Shane Gleghorn asks whether the JP Morgan Chase litigation will clarify the validity of surety bonds.

On 3 January 2003, JP Morgan Chase (JPMC) reached a $600m settlement with ten of the 11 insurers in the JP Morgan Chase Bank v Liberty Mutual Insurance Co case before the US District Court for the Southern District of New York. Liberty Mutual, the remaining insurer, continues its defence of the proceedings.

Under the settlement agreement, the insurance companies will pay 60% of the $965m that JPMC claimed from the insurers. The trial of the matter commenced in New York on 2 December 2002 and was originally scheduled to finish in late January or early February 2003. The settlement came just as the case was to come before a jury and leaves open the issue of whether the underlying oil and gas trades were legitimate transactions.

The litigation concerned surety bonds issued by the insurers to secure Enron's obligations under forward sale contracts. A surety bond is a third party undertaking for the performance of a contract or other legal obligation which is legal or statutory in nature and which requires cash, collateral or other forms of financial security. Three parties are involved in the surety agreement: the principal, the beneficiary and the surety.

In this case, Enron was the principal with the contractual obligation to supply specified monthly amounts of crude oil and natural gas under certain forward sales contracts to two special purpose vehicles, Mahonia Ltd and Mahonia Natural Gas Ltd (Mahonia). The insurers were the sureties who issued the surety bonds that secured Enron's obligations to make payments under the forward sales contracts to Mahonia. The two Mahonia companies were the beneficiaries under the surety bonds.

Between 1997 and 2000, Enron entered into numerous forward sales contracts under which Enron agreed to supply Mahonia with specified amounts of oil and gas, in exchange for which Mahonia agreed to make advance payments to Enron. The advance payments made by Mahonia under the forward sales contracts were funded by JPMC.

Under the terms of the forward sales contracts, Enron was obliged to pay Mahonia a fixed sum (which was roughly equal to the outstanding balance of the outstanding prepayments) if it failed to supply the specified oil and gas. In practice, no oil or gas changed hands. Accordingly, the forward sales contracts served a financing function because Mahonia (funded by JPMC) made the cash advances before Enron was obliged to supply oil and gas. In the event that Enron was unable to deliver the scheduled monthly amount of the commodities, Enron was required to remit to Mahonia the agreed `replacement value'.

The insurers alleged that JPMC, which provided Mahonia with the funds to prepay its entire obligation to Enron and which was appointed by Mahonia to act on its behalf, used Mahonia as a vehicle to disguise the fact that JPMC was making a series of loans to Enron. The alleged structure of the `disguised' loans was based on a series of `matched agreements'. Mahonia would borrow money from JPMC equal to the amount being prepaid by Mahonia to Enron for the commodities under the forward sales contracts. As security, JPMC would take an assignment of Mahonia's right to receive delivery of the commodities from Enron. In addition, JPMC would buy the commodities from Mahonia under a fixed price forward contract for the identical quantities of the commodities, for delivery at identical times and at a price that was similar to that being paid by Mahonia to Enron. JPMC purchased the commodities from Mahonia in advance and then sold them back to Enron. However, unlike the sales from Enron to Mahonia, there was no prepayment by Enron to JPMC because payment was deferred over the term of the relevant contract (e.g. a two to five year term). Accordingly, Enron kept the benefit of the prepayments made by Mahonia and was only obliged to make monthly instalments to JPMC to repurchase the gas. In addition, JPMC and Enron agreed that there would be a price differential between Enron's sales to Mahonia and Enron's repurchases from JPMC, which was similar to the interest that would be payable on an instalment loan.

As Enron became insolvent it was unable to meet its obligations to Mahonia under the forward sales contract, and on 7 December 2001 JPMC (on behalf of Mahonia) served the insurers with notices of demand for payment under the surety bonds. On 11 December 2001 JPMC commenced the proceedings as JP Morgan Chase Bank, for itself and on behalf of Mahonia Ltd and Mahonia Natural Gas Ltd.

There are many interesting issues relating to surety bonds arising out of the case, including:

  • the differences between surety bonds and insurance products;

  • the different expectations of bankers and insurers in respect of surety bonds; and

  • the enforceability of a surety bond issued in circumstances of alleged fraud.

    Surety bond characteristics

    The characteristics of a surety bond are:

    1. a promise or undertaking by a person (surety) to pay another person (the beneficiary) an agreed amount in the circumstances agreed upon or to perform some specified obligation for the beneficiary;

    2. the surety, at the request of its principal, issues the bond to secure certain obligations owed by the principal to the beneficiary under separate contractual arrangements. It is a primary and direct obligation assumed by the surety in favour of the beneficiary rather than a secondary obligation that would be the case under a guarantee; and

    3. the surety bond is issued on the basis that the principal gives the surety a legal right to recover full reimbursement from it for any losses, expenses or other liabilities arising or incurred in connection with the surety bond. Accordingly, if the beneficiary makes a claim on the surety bond, the surety has a corresponding right to recover full reimbursement from the principal of the money paid by the surety to the beneficiary under the surety bond.

    Surety bonds fall into two categories, namely `conditional bonds' and `unconditional bonds'. Under a conditional bond, the surety is only liable to pay or perform where it is satisfied that the principal has not performed its obligations to the beneficiary under the underlying contract (e.g. an event of default has occurred under the underlying contract). If a bond is unconditional, the surety must make the payment or performance irrespective of the surrounding circumstances.

    In this sense, a surety bond is similar to an unconditional bank guarantee. The commercial benefit of a surety bond is the ability of the beneficiary to be able to demand and recover monies immediately or at least on a summary judgment (i.e. without the necessity of a full trial). However, the insurers in this case were able to avoid payment and resist an application for summary judgment by arguing that they were induced into issuing the surety bonds by means of fraudulent misrepresentations, an argument akin to the English legal principle that `fraud unravels all'.

    Although insurance companies often act as sureties, suretyship is not another type of insurance. A surety under a surety bond does not have the same legal rights and obligations as an insurer. Insurance contracts fall within a special class of contracts designated uberrimae fidei, which imposes a positive duty on the parties to disclose material facts. The parties to a surety bond are subject to the general contractual principle that there is no positive duty to disclose material facts to another contracting party. Subject to certain exceptions to that general principle (such as fraud), a surety who gets the worst of a bad bargain has no recourse against the beneficiary.

    Unlike insurance products, surety bonds do not involve a risk transfer from the principal to the surety. The surety only takes on the credit risk that it will be unable to recover full reimbursement from the principal for the loss incurred in connection with the surety bond. This is exactly what occurred when Enron became insolvent because the insurers were unable to recover any money from Enron to reimburse them for any payment made under the surety bonds. In practical terms, of course, the insolvency of the principal is usually the reason why the surety becomes liable to the beneficiary under the surety bond. Accordingly, a surety will not ordinarily assume a credit risk unless it has carefully investigated the financial status of the principal.

    The insurers' allegations of fraudulent misrepresentation in the Enron case highlight the different expectations of bankers and insurers in respect of surety bonds. Bankers have viewed surety bonds as being analogous to letters of credit. On this view, a professional surety should undertake a due diligence process and ascertain the nature of the risk it is taking upon itself. Conversely, insurers have traditionally operated in an environment where contracting parties have a positive obligation to disclose material facts.

    In this case, JPMC alleged that the surety bonds were unconditional and the insurers were precluded from relying on the alleged fraudulent misrepresentations to defend the claim for payment. For example, JPMC alleged that the insurers represented and gave assurances that the surety bonds would be the "functional equivalent of letters of credit" and would "constitute absolute and unconditional pay-on-demand financial guarantees". That is, similar to letters of credit, the surety bonds would have to be paid on demand irrespective of the surrounding circumstances.

    For their part, the insurers alleged that the surety bonds secured an obligation that was akin to a performance obligation (i.e. performance of the obligation to deliver oil and natural gas) and did not secure a financial obligation under a standard debt instrument. In this regard, the essence of the insurers' defence was that in reality the future sales contracts disguised a series of loans from JPMC to Enron. Accordingly, the insurers rejected JPMC's demands for payment because they considered that JPMC misrepresented the nature of the contractual obligation that was secured by the surety bonds.

    The mid to late 1990s saw surety insurers underwriting hybrid products that share some of the characteristics of financial guaranty products. Surety bonds are usually less expensive than bank letters of credit and are usually off balance sheet. Consequently, insurers have been able to market surety bonds as a cheaper off balance sheet alternative to bank-issued letters of credit for use in, for example, structured financed transactions. As surety bonds are off balance sheet, they were not listed as a liability under US Financial Accounting Standards Board rules. Accordingly, surety bonds could be used to enhance a company's balance sheet and avoid the diminished borrowing capacity associated with letters of credit. For example, the insurers alleged that, although it paid a bond premium, Enron was not required to collateralise the surety bonds with assets segregated from its general accounts. This meant Enron was able to obtain the benefit of the prepayments from Mahonia (funded by JPMC) but was not obliged to record a loan transaction on its balance sheet, nor was it necessary to encumber any of Enron's assets.

    In this regard, JPMC alleged that a protracted soft market for traditional surety bonds resulted in the insurers aggressively marketing commercial surety bonds to companies (such as Enron) participating in pre-paid forward transactions. Further, JPMC alleged that the insurers were aware that there was a risk that the New York regulator would determine that the surety bonds issued to Enron contravened a statutory prohibition on financial guaranty insurance.

    Statutory prohibition

    In the late 1980s, the New York insurance commissioner became concerned that multiline insurance companies were increasingly exposed to significant risk (without proper underwriting or reserves) by issuing bonds covering debt or investment instruments. As a result, in 1989 New York enacted legislation to prohibit multiline insurance companies (such as the insurers in the Enron case) from issuing financial guaranty insurance. The statute prohibits multiline insurers from writing financial guaranty insurance where a loss is payable as a result of a principal's failure to pay a sum of money when due as the result of a financial default or insolvency. Multiline insurers are not, however, prohibited from writing traditional types of surety contracts where the bond is guaranteeing the performance of a contract of supply (rather than a contract of indebtedness or other monetary obligation). Accordingly, although the insurers were entitled to guarantee performance of contractual obligations (such as the delivery of natural gas), they were not legally entitled to issue financial guaranty insurance.

    On 2 June 2002, Judge Jed Rakoff dismissed an application by JPMC for Summary Judgment and held that the insurers were entitled to withhold payment on the surety bonds pending a final decision of the Court. At the summary judgment hearing, the insurers argued that the oil and gas trades they believed they were guaranteeing were in fact a disguised method of loaning money to Enron. Allied to this, the insurers contended that the surety bonds were void if they actually secured a loan because they would contravene the statutory prohibition on unlicensed multiline insurers issuing financial guaranty insurance. The insurers also argued that, unbeknown to the insurers the surety bonds "were designed to camouflage loans by [JPMC] to Enron" and, accordingly, the insurers were defrauded into guaranteeing loan obligations.

    Judge Rakoff held that it was inappropriate to grant summary judgment because there was sufficient evidence that the Enron transactions were actually disguised loans designed to keep large amounts of debt off Enron's balance sheet. He held that: "These arrangements now appear to be nothing but a disguised loan - or at least have sufficient indicia thereof that the court could not possibly grant judgment to the Plaintiff."

    Soon after the unsuccessful summary judgment motion, JPMC filed an Amended Complaint which alleged that the insurers were in fact aware of the true nature of the transactions. JPMC also alleged that it was untenable for the insurers to rely on the illegality argument because the insurers had all the information they requested on the transactions before the bonds were issued.

    The insurers relied upon the alleged disguised character of the original transactions as a defence to JPMC's assertion that the surety bonds are `unconditional pay-on-demand financial guarantees'. In particular, the insurers alleged that the actual (but disguised) intent of the transactions was not the taking delivery of oil or gas but rather the provision of low interest finance to Enron. For example, at the trial the insurers tendered an email from the vice chairman of JPMC that referred to transactions involving Enron as `disguised loans'.

    The insurers alleged that they were fraudulently induced into issuing the surety bonds because JPMC, Mahonia and Enron misrepresented the true structure and nature of the underlying transactions. In essence, the insurers asked the Court to determine that the surety bonds and forward sales contracts were merely mechanisms used by JPMC to disguise a complicated and undisclosed loan from JPMC to Enron, which was a materially different risk from the oil and natural gas delivery obligations that the insurers believed to the object of the forward sales contracts.

    JPMC did not deny that the nature of the transactions meant that no physical oil or gas changed hands. This was conceded by the lawyer for JPMC at the start of the trial when responding to a direct question from Judge Rakoff as to whether the "structure was totally circular". JPMC maintained, however, that the insurers signed "absolute and unconditional" surety bonds in full knowledge that the deals with Enron were financing arrangements. For example, JPMC's Amended Complaint alleges that the forward sale contracts were true supply contracts (albeit that they also served a financing function) and JPMC's representatives explained the full details of the transaction (including the fact that it would ultimately serve as a form of financing) to the insurers.

    The insurers' defence seemed to rely on the proposition that a surety cannot be held liable if it was misled by the principal and the beneficiary as to the true nature of the duty it purported to secure. In essence, the insurers sought to avoid the surety bonds on the basis that material facts were misrepresented. It seems that this argument was at least tenable because at the Summary Judgment hearing Judge Rakoff rejected JPMC's submission that the insurers had waived the defence of fraudulent misrepresentation, notwithstanding that the surety bonds contain wide exclusion of liability clauses.


    It seems that a number of commercial factors contributed to the settlement of the dispute, not least of which was the risks connected with a jury trial. In this regard, William Harrison, JPMC's CEO, was reported in the Financial Times as saying that JPMC decided to settle the matter because of the high risk associated with a jury trial of such a complex case.

    It also seems likely that the insurers recognised the risks associated with their reliance upon the defence of fraudulent misrepresentation. It would be surprising if the insurers' reinsurers were not following the litigation closely to determine whether there was any merit in JPMC's allegation that the insurers understood the true nature of the underlying transactions. Moreover, it is likely that the insurers wished to avoid any risk of an adverse finding that they illegally attempted to circumvent the statutory prohibition on issuing financial guaranty insurance. It is possible that the surety bonds would have been excluded from coverage under the insurers' reinsurance treaties if they were classified by the Court as financial guaranty insurance. In short, it appears that both sides faced commercial and legal risks that compelled them to settle the dispute without adverse findings being made by the Court.

    It appears, however, that Liberty Mutual has taken a different view of those risks because it has opted out of the settlement agreement. It would be interesting to know the reasons behind Liberty Mutual's decision to continue to defend the proceedings. In any event, it is to be hoped that the continuation of the litigation may serve the useful purpose of clarifying the extent to which the US Courts will interfere with the enforcement and validity of a surety bond. Until that decision is delivered, it appears that US law is unclear as to whether a surety bond will be enforceable in circumstances where a surety is mislead by the principal and/or the beneficiary as to the true nature of the obligation secured by the surety bond.

    By Shane Gleghorn

    Shane Gleghorn is a lawyer in the insurance practice of Baker & McKenzie, London.