Which is the BETTER option for contractors?
To manage risks in construction projects, surety bonds and letters of credit (LOC) are used to ensure financial compensation in case of default or failure to fulfill contractual obligations.
However, surety bonds have more an advantage over LOCs when it comes to the parties involved, pre-qualification process, coverage, borrowing capacity, cost, claims, and how to acquire them.
Here, we provide a side-by-side distinction between the two types that offer similar financial protection in construction and public works projects.
A surety bond is a three party agreement that provides a guarantee that a construction project will be fully completed under the provisions of the construction contract. The three parties involved include the Obligee (project owner), the Principal (contractor) project owner, and the Surety (bond company/provider). The Surety assures the Obligee that if the contractor defaults on the project, they will step in to ensure that the project is completed.
Letters of credit also involve a three party contract: the issuing bank or financial institution, the Seller and Buyer. These documents are issued on behalf of buyers, guaranteeing that the seller will get paid for the goods or services provided to buyers. When the seller forwards the goods, he must then submit documentation as specified in the letter of credit to the issuing bank. The bank’s role is to validate that the documentation meets the stipulation of the letter of credit and then issue payments.
The surety company’s underwriter evaluates the contractor’s business operations, financial resources, experience, existing workload and its profitability, and management capability to prove that the contractor is capable of performing the contract.
The bank assesses the liquidity of the collateral in case there is a demand on the LOC. If the banker is satisfied that the contractor can reimburse the bank if demand is made upon the LOC, there is no further prequalification process.
Construction bonds, or contract surety bonds, have performance and payment bonds that cover 100% of the contract amount for the completion of the project and protects subcontractors, laborers, and material suppliers against liens. There is also at least a 10% coverage for maintenance defects following the first year of completion.
Usually, 5% – 10% of the LOC can be acquired, but it can be obtained for any percentage of the contract. There is no financial protection/guarantee that subcontractors, laborers, and material suppliers will get paid in case of contractor default. They may file liens on private projects.
Construction bonds usually are issued based on a contractor’s financial strength and experience. The issuance of bonds does not reduce the contractor’s borrowing capacity and may be regarded as a credit enhancement.
Liquid assets are pledged to secure bank LOCs. Bank LOCs diminish the contractor’s line of credit and show on the contractor’s financial statement as a liability.
1% – 5% of the contract price. The bond is project-specific and covers the duration of the contract. The cost is included in the contractor’s bid price.
Cost is 1% of the contract amount covered by the LOC, typically 5% – 10%.
If the owner declares the contractor in default, the surety investigates. If the contractor defaults, the surety’s options are to:
- Finance the original contractor or provide support;
- Take over responsibility for completion (up to the penal sum of the bond);
- Tender a new contractor; or
- Pay the penal sum of the bond.
With LOCs, the bank will pay on demand of the holder if made before the expiration date. There is no completion clause in an LOC. The task of administering completion of the contract is left to the owner.
The owner must determine the validity of claims by subcontractors, laborers, and materials suppliers. If there is not enough money from the LOC to pay all of the claims, then the owner has to decide which claims will be paid and which will be rejected.
The contractor obtains the surety bond through a reliable surety bond company. An underwriter will conduct an extensive evaluation of a contractors’ capital, capacity, and character to qualify for a surety bond.
The contractor obtains the LOC through a banking or lending institution.
In conclusion, surety bonds have more of an advantage over LOCs as it provides a more stable kind of financial security. LOCs have high and shifting fee structures because banks sometimes charge a variety of fees. Likewise, LOC bank fees will often converge with interest rates and will reflect on a personal or business credit score. If a contractor fails to meet the LOC terms, he or she will pay off the letter, which can damage the credit rating. Sureties, on the other hand, financially backs up the contractor if a claim is made, where the contractor reimburses the whole amount paid out by the surety.