which the developer provides a guarantee to the oblige (project owner) that it will not only complete specified improvements but will do so at no cost to the bond obligee.
“Therefore, there is a project financing risk involved in Subdivision which isn’t present in a contract obligation. To address this risk, the surety underwriter will attempt to make sure there is a committed funding source sufficient to pay for the improvements to be constructed. This is an important piece of underwriting Subdivision,” he said.