Both bonds and letters of credit are used as secured financial means to pay for fabrication projects. First time fabrication customers frequently ask which is the better option to go with.
The following table, from Surety Association of Canada, explains the differences between a Surety Bond and an Irrevocable Letter of Credit:
Surety Bonds | ILOCs | |
Prequalification of contractor | Sureties have an extensive process for prequalifying contractors and only issue bond(s) when they have the confidence that a contractor has the skills/talent, labour, equipment, cash and experience to be able to complete the work. | Banks issue ILOCs based their assessment of the contractor’s financial status. Banks do not assess a contractor’s past performance before issuing an ILOC. |
Cash position | Sureties assess the working capital and cash flow of the contractor (principal). A surety bond does not negatively affect the ability of the contractor to access more bank credit. | An ILOC reduces a contractor’s line of credit which can cause cash flow issues during a project. The likelihood of default increase if the contractor does not have the cash flow and banking credit to pay the bills.A contractor must have access to significant cash reserves and/or borrowing lines to secure an ILOC. This could lead to a reduction in the number of qualified contractors bidding which may increase the cost of the project. |
Integrity of the security | Performance bonds and labour and material payment bonds cannot be cancelled. A standard CCDC Performance bond clearly states what constitutes completion of the work so there is no need for the obligee (owner) to ensure that the bond is still in force. | The onus is on the owner to ensure that the ILOC is still in force and has not been cancelled or expired. |
On-going monitoring | Because sureties monitor a bonded contractor’s entire work program on an on-going basis, they are often aware of problems that have the potential to negatively impact the bonded project. While these problems may have nothing to do with the bonded contract, sureties will use this information to work with the contractor to prevent performance problems on the bonded project. | Banks focus strictly on the contractor’s ability to repay the outstanding amounts. |
Trigger | Surety bonds are “on default” instruments. Therefore, the obligee (owner) must also honour its obligations and demonstrate that a default has occurred. The Canadian Construction Association and other industry groups recognize that surety bonds provide a fair balance between the rights and obligations of obligees (owners) and principals (contractors). | An ILOC may be demanded by the owner at any time for any reason providing little protection to the contractor to discuss issues at hand. |
Performance Bond vs. ILOC | A performance bond guarantees that the obligee (owner) ends up with a completed project at the original contract price (plus approved change orders). | An ILOC does not provide a completed project. It only provides cash (usually 10% to 20% of the contract value). Surety industry claims experience indicates that average losses approach 40% of the contract value and there have even been cases when the loss exceeds 100% of the contract value. Therefore, it is likely the cash from an ILOC will not be sufficient to complete the project and the owner will greatly exceed its original budget. |
Labour and Material Payment Bond vs. ILOC | A labour and material payment bond ensures payment to the defaulted principal’s (contractor’s) direct subcontractors and suppliers. Payment to these subcontractors and suppliers is handled by the surety, therefore no additional administrative burden falls to the obligee (owner). | The claims for non-payment and liens placed by subcontractors and suppliers can easily exceed the amount of the ILOC. The owner has to use its own resources to vacate the liens and secure clear title to the property. |
At the end of the day, the method of payment is the customer’s choosing. After careful consideration of the pros and cons of surety bonds and letters of credit, your fabrication company will work with you with the method of payment you choose.
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