- Letters of credit often are used in place of surety bonds on construction projects.Jupiterimages/Photos.com/Getty Images
Although letters of credit (LOCs) often are used in lieu of surety bonds, LOCs are not guaranties or the equivalent of surety bonds. Used frequently in construction projects, a letter of credit is a cash guarantee to the project owner with no promise of performance on the contractor's part. Surety bonds, on the other hand, are three-way contracts among the bank, contractor and owner that financially protect the owner and sub-contractors while ensuring completion of the project. - A surety bond is secured by a building contractor and is a three-way contract among the surety (bank), the "oblige" (the project owner) and the "principal" (the contractor). The agreement includes a performance bond that protects the owner in the event of non-performance by the contractor -- in other words, if the job isn't completed or the contractor otherwise defaults. It also includes a payment bond, ensuring against nonpayment to subcontractors, laborers and suppliers by the contractor. A letter of credit guarantees cash payment to the owner---usually 10 percent of the total of the construction contract---that is callable on demand by the owner. It is a payment to the owner financed by the contractor with interest charged to the contractor by the bank.
- LOCs usually have expiration dates or, at best, automatic renewal options (with associated bank fees). A surety bond, however, remains in effect for the duration of the construction contract.
- Surety bonds generally cost 0.5 to 3 percent of the contract price and are included in the contractor's overall bid price. A letter of credit is 1 percent of the contract amount that's covered by the LOC. In other words, the letter of credit doesn't cover the entire cost of the project but, rather, a portion, such as 10 percent. For example, an LOC could be formulated as "1% x (10% x Contract Amount) x number of contract years." Therefore, an LOC can be purchased, in most cases, for much less than a surety bond but offers less protection for the owner and no performance guarantees.
- LOCs provide no guarantees of performance. Upon default, the bank simply pays the beneficiary (the project owner) the amount specified in the LOC contract---namely, 10 percent of the construction contract. The owner is left to fend for himself in finding, and paying, another contractor to finish the job. Surety bonds insure 100 percent of the contract amount for completion of the job, as well as 100 percent payment to subcontractors to ensure against liens against the owner's property.
- Surety companies perform in-depth assessments of contractors' finances, including debts and liquidity; business operations; employees; current workload; and profitability. Management also is evaluated to determine the contractor's ability to complete the proposed project. No such thorough investigation is conducted by a bank for purposes of an LOC. The bank simply examines the contractor's finances and liquidity to satisfy conditions for re-payment of the letter-of-credit terms if the contractor defaults.
- Once a project owner claims the contractor is in default, a surety company will investigate and, if the contractor is found at fault, will finance the contractor or provide assistance; assume job-completion responsibilities; find a new contractor; or pay the "penal" sum of the bond (the total limit of the surety's liability to all claimants). The surety also pays the claims of subcontractors, laborers and suppliers---up to the penal sum of the bond. A bank pays on an LOC upon demand of the holder if a claim is made prior to the contract's expiration date, but there is no completion clause. The owner must determine which subcontractor and supplier claims he'll pay, which ones will be rejected and which will go to litigation.
