Contract surety bonds and bank letters of credit are very different forms of risk management. The differences between these two products are especially apparent when examining the prequalification process, effect on borrowing capacity, costs and duration of coverage, and claims.

There are three parties to a contract surety bond: the surety, the project owner (obligee), and the contractor (principal). There are three basic types of contract surety bonds. The bid bond assures that the contractor’s bid was submitted in good faith and that he or she intends to enter into the contract at the price bid and provide the required payment and performance bonds. The performance bond assures the project owner that the contractor is qualified to perform the particular contract. In the event of contractor default, the surety is responsible for project completion. The payment bond protects certain subcontractors, laborers, and material suppliers against nonpayment by the contractor.

A letter of credit is a commitment by the bank on behalf of the contractor to the owner to meet a demand for payment. An owner can call on a standby letter of credit simply by presenting specified documents indicating a default – no proof of default is required. A conditional letter of credit may require some burden of proof of default, but not to the degree of the surety’s investigation of a surety bond claim. In either case, once the owner calls on the letter of credit, it becomes a cash payment to the owner and an interest-bearing loan for the contractor.

The surety bond protects the owner from nonperformance and financial exposure if the contractor defaults on the contract. Contract performance determines the rights and obligations of the surety and the project owner. The surety stands behind the contractor, guaranteeing performance of the contract. Should the contractor default, the surety will investigate in order to meet its obligations to the owner while protecting the contractor against an invalid declaration of default.

Costs & Duration
Generally, surety bonds cost 0.5% to 2% of the contract amount. The one-time premium generally includes a 100% performance bond, 100% payment bond, plus a one-year warranty period. The contractor includes the bond premium in the bid, passing the cost on to the owner.

Bank letters of credit operate on a different pricing structure. The cost of bank letters of credit is generally 1% of the amount of the letter of credit. If, for example, the letter of credit covers 10% of the contract, the cost is 1% of 10% of the contract amount. For multi-year contracts, the letter of credit may be renewed each year with related fees. Its cost may be included in the contractor’s bid.

Surety bonds remain in force for the duration of the contract, subject to the terms and conditions of the bond, the contract documents, and underlying statutes. In contrast, a letter of credit is usually date specific – generally one year. Letters of credit may contain “evergreen” clauses for automatic renewal unless canceled, with related annual fees.

“The bet made on the amount of the letter of credit is that it will be enough to cover shortfalls in performance or payment,” explained Dev Strischek, Senior Vice President and Senior Credit Policy Officer, Credit Risk Management, SunTrust Banks Inc., Atlanta (GA).  “If the owner loses the bet, the owner must cover the shortfalls, complete the project himself, and deal with possible liens from unpaid subcontractors, workers, or suppliers.”

Prequalification
The cost of a surety bond is essentially a fee for the surety’s rigorous prequalification of the contractor. Known as underwriting, this process differs greatly from the method used by banks. The three Cs of underwriting – capital, capacity, and character – are all scrutinized by the surety. The surety assesses the contractor’s entire business operation, checking for financial resources; experience; management and organization; and past, existing, and future workload and profitability.

“The surety prequalification process is of great importance to an owner,” explained James E. Lee, President and CEO, Old Republic Surety Company, Brookfield (WI). “It provides the owner with peace of mind that the contractor performing his or her work has been screened by a professional third-party organization and deemed capable, via proven experience and financial means to undertake the contract and complete it on time, in accordance with plans and specifications, and with assurances that claims and liens will be satisfied.”

While a surety examines a multitude of components to prequalify a contractor, banks focus primarily on the financial aspects of a contractor’s business. The banker examines the quality and liquidity of the collateral available to the bank in case there is a demand on the letter of credit. If the banker is satisfied that the contractor can reimburse the bank or that the bank is holding sufficient collateral, there may be no further prequalification.

“An owner who accepts a letter of credit instead of a surety bond has no assurance of a contractor’s qualifications other than that the contractor had the ability to secure a letter of credit,” Lee continued. “The collateral required to be posted for the letter of credit could have come from a source totally independent of the contractor, which does not give the owner any satisfaction as to the contractor’s professional workmanship abilities.”

Borrowing Capacity
Bank letters of credit are frequently secured by pledging specific assets and can diminish an existing line of credit, which are reflected in the contractor’s financial statement as a contingent liability. Having assets tied up, or an available line of credit diminished, can be counter-productive to both the project owner and contractor.

“Contractors usually do not possess the excess liquidity to collateralize letters of credit, and tying up liquidity for collateral is likely to cause cash flow shortages in its construction activity,” said Strischek, who knows both banking and construction. “The surety’s performance and payment bond is usually an unsecured obligation that leaves the contractor’s limited liquidity intact.”

With few exceptions, performance and payment bonds are issued on an unsecured basis. That is, they are usually provided on the overall strength and capability of the construction company and the contractor’s corporate and personal indemnity. The issuance of bonds has no direct effect on the contractor’s bank line of credit, and in some instances, can be viewed as a credit enhancement. Unused bank borrowing capacity can be viewed as an off-balance sheet strength.

“Because of its unsecured nature, the surety’s evaluation of the contractor’s performance tends to be more exacting and rigorous than that of a bank secured by liquid collateral,” Strischek said.

Claims
The manner in which the claims process is handled by sureties and banks also differs greatly. The surety company has obligations to both the owner and the contractor. If they disagree on contract performance issues and the owner declares the contractor in default, the surety must investigate the claim. The surety may take one of the following actions, depending on the bond form and specific facts of the default:

• • Retain the original contractor, providing financial assistance or technical support to allow the contractor to finish the project;
• • Tender a new contractor to complete the contract;
• • Take over responsibility for completing the remaining work (i.e. the surety hires a completion contractor and becomes the contractor of record); or
• • Pay the cost of completion, up to the penal sum of the bond.

“It is in the surety’s interest to get the job finished, whether that means financing the current contractor, finding another, or taking over the job itself,” Strischek noted.

A bank will pay on a letter of credit upon demand of the holder. However, the holder or beneficiary must make a demand prior to the expiration date since no funds are available after the expiration date, even for liabilities incurred prior to expiration.

While a surety company has a number of options to assure completion of a project, there is no completion clause in a letter of credit – the task of administering completion of the contract is left to the owner.

With the payment bonds, the surety pays the rightful claims of certain subcontractors, laborers, and suppliers. In contrast, with letters of credit, the owner must determine the validity of those claims. If there is not enough money from the letter of credit to pay all of the claims, then the owner has to decide which claims will be paid in addition to covering the cost of completion.

“The bond’s payment feature,” Strischek added, “is more attractive to subcontractors and suppliers with potentially more attractive pricing of materials and labor.

“The surety industry has been writing bonds for contactors for many years,” he concluded. “The surety bond is simply a better instrument than a bank letter of credit for underwriting construction risk on any given day.” SLDT