In this article we will peel back the onion on Set Aside Letters (SAL) issued by banks in connection with construction loans. What are they, when they are useful and when are they not?
Here is the essence of such documents:
“The agreement covering the project will provide that the funds in said impound account are… to be disbursed for payment of the (Name of Project) mentioned above and only after (Bank) has satisfied itself that the work paid for has actually been performed… In the event (Borrower) fails to complete the project described herein… all funds remaining in said impound account shall be immediately available to Surety to complete and pay the costs of said project, and in such event, (Borrower) waives any claim or interest in the remaining funds. Surety shall not in any way be obligated to repay said funds so used to (Bank).
This is an irrevocable commitment of funds which is not subject to recall or offset by (Bank).”
Pretty interesting! This letter / agreement keeps the loan in play to fund the completion of the project – even if the borrower (bank customer) fails / defaults.
When Are Set Aside Letters Used?
These documents are a common underwriting requirement when a Site or Subdivision Bond is issued by a surety. If the bond applicant (who is also the developer and borrower) is relying on a construction loan to fund the bonded work, the SAL protects the surety by providing funds for the completion of the work in the event of a default.
What a great idea. So why don’t we use these on everything? Let’s look at another example.
The project owner hires a bonded contractor and a bank loan will fund the project. The bank needs a guarantee that the asset / project (which backs the loan) will be built as intended. A Performance and Payment bond accomplishes this and assures there will be no Mechanics Liens against the property for unpaid bills. These two aspects benefit the project owner and the lender. Keep in mind, in a borrower default situation, the bank becomes the new owner of the project.
It is common for the bank to stipulate that a bonded contractor is used for the project, and they may want to be a named beneficiary on the P&P bond – accomplished by issuing a Dual Obligee Rider. Should a smart underwriter also require a SAL from the lender?
On Commercial projects, the normal practice is to NOT obtain a SAL from the lender. Why not? What’s different about this?
a. The bank is a secured lender
b. The bank can subrogate against the borrower’s assets
c. The Dual Obligee Rider serves a similar purpose to the SAL
a. and b. are true, but the answer is c.
Welcome to the Weeds
We’re going in now. The Dual Obligee Rider adds the lender as a beneficiary with all the rights and obligations of the obligee named on the bond (the project owner). And what are they? Obviously they are entitled to make a performance claim and have the project delivered as indicated in the contract.
The named obligee also has obligations, one of the most primary is to PAY the builder. Important: The obligee is prohibited from making a performance claim if they have failed to pay the contractor.
Therefore, when the bank is included under a Dual Obligee Rider, they accept the benefits and obligations. If the borrower defaults, the lender cannot make a bond claim unless they continue to pay the construction loan to the surety. (Now the bank owns the project and the surety has become the contractor.)
Is this starting to make sense? When a borrower defaults on a commercial project, a lender included by Dual Obligee Rider cannot make a claim unless they continue to pay the project funds to the surety.
On Site and Subdivision there is a unique risk – the lender can take a free ride on the surety by having the bonding company pay out of pocket to complete the project.
Site and Sub-D bonds have the local municipality as obligee, not the bank. The bank doesn’t want a Dual Obligee Rider because they automatically receive a financial benefit if the municipality makes a bond claim to demand completion. If the borrower has defaulted, the bank has the opportunity to withhold the balance of the loan (the borrower is gone), and watch the surety pay to complete a project they now own. And they were not even the bond claimant…