Recently, I met with several successful business owners who are proud to say that they provide letters of credit in lieu of surety bonds for performance guarantees. And, I see why this can be considered a positive approach.
Companies including developers, property owners and manufacturers already have established banking relationships. But the idea of creating a surety relationship, which can be fully indemnifiable, is unpalatable. Finding another trusted financial adviser can be challenging. Besides, these folks already have a certified public accountant, attorney, banker, real estate broker, 401(k) fiduciary, and insurance agent.
The Risks of Using a Letter of Credit
Unfortunately, because most business owners are not traditional surety bond consumers (i.e. not public works contractors), they do not realize the risk they are taking by pursuing the path of least resistance a letter of credit provides. But for a business owner who is required to post security for an obligation, whether it be a lease, performance guarantee of a contract or for monies held in trust, it is important that they communicate with surety agents and carriers.
Your banker will tell you letters of credit are a pain and are not profitable for the bank. Furthermore, they often require restricted cash (collateral) or a draw on your line of credit. This impacts your liquidity and, subsequently, your balance sheet. This point alone should be a determining factor in choosing bonds over letters of credit. Collateralized surety bonds are exceedingly rare. As a business owner, I would do everything possible to avoid cash being held as security for a performance guarantee.
Additionally, letters of credit are demand instruments and may be fully drawn down at any time, for any reason. The holder does not need to prove that you failed to uphold your obligations – they simply take your money.
The Benefits of Securing a Surety Bond
A surety bond, in contrast, does not require collateral, does not impact your balance sheet and is protected by the surety carrier’s obligation to both you as the principal and any claimant. 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.
This claims process is balanced by prequalification of the principal by the surety carrier. As a local leading surety company explains, “Carriers underwrite for a zero-percent loss ratio.” That means their intent is to only provide bonds for companies that have nominal risk of defaulting on their contract.
This prequalification process should provide the upstream partner with an increased level of confidence that they are working with a sophisticated company. I also have found that this process provides a source of free, expert consultation. Underwriters have access to loss indicators and escalators from accounts across the country, and their ability to identify risk factors ultimately helps business owners succeed.
While connecting with yet another professional adviser with a unique product is an added step, think twice before taking the easy route with a letter of credit. There is a more refined approach through surety.
