Letters Of Credit

SHOULD THEY BE USED IN LIEU OF PERFORMANCE AND PAYMENT BONDS?

Contractors who do not qualify for the corporate surety Performance and Payment Bonds often want to substitute letters of credit for bonds.

The question confronting construction purchasers is whether a letter of credit is a suitable substitute for corporate surety bonds to guarantee the performance of construction contracts and the payment of subcontractors and material suppliers.

The direct answer is "NO!" Performance and Payment Bonds are best suited for guaranteeing a contractor's performance and the payments to direct subcontractors and suppiers. Bonds differ considerably from letters of credit. This critical difference benefits both the project owner and the contractor.


BONDS AND LETTERS OF CREDIT - TWO DIFFERENT INSTRUMENTS

The type of letter of credit which would be used to guarantee a contractor's performance of contracts is a "standby" letter of credit. It is normally issued by banks in favour of the owner of the construction project. The letter is callable by the owner upon demand. When that happens, the bank pays over to the owner the amount of the letter of credit.

Performance and Payment Bonds are also a type of guarantee, but that is about all they have in common with letters of credit.

The Performance Bond is directly tied to an underlying contract and responds if the contractors defaults in performing the contract. The surety company has duties and responsibilities to both the contractor and the project owner and strives to be equitable to all concerned. This role contrasts sharply with a letter of credit which simply pays over a sum of money on demand.

The labour and material payment bond, protects direct subcontractors, labourers and material suppliers against nonpayment by the contractor. On public work, these parties generally are not allowed to file a lien against the property. In addition, the ability to place a lien is not of much use if the funds are inadequate or nonexistent. These claimants depend on the payment bond for protection in the event they are not paid for their services or material. Generally, such claimants may seek recovery directly from the surety company under the payment bond.