This is the 3rd post in a series exploring surety bonds and bank letters of credit – what each is, their differences, and advantages and drawbacks to each.
What is the expected cost of each instrument?
- For a surety bond, cost is generally 0.5% to 2% of the contract price. A bond is project specific and covers the duration of the contract. The cost of the bond is included in the contractor’s bid price.
- For a bank LOC, the cost is generally 1% of the contract amount covered by the LOC, i.e. if the LOC covers 10% of the contract, the cost would equal 1%x (10% x Contract Amount) x years of the contract. Again, the cost of the LOC is included in the contractor’s bid price.
What does each instrument cover?
- The performance bond covers 100% of the contract amount for project completion. The payment bond covers 100% of the contract amount and protects certain subcontractors, laborers, and materials suppliers and protects the project owner against liens. The bond also provides at least 10% coverage for maintenance of defects the first year after completion.
- As discussed earlier, the LOC may be obtained for any percentage of the contract but 100% is typical. With a LOC, there is no protection or guarantee that subcontractors, laborers, and materials suppliers will be paid in the event of contractor default. They may then file liens on the project. In addition, if there is performance default and payment default, the LOC may not be sufficient to cover all of the claims.
Finally, let’s look at the claims process for each instrument.
- When an owner declares the contractor in default and there is a performance bond, the surety investigates the claim. If the contractor does default, the surety’s options are to:
- Finance the original contractor or provide support;
- Takeover responsibility for completion (up to the penal sum of the bond);
- Tender a new contractor;
- Pay the penal sum of the bond.
- With a payment bond, the surety pays the rightful claims of certain subcontractors, laborers, and suppliers up to the penal sum of the bond.
Bank Letters of Credit:
- The bank will pay a LOC upon demand of the holder, if made prior to the expiration date.
- There is no completion clause in a 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.
In the final blog post in this series, we will discuss the advantages and drawback for each.