Standby Letters of Credit (OPINION)

Contractors and developers in Northwest Arkansas are saving money, eliminating underwriting redundancies and better securing projects by utilizing a financial assurance instrument called a standby letter of credit. 

Practical project developers, their investors and their lenders need assurance from general contractors that project subcontractors will be compensated and that the project can still be completed according to contract requirements.

Traditionally, this guarantee has been provided through payment and performance bonds, typically called surety bonds, issued by an insurance company or surety company. However, an alternative financial tool used to guarantee payment and performance called a standby letter of credit provides a cost-effective and simple solution for all parties involved.

In its most basic form, a standby letter of credit is a safety net for payment performance on the overall project. Standby letters of credit are quick and easy for developers to use in case of contractor default or dispute.

They are trusted commercial instruments frequently used across multiple industries to protect against non-payment of a bill or non-performance of a service. A standby letter of credit requires a bank to pay upon the presentation by the developer of complying documents specified in the letter.

After making payment, the bank then seeks repayment from the contractor. If there are any legal disputes resulting from the standby letter of credit, the project can still be completed according to the regular schedule and budget. Alternatively, when a surety bond is used, projects may be halted indefinitely while developers, contractors and the insurance company responsible for issuing the surety bond argue the details in court.

Using standby letters of credit in lieu of surety bonds yield numerous benefits. First, a surety bond is created in an attempt to avoid default within the project, while a standby letter of credit is designed to cover losses in case of default. In addition, surety bonds are usually required to cover 100 percent of the construction costs, whereas standby letters of credit are often required to be issued for only 25 percent of the contract price. Hence the collateral required for a surety bond is four times that of a standby letter of credit. This greatly favors the construction and development industries where loan amounts are dispersed at established points of the construction timeline to cover the next portion of construction as opposed to being dispensed all at once.

Additionally, surety bonds are often more expensive than standby letters of credit, even when issued for the same face amount. Some of the contractual wording of a surety bond may cover penalty costs in addition to the actual costs, so fees charged will include the designated penalty. Since a surety bond requires coverage of the full amount of a project, any interest charged will be based on the total coverage amount and will result in a larger cost for the service.

Providing a surety bond to satisfy a contract requirement necessitates that a contractor undergo a separate underwriting process by the insurance company in addition to satisfying the underwriting standards put forth by its bank to obtain a loan for the project.  By utilizing a standby letter of credit, contractors will not be forced to work with an insurance company, and can leverage their existing community bank relationship to issue the letter of credit. In doing so, a contractor may minimize the amount of underwriting and documentation required, while reducing ancillary fees, saving time and simplifying the entire process to ensure the project is completed successfully.

Standby letters of credit are a useful and cost-saving financial tool for construction and development projects that benefit the overall project owners, the developer, as well as the contractors. Contact your commercial lender or bank to see if they can help you by providing standby letters of credit for your next job. 

Ashley Allen is a vice president and international banking manager for Arvest Bank. You can contact her at 918-631-6924 or via email at [email protected].