Enron Mess Highlights Need For Better Surety Underwriting

In the post-Enron world, sureties will need to be more careful about the risks they undertake, say industry observers.

While the surety industry remains well-capitalized and interest in writing surety bonds has not waned, “closer scrutiny in the underwriting process” can be expected, said Lynn Schubert, president of the Washington, D.C.-based Surety Association of America.

Steven S. Katz, an attorney whose practice includes surety and insurance law and litigation, was more adamant. “I think the underwriting process will be more stringent,” said Mr. Katz, who is counsel in the Short Hills, N.J., office of Edwards & Angell, LLP.

The actual terms of the various surety contracts covering Enron are not available due to ongoing litigation. However, it has been widely reported that the energy trading giant acquired the surety bonds to guarantee its performance of fuel-delivery contracts.

Mr. Katz believes that the Enron bonds, which were issued by numerous insurance companies, functioned as financial guarantee bonds.

“They are strict guarantees, and the surety often waives any defenses to bond claims” on such guarantees, he explained. Because of this feature, financial guarantee bonds, unlike the usual surety payment and performance bonds, operate like letters of credit, Mr. Katz said.

Also similar to letters of credit, if the principal company (the company to which the guarantees are issued) fails to make payments on the underlying contracts, the surety must then step forward and make those payments, he stated.

(A typical surety performance or payment bond is a three-party contract under which a surety company guarantees a project will get done or a payment will be made by the bond principal. A third party, referred to as the obligee, is the beneficiary to a surety bond.)

According to Mr. Katz, the type of bond involved in a transaction affects “the way the surety takes a look at underwriting its risk.”

In a financial guarantee bond situation, the surety generally looks at the overall financial health of the principal to ascertain its ability to finance payments under the underlying contracts, he said.

In a traditional surety situation, the underwriter additionally considers the principal's ability to actually perform the work, he stated. “In that underwriting process, oftentimes sureties look at other projects where the services have been performed,” Mr. Katz indicated.

Ms. Schubert concurred, noting that if a particular surety arrangement involves delivery of a service or product, a surety will look at the principal's ability to deliver on the underlying contracts.

Typical inquiries include whether the company performs that service as a business, whether it understands that business and whether it has people in place who know how to perform the contract, Ms. Schubert stated.

Mr. Katz speculated that in the Enron case, when the surety underwriters looked at the Enron books, they saw a balance sheet–as did the public and investors–”bereft of information” either omitted by Enron's accounting firm or concealed through “questionable” accounting methods. As a result, when the underwriters looked at the risk, they, like everyone else, “did not see the down side,” he suggested.

He also believes that future Enron-type scenarios are possible. “If the accounting irregularities are as widespread as I believe them to be, they have occurred already” and it is just a matter of time before they come to light, he said.

At that point, if the economy strengthens, “we're probably not going to see much of a problem” as long as the principal company repays the underlying obligations, Mr. Katz indicated.

But principals unable to pay the underlying contracts, “we're going to see a lot of these financial guarantee bonds being called,” he said.

To prevent other Enron-type debacles, sureties will likely take “a much closer look at the ability of their principal to perform,” Mr. Katz said.

Additionally, if sureties find that they relied on false or incomplete information from a principal's accounting firm, the sureties will sue the accounting firms, Mr. Katz said. The sureties would claim they were third-party beneficiaries of the information on which the accountants intended them to rely.

While the SAA declined to speculate on the financial fallout for its members from the Enron matter, Mr. Katz pointed out that for the larger insurance companies, surety bonds represent only about 10 percent of the business they write. Therefore, these insurers will not experience “economic collapse,” he said.

“But the smaller standalone, monoline companies are going to have a problem if bonds get called because they don't have the other business to support them,” he predicted.

The SAA continues to stress that the surety industry is well regulated and that safeguards are in place to ensure that sufficient funds are available to pay claims.

As Ms. Schubert explained, the insurance companies that write the surety bonds are regulated state by state. Additionally, sureties that write bonds for the federal government also are regulated by the U.S. Treasury Department, she said.

Among the safeguards are the capital and surplus requirements applicable to any insurance product. In addition, the states that “regulate rates” ensure that sureties rates are adequate to ensure that they have the funds to fulfill their obligations, Ms. Schubert noted.

Nevertheless, Mr. Katz said that even before Enron, he “was struck by the informality” of financial guarantee bonds. He indicated that other types of surety bonds are “very formal.”

“You know exactly what they are to cover, you know what the underlying debt is and often the underlying contract is made a part of the surety bond itself by incorporation,” he explained.

But in financial guarantee bonds, the underlying obligation often is not part of the bond, he observed. For Mr. Katz, this presents the question of when a default occurs: when the obligee (the beneficiary to a surety bond) says so or when there is actually a default under the contract.

“They could be two different things depending on which position you take,” he noted.

A related problem is that “the financial industry in large measure is an old-boy network where things are done by handshakes,” Mr. Katz revealed.

“We've seen multibillion dollar deals consummated with handshakes,” with the understanding that the lawyers can “clear up the paperwork later,” he said.

“However, when you raise the specter of accounting irregularities, then nobody has the critical information necessary to make the appropriate handshake,” he noted.

Finally, Mr. Katz pointed out a potential paradox. He noted that the Enron sureties are claiming to have been defrauded. By taking that stance, the sureties may have a third-party action against Enron's accounting firms, which in turn would look to their errors and omissions coverage, Mr. Katz said.

If the insurers that wrote the Enron bonds are also the E&O carriers of the accountants, the insurers may end up “feeding on themselves,” taking “out of one pocket to put in the other,” he said.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, February 25, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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Enron Mess Highlights Need For Better Surety Underwriting

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