Surety Bonds

A contract surety bond is a three-party agreement whereby the surety guarantees to the obligee (the owner) that the principal (the contractor) is capable of performing the contract.
Performance of the contract, which is the subject of the bond, determines the rights and obligations of the surety and the obligee.
A performance bond protects the owner from non-performance and financial exposures should the contractor default on the contract. It is directly tied to the underlying contract and if the contractor is unable to perform the contract, the surety has responsibilities to the owner and contractor for project completion.
A payment bond, sometimes called a labor and material bond, protects certain subcontractors, laborers, and material suppliers against nonpayment by the contractor. Generally, these claimants may seek recovery directly from the surety company under the payment bond. It also protects the owner from these subcontractors asserting their right to file a lien against the owner's project for non-payment

Bank Letters of Credit

A bank letter of credit (LOC) is a cash guarantee to the owner. The owner can call on the letter of credit on demand without cause. Once called upon, the letter of credit converts to a payment to the owner and an interest-bearing loan for the contractor.
A letter of credit has no guarantee of project completion. The performance of the underlying contract has no bearing on the bank's obligation to pay on the letter of credit.
A conditional letter of credit may require some burden of proof by the owner that the contractor has failed to perform before the bank will pay on the letter of credit.
A standby letter of credit is normally used for open accounts and deals only with payment of documented sums within a stated time period.
A transactional letter of credit applies to one specific transaction.
Most letters of credit are irrevocable, which means that both parties must agree to any changes to the letter of credit. Changes must be documented by an amendment signed by both parties.

Bonds

A surety company and producer assess the contractor's entire business operation, checking for adequate financial resources, necessary experience, organization, existing work load and its profitability, and management skills to carry on the business and successfully complete the project for which the bond is required. When it issues a bond, the surety company has verified that the contractor is capable of performing the job for the stated price and in the time allotted. This process is designed to disqualify contractors who are unable or unqualified to complete the project for any number of reasons. Contractors who cannot qualify for a surety bond but can provide a letter of credit may not possess all the necessary ingredients to perform the work successfully to completion.

Letters of Credit

The banker examines the quality and liquidity of the collateral available to the bank in case there is a demand on the letter of credit. If the banker is satisfied that the contractor can reimburse the bank if demand is made upon the letter, there is no further prequalification.

Surety Bonds

With few exceptions, performance and payment bonds are issued on an unsecured basis. That is, they are usually provided on the strength of corporate and personal signatures of the owners of the construction company. The issuance of bonds has no effect on the contractor's bank line of credit and in some instances, can be viewed as a credit enhancement. Unused borrowing capacity can be viewed as an off -balance sheet strength.
Subcontractors and material suppliers may be more willing to extend credit to the contractor when they know a payment bond has been issued on a project to protect them.

Bank Letters of Credit

Specific assets are pledged to secure bank letters of credit. Bank letters of credit diminish an existing line of credit, and are reflected on the contractor's financial statement as a contingent liability. Having assets tied up, or an available line of credit diminished, is counter-productive to both the owner and contractor. The contractor's cash flow in funding initial stages of construction and retention amounts throughout a contract term can be adversely affected when liquid assets are pledged to a bank or the bank reduces its borrowing capacity as a result of the issuance of a letter or credit.
Subcontractors and materials suppliers may be reluctant to extend credit to the contractor for labor or materials since they have no access or rights to funds available from the letter of credit.

Surety Bonds

When a construction project owner specifies a surety bond in the construction contract, the contractor is responsible for obtaining the bond. Most surety companies issue bonds through knowledgeable surety bond producers, also called agents or brokers.