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Letters of Credit Do Not Guarantee Performance

Letters of Credit (LOC) are frequently viewed as substitutes for performance and payment bonds. However, LOCs are not suited to guarantee performance of contracts which require more than a single delivery of goods or payment of a certain sum.

One of the reasons given by the Comptroller of the Currency in allowing banks to write municipal bond insurance (which he said was the "functional equivalent" of a standby letter of credit) is that "if a factual investigation as to whether default has occurred were necessary, it would not involve the type of non-banking expert judgement or prolonged litigation needed to determine whether, for example, a performance bond has been defaulted upon."

The Comptroller of the Currency thus recognizes that LOCs are not appropriate substitutes for performance bonds.
Another shortfall of the LOC, compared to a bond, is that the demand or draft on the LOC must be in precise accordance with the terms of the LOC. Substantial compliance is not good enough. This strict adherence is enforced by the courts and, as an example, one beneficiary under a LOC was recently denied recovery because a name in the draft was spelled incorrectly.

LOCs are not an instant source of cash as some owners may think. Where banks have feared multiple liability, they have been able to enjoin the beneficiary from receiving payment in order to let a court examine the merits of the underlying dispute.

An alternative to surety bonds on private construction projects -- and one utilized extensively around the world -- is bank guarantees or letters of credit issued by a bank in favor of an owner of a construction project. Generally, these are issued in an amount of 10% of the total contract and are strictly a financial transaction with amounts callable by the owner upon demand. Prequalification of the contractor is limited to the bank securing its financial position with respect to the letters of credit issued. The contractor's managerial ability and technical skills to complete the contract are not as thoroughly explored as when a surety company issues a 100% performance bond and a 100% payment bond.

The critical difference between LOCs and surety bonds becomes very clear at the time of a default. The performance bond assures that the owner will obtain what he/she originally contracted for -- the completion of its building or construction project! On the other hand, letters of credit, upon default of a contractor, will simply generate the stated sum of money to be paid to the owner and leave the task of administering the completion of the contract to the owner. Furthermore, the payment bond assures that all rightful claims of subcontractors, laborers, and suppliers will be paid, thereby eliminating liens or encumbrances on the project. A letter of credit will not assure such payments.

Surety bonds remain in force for the duration of the contract while letters of credit can be released prematurely. Also, the amount of coverage offered -- 100% performance and 100% payment bonds -- assures completion of the contract and is usually competitively priced when compared to much smaller percentage letters of credit.
Letters of credit also diminish borrowing capacity of a contractor, whereas the issuance of performance and payment bonds are done so on an unsecured basis with little effect on a contractor's bank line of credit and working capital.

SOURCE: This information is based on articles published in SURETYSCOPE, the National Association of Surety Bond Producers' professional surety journal, by C. Allan Reeve, Senior Counsel - Goldberg & Connolly, Attorneys At Law, Rockville Centre, NY and Construction Business Review by Matthew Klimczak, AFSB, Vice President/Bonds - Peerless Insurance Company, Keene, NH.