Surety Bonds Compared to LCs

Surety Bonds Compared to LCs

August 01, 2002

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 pending lawsuit that grew out of the Enron collapse shows the dangers of choosing unwisely.

A letter of credit is a bank’s promise 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.

Enron

A recent lawsuit by JPMorgan Chase Bank, following the collapse of Enron, highlights the key distinctions.

Chase sued a group of 11 insurers for failure to pay on demand under $1 billion worth of surety bonds issued by them as security for Enron in certain forward crude oil and natural gas contracts between Enron and two offshore Chase entities, Mahonia Limited and Mahonia Natural Gas Limited. When Enron went bankrupt and failed to deliver the oil and gas to the Mahonia entities as required by the forward contracts, Chase demanded payment from the insurers on the surety bonds for the fixed replacement value of the oil and gas.

Despite a payment-on-demand provision negotiated into these bonds by Chase and other provisions that look strikingly like provisions typically found in a letter of credit, the insurance companies declined to pay on the surety bonds. In their responses to Chase’s lawsuit, the insurance companies alleged, among other things, that they were defrauded by both Chase and Enron into issuing the surety bonds on the understanding that they were providing these bonds to backstop commercial oil and gas transactions instead of financial loans to Enron by Chase. The insurance companies also noted they are prohibited under New York insurance law from issuing surety bonds on financial transactions because such bonds would be tantamount to prohibited financial guarantees by insurance companies. The insurance companies had expressly waived nearly all their defenses to payment under the surety bonds, but the court nevertheless permitted them to raise defenses that they presumably waived.

The Enron-Chase forward contracts lasted years. Early on, Chase required Enron to post letters of credit as security for its obligations. It was only in the later transactions that Chase relied on surety bonds as security. Enron requested this change, with some encouragement from its insurance companies, because surety bonds were generally easier and cheaper to procure and they did not appear on Enron’s balance sheets as contingent financial obligations.

The lawyers tried to draft the surety bonds as closely as possible to letters of credit in order to minimize the collection risk.

Despite their efforts, bad timing and the underlying laws of surety obligations may result in a potentially $1 billion loss to Chase.

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 theories 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 credits 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 credit after it receives evidence from the beneficiary that the other party to the underlying contract is in default under the terms of the contract. 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 and actuarial statistics 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 proper 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, the 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 theories. 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

As in the case of the Chase-Enron transactions, many obligees may be pressured to accept a surety bond over a letter of credit in order to facilitate a particular transaction.

One way to minimize the disadvantages of surety bonds as security instruments 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. This was done in the Enron case; however, it remains to be seen whether such waivers are enforceable against the surety. Because of the press coverage surrounding the Enron case, the uncertainty of payment under surety bonds, and the increasing premiums charged by surety companies throughout the industry, many bankers believe that many companies will no longer explore surety bonds as acceptable credit security in their commercial transactions.

One footnote to the waivers of defenses by the insurance companies in the Enron case: the insurance companies have claimed fraud as a defense to their performance under the surety bonds. Presumably, even if the Enron credit security in the transactions consisted of letters of credit instead of surety bonds, the letter of credit issuers would still retain and raise fraud as a defense to payment as a legal and public policy matter.

Transactions Governed by English Law

The use of standby letters of credit as security in English law transactions, now widely established, was originally imported from the United States where banks are prohibited from issuing guarantees. In the United Kingdom, where no such prohibition applies, the growth in international trade saw the development of a hybrid instrument known as the on-demand bank guarantee or bond. These guarantees 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 to the underlying agreement, after the issuance of the guarantee to refuse payment, on the basis that the risk it initially agreed to take has now changed. Also, the guarantor may require that the primary obligor’s default be proven by the guaranteed party.

An on-demand guarantee or bond is one that is autonomous and payable on demand upon presentation of specific documents. It 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. English law mandates that a guaranty that contains such a waiver should be treated like a standby letter of credit.

Therefore, the risk for the bank is very similar whether it is issuing a standby letter of credit or an on-demand bond or guarantee. Accordingly, the security or indemnity that it will demand and the price that it will charge are likely to be the same.

An informal poll of London bankers indicates their perception is that a bank’s reputation would suffer the same amount of damage from a refusal to pay under a letter of credit as it would from a refusal to honor an on-demand guarantee, although some feel that the damage would be marginally worse in the case of a letter of credit.

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 main factors seem to be geography and custom. The fact that American banks may only issue letters of credit seems to have led to their dominance in international transactions (including those governed by English law) as the “lowest international common denominator.” Standby letters of credit are also 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, most British domestic infrastructure projects involve on-demand bonds, as do some construction contracts.

Another reason to choose a standby letter of credit over an on-demand guarantee is to avoid concerns regarding the robustness and comprehensiveness of the provisions of the guarantee that purport to transform it from a classic guarantee into an on-demand one. English courts have made it clear that such provisions are valid and enforceable, but they need to be very clear and explicit.

As in the United States, surety bonds under English law are by nature guarantees. Accordingly, the defenses available to a “classic” guarantor would apply but could be waived by the surety. In theory, a surety bond could be drafted as an on-demand guarantee and operate as such. However, in practice, surety bonds (at least on smaller transactions) are less negotiated and look more like classic guarantees than on-demand bonds. The reason for this is that they are issued by insurers and surety companies.

Therein lies the real difference between surety bonds and on-demand bank guarantees or standby letters of credit. A bank, when issuing a letter of credit or an on-demand guarantee, will usually require an indemnity or some form of security (sometimes even a cash deposit) and assume that if called upon, it will make the payment. An insurance company assesses the risk, underwrites the obligation and sets a premium as part of the management of its risk portfolio. It bets against a payment event ever occurring. This explains why an insurance company is less likely than a bank to accept issuing pure on-demand bonds and is more likely to use defenses available to it to avoid paying. The advantage of surety bonds over bank instruments is that they tend to be cheaper, although that is not necessarily the case depending on the terms of the bond and the state of the insurance market. Indeed, after the difficulties recently encountered by the insurance markets and the Enron debacle, some London bankers expect the demand for letters of credit and on-demand bank bonds to increase at the detriment of surety bonds.