Surety bonds compared to LCs

Surety bonds compared to LCs

August 19, 2020 | By Paul Weber in New York, Connie Gao in New York and Rob Marsh in London

Parties to project finance transactions are sometimes asked to accept surety bonds as security in place of letters of credit. There are key differences between the two instruments.

A letter of credit is a promise by a bank to advance up to a certain amount of money to one deal party if the other party defaults.

A surety bond is a guarantee in which a third party — often an insurance company — agrees to assume a defaulting party's financial obligations.

Although letters of credit and surety bonds are similar in function, there are legal differences that could affect a beneficiary's ability to obtain full and prompt payment on its claim.

Parties to commercial transactions have for years argued over the forms of security providing credit support to their deals. Beneficiaries, known as "obligees," prefer letters of credit over surety bonds because letters of credit generally are easier to collect upon, usually merely by presentation of certain documentation. Payment under surety bonds is usually a more drawn-out process and involves a greater risk of litigation on the underlying commercial transaction and any other defenses that may be available to the surety company.

The key distinctions between letters of credit and surety bonds arise from the business concepts and legal principles underpinning these forms of security.

Letters of Credit

A letter of credit is a written instrument that is traditionally issued by a bank. It authorizes a party to draw up to a certain amount of money under terms outlined by the instrument.

Three main parties are involved in a letter of credit transaction, namely, the issuer (bank), the customer of the issuer (applicant) and the beneficiary (obligee).

Usually, the letter of credit is accompanied by a promissory note from the applicant to the beneficiary and the applicant's agreement to reimburse the issuer upon its payment to the beneficiary. Parties select either the Uniform Commercial Code of the relevant jurisdiction, or "UCC," or the Uniform Customs and Practice for Documentary Credits, or "UCP," issued by the International Chamber of Commerce to govern their letter of credit.

Two types of letters of credit are frequently used in commercial transactions: documentary letters of credit and standby letters of credit. A documentary letter of credit, which is usually governed by the UCC, is one in which the beneficiary must present specified documents to the issuer in order to draw funds from the letter of credit. Documentary letters of credit are primarily used as direct payment devices to facilitate sales-of-goods transactions. The typical documents that a seller of goods (the beneficiary) must produce in order to draw from the letter of credit include a bill of lading, commercial invoice, certificate of insurance covering transport or import-export documentation.

In a standby letter of credit, the issuer must honor the letter of credit after it receives a statement (usually in the form of a properly completed draw certificate) from the beneficiary that the other party to the underlying contract is in default under the terms of the contract or that the conditions to a draw have otherwise been satisfied. Standby letters of credit are the prevalent security instruments supporting obligations under construction contracts for thinly-capitalized construction companies, special-purpose project companies or owners, power offtakers with shaky credit ratings or any other entity that may need some credit support for its obligations.

Surety Bonds

Surety bonds are forms of guarantees. Under a surety or guaranty, a third party becomes liable upon the default of the principal, who is the debtor or guaranteed party.

Surety bonds can be payment bonds or performance bonds and involve the following three parties: a surety (the entity that assures payment or performance of the contract between the principal and the beneficiary), a principal (the entity who has the obligation to pay or perform) and an obligee (the beneficiary, or entity that is owed the obligation).

A suretyship is different from more common forms of insurance because sureties can seek repayment from principals, but insurers normally cannot seek reimbursement from those they insure and, instead, rely on payment of premiums across a portfolio of surety bonds for reimbursement coverage.

Key Distinctions

All letters of credit operate under the doctrine of independent contracts, which says that the issuing bank's obligation to honor or pay upon a properly presented draft is independent of the underlying contract or commercial relationship between the account party and the beneficiary presenting the draft.

Accordingly, the issuer is required to pay on the letter of credit regardless of whether the underlying contract has been properly performed by the account party or whether the account party has defenses to due performance. However, the issuer need not honor a draft under a documentary letter of credit if the documents or the transaction itself are fraudulent.

Because letters of credit are independent from the underlying transactions, they are often more attractive to beneficiaries because there is no need to prove a breach of the underlying contract or the extent to which the beneficiary suffered damages. Further, traditional defenses and claims in contract law do not apply to letter-of-credit transactions because a letter of credit is governed by its own set of legal principles. Thus, from the point of view of a beneficiary, letters of credit are enforceable against an issuer regardless of the bankruptcy of the applicant.

Unlike a letter of credit, a surety bond attaches to the underlying contract and thus must be interpreted consistently with the underlying contract. The surety bond operates like a guaranty where a guarantor's obligation is secondary. This means that the surety's obligation does not mature until the principal obligor defaults on the underlying contract. In contrast, the obligation of an issuer in a letter-of-credit transaction is primary.

An obligee may see surety bonds as less desirable because they are not demand instruments like letters of credit. They involve a "claim adjustment process" in which the surety investigates the underlying default. This slows down the reimbursement process. Sureties will deny claims they believe are without merit.

At the same time, surety bonds, like other financial guarantees, are attractive to principals because they do not appear on a corporation's balance sheet, and their use does not diminish a company's line of credit. In addition, surety bonds are generally cheaper to procure and maintain and may not require posting of collateral to the surety by the principal obligor.

Making Sureties Work Like LCs

Because of these advantages, some sponsors are pressing certain obligees, including offtakers under power purchase agreements and virtual PPAs and interconnection agreement counterparties, to accept a surety bond over a letter of credit in order to facilitate a particular transaction.

The key to successfully persuading these counterparties to accept a surety bond is to craft the surety bond to minimize the disadvantages of a surety bond compared to a letter of credit.

One way to minimize the disadvantages of surety bonds is to draft the terms of the surety bond so that they provide protections to the beneficiary that are similar to those contained in a letter of credit. Since a traditional surety bond is subject to the surety's defense that no default of the underlying agreement has occurred, the obligee could change the payment trigger on the bond from one relating to the occurrence of an event of default to simply one triggered by the due presentation of a proper notice of default, notice of payment or other agreed-upon documentation.

Further, because the surety enjoys many of the same defenses that are available to a principal, the obligee should negotiate for language in the surety bond that waives the surety's ability to assert these defenses. Typical provisions should state that the surety's obligations are absolute and unconditional irrespective of any circumstance whatsoever that might constitute a legal or equitable discharge or defense of a surety and include an express waiver by the surety of such defenses. Courts have generally held that these broad waivers are enforceable.

Transactions Governed by English Law

Standby letters of credit were first developed in the United States because US banks were prohibited from issuing guarantees.

Outside of the US, it is common to use an on-demand instrument, in similar circumstances, as a form of quasi-security to secure the obligations of a party to a contract. In practice, these English law-governed quasi–security instruments are labelled as a "bond" or "guarantee."

Irrespective of the title of the document, the instrument should be clear whether it creates primary ("autonomous") or secondary ("accessory") obligations. Disputes over whether these documents create primary or secondary obligations frequently lead to litigation or arbitration.

In general, security instruments that impose autonomous obligations are often labelled on-demand bonds or guarantees, first-demand bonds or guarantees, demand bonds or guarantees or standby letters of credit.

Security instruments that impose accessory obligations tend to be called simply guarantees, default bonds or surety bonds.

An on-demand bond or guarantee will usually stipulate what documents have to be presented to the issuer in order to receive payment. The beneficiary need only issue a demand in accordance with the terms of the instrument and present the required documents. Unlike a conditional bond, there is no requirement to establish breach and quantum of loss. An on-demand bond operates independently of performance or non-performance of the underlying contract terms (hence, it is "autonomous"). These instruments operate like standby letters of credit by creating an autonomous payment obligation essentially in the nature of a standby letter of credit rather than a guarantee of a third party's performance.

Under a classic (as opposed to an on-demand) guarantee, the guarantor guarantees the performance of another party under an underlying contract and is a secondary obligor that has available to it all the defenses available to the primary obligor. In addition, the classic guarantor can often rely on modifications made to the underlying agreement after issuance of the guarantee to refuse payment on the basis that the risk it initially agreed to take has been changed. Also, the guarantor may require that the primary obligor's default be proven by the guaranteed party.

On-demand instruments often provide that they are payable upon presentation of a written demand and certain documents in a specified form. The instrument must state that the bank's undertaking to pay is irrevocable, unconditional and is a primary obligation. The bank must expressly waive all defenses related to the transaction in connection with which the bond is given or against the party against whose default the bond is meant to offer protection.

Despite the name, English-law standby letters of credit have more in common with on-demand instruments than with letters of credit. They enable the beneficiary to obtain payment from the issuer of the standby credit when the other contracting party has failed or is alleged to have failed to perform the contract.

In view of the apparent near equivalence of the two instruments, what determines the choice of one instrument over the other in an English law transaction?

The two key factors seem to be practice and location. The fact that US banks may only issue letters of credit has clearly led to the prevalence of standby letters of credit in international transactions involving American banks and in sectors where their use is the norm. In addition, standby letters of credit tend to be more widely used in connection with long-term contracts, such as project finance loans, and projects involving multilateral agencies. They are also found in oil and gas projects in the Middle East. On the other hand, in UK domestic construction and infrastructure projects, bonds and guarantees prevail.

There is a third factor. Calling on a bond should result in swift payment and receipt by the beneficiary. However, English courts in recent years have seen a number of cases concerning the proper interpretation of these security instruments. The attention given by the English courts to bonds and guarantees in recent years may also steer parties toward a standby letter of credit over an on-demand instrument.

Of paramount importance are clarity and certainty — and caution. Whatever instrument is chosen, the wording proposed may well have been used previously and, therefore, be regarded as "tried and tested." A precedent form is only tried and tested to the extent it has been analyzed by a court and not found to be wanting. It is important to understand its provisions fully. The key question to ask is whether the wording clearly describes the obligations of the parties and prescribes the desired outcomes for all of the relevant fact patterns.