6 Reasons to Choose a Surety Bond vs a Letter of Credit

Considerable media and sales energy has focused on the use of Letters of Credit (LCs) when securing construction contracts and commercial obligations. There are at least six reasons why obtaining a surety bond is often the better choice.  

See surety bond and letter of credit definitions

Before issuing a bond, the Surety thoroughly vets the prospective Principal, examining the Principal’s financial statements, experience, management, and any actual or potential backlogs of contracted work, among other things. As a result, a bond can give the Obligee greater assurance that the Principal will complete the project as promised. 

For example, a project owner may require a performance bond to guarantee that a project will be delivered on schedule and as agreed to in the underlying bonded contract.

Similarly, a Surety that issues commercial surety bonds thoroughly vets its customer, among other things, as part of its due diligence. For instance, in the renewable energy sector, a commercial surety bond can be utilized to ensure that a Principal will fulfill its obligations to an Obligee under a development contract, interconnection agreement, or power purchase agreement.  

An LC, on the other hand, is typically issued based solely on a review of the LC applicant’s financial position and security package provided to the bank. 

Reach Out to the Surety Team

Unbonded projects are more likely to default than bonded projects, according to an EY analysis commissioned by the Surety and Fidelity Association of America (SFAA).¹

Surety bonds offer three avenues to financial protection: 

A performance bond can protect the Obligee against non-performance of the Principal, including contractually specified liquidated damages assessed due to an unexcused project delay caused by the Principal. An example is when the project owner has contracted to supply a third party with power from a plant it is building and is unable to deliver due to a project delay. Liquidated damages are generally set at a certain amount per day and capped at a certain dollar amount or a percentage of contract value. 

A payment bond, generally issued in conjunction with a performance bond, ensures that subcontractors, laborers, and material suppliers on a project are paid. This is critical for a contractor to deliver a lien-free project to the owner. 

Warranty obligations of the Principal for up to 12 months are also typically included as part of the surety premium for certain types of performance bonds.

A commercial surety bond also provides protection to the Obligee, guaranteeing that the obligations of the Principal will be fulfilled in accordance with the terms of the underlying bonded contract or obligation. If a default is declared by the Obligee, the Surety will respond. Generally, a claim against an LC does not require a declaration of default. 

Furthermore, an LC will pay out on demand of the beneficiary, but, for example, the beneficiary must still find a replacement contractor and incur any costs associated with remedying existing work or discharging any liens or other encumbrances against the subject project. An LC does not allow separate payment to be made to laborers, material suppliers, or subcontractors and typically does not include any warranty coverage.  

Surety claims are not always black and white. If a dispute arises when an Obligee declares a bonded Principal to be in default, the Surety will investigate and ensure that valid claims are addressed properly and on a timely basis. For example, a Principal/contractor may have legitimate defenses for ceasing work on a project, including lack of payment or access to the worksite. A thorough review of the dispute creates transparency, which gives all parties confidence in the resolution of claims. 

When a claim is validated, the Surety can provide broad financial protection and resources and expertise to support project completion. 

By comparison, when an LC is provided in support of a contract the LC may fall short in the event of a claim. For example, an LC may be insufficient to cover the entire claim amount, as it does not provide separate payment protection to subcontractors and others. LCs also lack resources or support for project completion. Moreover, once a contractor’s LC is drawn down for a claim, the contractor may not have sufficient capital or incentive to complete a project. 

A surety bond leaves the Principal free to allocate capital strategically, while an LC will likely tie up capital and impact existing credit lines or loan covenants. A surety bond is also backed by the financial security and stability of the Surety provider. 

A performance bond will typically accommodate minor increases in contract costs automatically. Additional charges and credits, reflecting price increases and decreases, may apply at the end of the contract period. An LC requires increases to be satisfied via an increase amendment, which may impact the LC applicant’s available credit. 

A performance bond remains in effect for the duration of the project, providing the Obligee with peace of mind as change orders are agreed to during the term of the underlying bonded contract. Alternatively, an LC is in place for a set term with the potential for (but not guaranteed) automatic renewal.

Additionally, a surety bond will remain in force regardless of ownership changes of the Principal. The Obligee does not need to intervene to continue to enjoy the protections afforded by the bond. An LC, on the other hand, may need to be reissued upon ownership changes, which may cause disruption. 

An EY/SFAA analysis¹ helps to quantify the positive economic impact of surety bonds on construction projects. Among the key findings:  

• When a contractor defaults, projects without surety bonds were discovered to have completion costs up to 85% higher compared to projects protected by bonds. 
• An unbonded project – absent the expertise, tools, and resources of a qualified Surety – was found to take nearly twice as long to complete than a bonded project.² 
• Five times as many public and private project owners said that bonded projects are more likely to be completed on time or ahead of schedule compared to non-bonded projects. 

A surety-backed letter of credit, also referred to as a bank fronted surety bond, is a letter of credit issued by a financial institution. The LC issuer then has the support of a Surety provider (but no direct right of access to the Principal). This introduces a fourth party into the “Surety arrangement”. Although supported by a Surety, these LCs maintain the limitations discussed in this article.

In addition, if a Surety agrees to back a letter of credit, and a claim is made against the LC, the issuing bank will need to make payment and seek reimbursement for its payment from the Surety. The Principal will need to reimburse its Surety for the amount paid to the bank along with any other fees incurred by the Surety, regardless of any defenses the Principal may have against the Beneficiary/Obligee.

Nevertheless, there are a few scenarios in which an LC supported by a surety bond may make sense. These include: 

• When collateral is required by an insurance company that does not accept surety bonds from the insured’s Surety or will not accept a sufficient amount of bonds to meet collateral requirements 
• When a beneficiary requires payment in 1-3 days, and there can be no factors that mitigate a draw on the collateral posted
• When an Obligee is in a country where the Surety is not licensed, and an LC is the standard practice for performance security

When selecting a Surety, prospective Obligees and Principals have choices and should actively participate in the process. Obligees should prioritize a Surety with financial strength and a track record of claims responsiveness, while Principals should look for a Surety that can support their bond needs and will issue bonds that are acceptable to potential Obligees. For companies expanding internationally, considering a Surety’s global network is important. Surety business is much different in jurisdictions outside of the U.S. and working with a Surety that has local market expertise is critical. 

An experienced surety bond broker can help Obligees and Principals navigate the surety marketplace and align them with an appropriate Surety or Sureties.