The Office of General Counsel issued the following informal opinion on May 29, 2002, representing the position of the New York State Insurance Department.
Re: Surety Company Insuring Bank against Risk of Non-performance by Developer
May a property/casualty insurer, licensed to write surety insurance in New York, insure a bank against the risk that a developer will not perform a certain task for a municipality, when the developer provides a performance letter of credit issued by the bank to the municipality and the municipality makes a claim on the performance letter of credit for the non-performance of the task?
Yes, such an insurer may insure a bank against the risk that a developer will not perform a certain task for a municipality, when the developer provides a performance letter of credit issued by the bank to the municipality and the municipality makes a claim on the performance letter of credit for the non-performance of the task.
A national bank regularly issues performance letters of credit to municipalities on behalf of residential real estate developers ("developers").
As an example, a developer would request permission from a municipality to build twenty houses on a site and the municipality would require the developer to file construction documents with the municipality setting forth with particularity how the site will be developed. To ensure that the developer performs a task pursuant to the documents filed with the municipality, the municipality may require the developer to provide a performance letter of credit guaranteeing the completion of a specific task. If the developer fails to perform this task, the municipality can "draw" or collect on the performance letter of credit.
The performance letters of credit do not guarantee the overall completion of the project nor do they guarantee developers financial viability. Rather, these performance letters of credit run only to the municipality and only address specifically identified, critical construction performance line items contained within construction documents filed with the municipality.
If the developer fails to perform the specific task regarding which the performance letter of credit was issued, the municipality can draw on the face value of the performance letter of credit, which the bank pays to the municipality. However, the developer is then subject to "salvage/collection rights" held by the bank. At the time when the bank makes payment of the performance letter of credit to the municipality, the developers obligation to repay the bank does not take the form of a loan. Rather, the banks right to recovery against the developer is based on an indemnification agreement entered into between the bank and the developer.
We are assuming that the insurer has the right to pursue the developer so that the bank cannot obtain a double recovery. Additionally, we have not seen the proposed language of the contract, thus this opinion is written based upon the assumptions as set forth herein.
The national bank is interested in purchasing insurance coverage for potential losses arising out of or associated with its issuance of performance letters of credit from a surety company.
Financial guarantee insurance is defined in N.Y. Ins. Law § 6901(a) (McKinney 2000) and states, in part, as follows:
As used in this article: (a)(1) "Financial guaranty insurance" means a surety bond, insurance policy or, when issued by an insurer or any person doing an insurance business as defined in paragraph one of subsection (b) of section one thousand one hundred one of this chapter, an indemnity contract, and any guaranty similar to the foregoing types, under which loss is payable, upon proof of occurrence of financial loss, to an insured claimant, obligee or indemnitee as a result of any of the following events:
(A) failure of any obligor on or issuer of any debt instrument or other monetary obligation (including equity securities guarantied under a surety bond, insurance policy or indemnity contract) to pay when due to be paid by the obligor or scheduled at the time insured to be received by the holder of the obligation, principal, interest, premium, dividend or purchase price of or on, or other amounts due or payable with respect to, such instrument or obligation, when such failure is the result of a financial default or insolvency or, provided that such payment source is investment grade, any other failure to make payment, regardless of whether such obligation is incurred directly or as guarantor by or on behalf of another obligor that has also defaulted;
. . .
(2) Notwithstanding paragraph one of this subsection, "financial guaranty insurance" shall not include:
. . .
(B) fidelity and surety insurance as defined in paragraph sixteen of subsection (a) of section one thousand one hundred thirteen of this chapter . . . .
Fidelity and surety insurance is defined in N.Y. Ins. Law § 1113(a)(16) (McKinney 2000 & Supp. 2001-2002), and states, in part, as follows:
(C) Any contract bond; including a bid, payment or maintenance bond or a performance bond where the bond is guaranteeing the execution of any contract other than a contract of indebtedness or other monetary obligation;
. . .
(E) Becoming surety on, or guaranteeing the performance of, any lawful contract, not specifically provided for in this paragraph, except . . . (ii) a contract that falls within the definition of financial guaranty insurance as forth in paragraph one of subsection (a) of section six thousand nine hundred one of this chapter . . . .
Based upon the facts as provided, the proposed contract would be a type of surety insurance, if it guarantees to the bank the performance of the developer and it is limited to the developers failure to perform. The letters of credit may be drawn upon only if the developer fails to complete specific tasks pursuant to the tasks filed with the municipality, and not based upon the financial default of the developer. The proposed contract does not guarantee the banks performance under the letters of credit nor does it guarantee a financial default, which would be financial guarantee insurance.
This Department is commenting only about whether a surety may issue this type of insurance. The question of whether the bank is allowed to purchase such insurance is under the jurisdiction of the appropriate banking regulatory authority.
For further information, you may contact Senior Attorney Meredith S. Kaufer at the New York City Office.