Can a Bank Letter of Credit be Replaced with a Surety Bond?
Many businesses, including contractors, are required to provide financial security to public agencies or other private entities to guarantee their performance obligations. Historically, the two main forms of financial security used to meet these obligations have been in the form of a Bank Letter of Credit (standby LOC) and a Surety Bond. In some cases, Surety Bonds have been required, while in other cases Letters of Credit have been required. However, we are seeing in the marketplace more and more cases where a Bond is accepted in lieu of a Letter of Credit.
One key factor driving this trend has been the turmoil in the banking industry as several banks have either failed or have been downgraded below minimum credit rating criteria, while most surety companies have solid credit ratings.
Another key factor has been the appeal to many businesses the ability to set free capital tied up by Letters of Credit. By replacing Letters of Credit with Bonds, many businesses have been able to free up capital for other operating purposes.
To better understand this trend and consider the process of placing a Bond as a replacement to a Letter of Credit, we can start by comparing Bonds to Letters of Credit.
What is a Bank Letter of Credit?
A Letter of Credit is issued by a Bank on behalf of a Buyer (Principal) to a Beneficiary to serve as a guarantee for the Principal’s performance of an obligation. When a Principal obtains a Letter of Credit, the bank typically ties up the Principalʼs liquid assets in the same amount as the Letter of Credit. If a Principal does not fulfill its obligations to a Beneficiary guaranteed by a Letter of Credit, the Beneficiary is typically able to draw down the funds on demand.
What is a Surety Bond?
A Surety bond is a promise to honor the obligations or another party to the extent of the terms of the bond. It is a three-party agreement whereby one party (Surety company) is bound with the person or entity bonded (Principal) in the performance and or obligations to a third-party Beneficiary. A surety bond is a three-party agreement between a Principal, a Beneficiary, and a Surety company. If
a Principal does not fulfill its obligations to the Beneficiary, the Beneficiary can make a claim on the bond. Once the Surety company receives the claim, the surety company will investigate and determine whether the claim is valid prior to paying a claim. Surety bonds typically are not payable on on-demand.
What are some opportunities for a Bond to be used in lieu a Letter of Credit?
We have seen Bonds be accepted in lieu of standby Letters of Credit in support of a broad array of financial and performance obligations related to the following:
- High Deductible – Self Insurer Insurance Programs (Workers Comp, Liability, Auto, etc.)
- Performance / Financial Obligations (Leases, Utility Deposits, etc.)
- Court Decisions (Security for Appeals)
- International Performance / Financial Obligations (typically require 10% Letter of Credit)
What are some of advantages of using Bonds vs. Letters of Credit?
Financial flexibility: Banks can tie up credit capacity and or liquid assets in support of Letters of Credit, but Surety Bonds aren’t credited against a company’s bank line and typical do not require collateral.
Credit enhancement: Banks may place financial covenants in support of Letters of Credit, and or require security interest in liquid assets. Surety companies can be more flexible and typically are an unsecured creditor with Surety Bonds being an off-balance sheet product.
Default protection: While a bank Letter of Credit is a pay on demand product and can be drawn down by the Beneficiary at any time. Surety Bonds however usually are not pay on demand, and the Surety company will investigate and require proof that a claim is valid prior to paying out. Surety companies have dedicated claims staff to handle disputes and the claim resolution process. Banks on the other hand do not have a claims staff and do not offer any defense.
Cost of capital: The cost of Letters of Credit can fluctuate widely depending largely on market conditions. Surety companies charge rates that do not fluctuate much and tend to be tied to the credit ratings. Banks may charge other fees while Surety companies do not charge for establishing a facility. Premium for a Surety Bond is usually about 0.5% to 3% percent of the penal sum, and largely depends on the Principal’s credit ratings and financial wherewithal. The cost for a Letter of Credit is usually about 0.5% to 2.5% percent of the letter’s coverage amount.
Overall, Surety Bonds and Bank Letters of Credit have many similarities and can both be acceptable forms of security, but in many cases the advantages are compelling reasons why companies select Surety Bonds in lieu of Bank Letters of Credit.
The Performance Bonding Advantage
Since Surety is our only focus, your bond needs will always receive immediate attention. As your committed partner, Performance Bonding Surety & Insurance Brokerage will stay one step ahead of your needs and expectations. We have direct appointments with the Top 10 US Surety Carriers, including direct access to upper management/decision makers. We are licensed to write bonds in virtually every state, including the District of Columbia, and are experienced with international surety. Contact us for timely, dynamic, and reliable surety services to meet your immediate and long-term needs.
