When construction companies and homebuilders embark on a project, they are confronted with myriad risks that can profoundly impact timelines, budgets, and overall project viability. One of these risks comes in the form of financial assurances, where the contractor or homebuilder guarantees performance of an underlying obligation to their client.

Surety bond agents help clients provide bonds to satisfy their financial assurance requirements. And, where allowed, construction companies also utilize bank letters of credit or cash.

This article details how a blending of some of the best aspects of surety bonds and letters of credit can offer a new, advantageous solution for contractors, homebuilders, and developers facing financial assurance requirements.

Surety Bonds vs. Letters of Credit

There are pros and cons to both surety bonds and letters of credit (Exhibit 1), usually depending on the relative position of the transacting parties. In using surety terminology, the principal is the contractor, homebuilder, developer, etc., and the obligee is their client (often a municipality).

Surety bonds are generally preferred by principals because they are typically unsecured credit instruments and backed only by a general indemnity agreement, which allows the supporting surety carrier to recover losses from corporate and personal indemnitors. Conversely, a letter of credit is typically secured through restricted cash or a draw on an existing line of credit. This reduction in liquidity or banking capacity is a strong deterrent to using letters of credit as financial assurances.

Surety bonds are also off-balance sheet financial instruments, as open bonds are not considered liabilities.

On the other hand, outstanding letters of credit are often reflected on corporate financial statements and can negatively impact working capital and equity calculations.

Another key aspect of suretyship is its three-party arrangement. When a surety carrier supports a bond, it does not automatically side with the claimant, as sureties have a duty to investigate all claims. When a claim occurs, the surety requests proof of default from the obligee and works with the principal to identify defenses that lessen or completely avoid losses.

Carriers generally only pay claims when the obligee has adhered to its obligations within the underlying contract or agreement. The carrier can defend and support the principal in the event of an improper default or termination. In comparison, letters of credit have on-demand payment clauses, ultimately requiring banks to pay claimants without defending its principal.

David Sauerman, Managing Director of the Construction & Engineering Division of CIBC Bank USA, notes: “As a banker and provider of letters of credit, a number of my clients and I have experienced the issue of letters of credit vs. surety bonds for years.

“In rare cases, my company has issued performance guarantee letters of credit, and never if a surety bond is otherwise available to the client and acceptable to the project’s owner.

“Bankers and sureties underwrite from different perspectives: bankers don’t like taking surety risk and focus on cash flows, while sureties tend to be more balance sheet focused. Unless bankers are also financing the project itself, they generally don’t get too deep in the weeds on specific job risks.

“If surety backed letters of credit become accepted in the marketplace, it can lessen the overall risks by bringing together the best of both worlds.”

The merits of surety bonds vs. letters of credit can be reasonably debated, and there are situations that are better suited for each party. Traditionally, public project owners (such as federal, state, and city/county governments) have allowed for surety bonds, as the surety industry has done well in not just providing financial assurance for public work projects, but also by providing the expertise and resources needed to successfully complete projects with replacement contractors.

Traditional Contractors vs. Developers & Homebuilders

Construction companies are well-practiced in forming bond programs and going through the underwriting process; developers and homebuilders face a different decision matrix.

First, private commercial construction can often be executed without any financial assurance, especially when it is tenant finish or in-fill development. As such, many developers do not need bond programs.

Once a developer or homebuilder expands to subdivision work — where it’s responsible for streets, sidewalks, and sewer systems — municipalities will often require security to ensure the project will be completed. A half-built subdivision is worse than undisturbed land, as it is more expensive to reallocate the land to other users.

Developers typically have robust banking relationships but are also consistently facing liquidity constraints as it looks to produce returns for investors. Developers also commonly have complex and disparate financial conditions, with single-purpose entities accounted for separately and not compiled by an independent CPA company. This deficiency in financial reporting can make it more difficult for developers to obtain a surety program.

Based on the author’s professional opinion, during the Great Recession, many municipalities found the surety claims process too onerous and have opted to only allow for letters of credit or cash security. In this situation, the municipality gains protection against nonperformance, and unpaid subcontractors and suppliers are left to the mechanics lien process or the court system to find recourse for nonpayment.

Additionally, as compared to surety carriers, in recent years, more banks have failed or gone out of business. As such, some municipalities may start to rethink their approach of only accepting letters of credit.

Other Scenarios Requiring Financial Assurances

Energy & Commodity Producers

For energy and commodity producers such as oil, gas, and mining operations, the required reclamation security ensures that land disturbed from such activities is reclaimed and returned to its original state.

Due to the long-term nature of these operations, the associated financial assurances are typically noncancellable. Surety carriers are loath to underwrite such perpetual arrangements, and the availability of reclamation bonds is extremely limited. As such, energy producers will often instead post cash or letters of credit.

Large Companies

In another use case, large companies often form supplier agreements. For example, if a distributor purchases products from a supplier daily but forms a credit agreement that only requires payment for the product every week or month, then, depending on the volume purchased, these credit agreements can be quite large. Unfortunately, the suppliers often only allow for a letter of credit to back up the credit line.

International

On the international front, bank instruments are more commonly utilized for financial assurances than surety bonds; however, this trend is reversing. In 2019, the total premium for surety bonds (including the U.S.) was $16 billion.¹

Premium volume is expected to experience an annual growth rate of 6.4% over the next three years, culminating in $25 billion of written premium by 2027.² It can be expected that surety bonds will continue to grow in popularity in international economies.