Why You Should Replace Your Letter of Credit with a Surety Bond
It is a requirement of many businesses, big and small, to provide security to the government or other enterprises in the form of a Letter of Credit as a way of guaranteeing they will meet their performance obligations. However, keeping large sums of money tied up by a letter of credit restricts your access to cash and ultimately hurts operations. For most, this is not a preferred or viable option. By using a surety bond instead of a letter of credit your business is able to free up this capital, which may be crucial to your company’s operations.
To better understand this, let’s start by comparing a Letter of Credit to a Surety Bond.
What is a Letter of Credit?
A letter of credit (commonly referred to as an ‘LOC’) is issued by a bank to the ‘beneficiary’ (for construction projects this would be the owner) to serve as a guarantee for the performance of a construction or supply contract. In order to obtain an LOC, a bank often freezes the buyer’s liquid assets in the total amount of the LOC. The buyer is then unable to access these funds until the bank releases the LOC. If a buyer does not fulfill his obligations to the beneficiary of the LOC, the beneficiary is able to cash in the LOC to access the funds on demand without consultation.
What is a Surety Bond?
A surety bond is a three-party agreement between a principal (normally the contractor), a project owner (the beneficiary) and a surety. The bond represents a promise by a surety or guarantor to pay the project owner a certain amount if the principal fails to meet some obligation, such as fulfilling the terms of a contract. If a principal does not complete his or her obligations, the owner can make a claim under the bond. At this time, the surety will complete a thorough investigation to determine the validity of the claim. Surety bonds are not on-demand instruments.
Top 7 reasons for replacing your Letter of Credit with a Surety Bond today:
1. Free up your cash
Surety bonds are issued in place of the LOC thus freeing up any cash that was being held by your financial institution as security.
2. Free up your credit
LOCs are often issued under a company’s credit facility. By replacing the LOC with a bond this credit will be available for future needs.
3. Re-invest & grow
With your cash back in hand you can use this new found liquidity to continue re-investing in the growth of your company.
4. Minimize risk
Owners can decide to cash in an LOC at any time. With Surety Bonds, if the owner decides to make a claim against the bond, the bond company will first complete a full investigation of the claim. This involves listening to both sides of the argument before determining how best to move forward.
5. Stronger defense
If a claim is made against a surety bond, the surety company will work with your business to help you defend the claim. They are on your side with your shared interest in mind.
6. Rates & fees
Surety rates are often less than what a bank is charging for your LOC, which often includes hidden fees throughout the duration of the LOC.
7. Improved financial statements
Typically bonds are not included on your financial statements, while outstanding LOCs are. This can help with future applications for additional credit and or surety needs.
How does this work?
In today’s market place, it has never been easier to obtain a bond. Surety Bonds are underwritten by Insurance companies commonly known as a “Bond Company”. There is a qualification process that the applicants must go through in order to qualify for a bond facility. This involves providing financial information about the company and its owners as well as information about the history of the company and its relevant experience. Bonds are underwritten based on the strength (financial and professional experience) and character of the company and its principals. The bond company relies on the indemnity of the corporation and does not usually require further collateral.
Top 7 examples of where we have replaced a Letter of Credit with a Surety Bond?
1. Bid Bonds for Letter of Credit or Certified Cheque
Has the government purchasing department asked you to include an LOC or certified cheque with your project bid? A bid bond can be issued in place of these instruments as part of a bidding process by the contractor to the project owner, to provide guarantee, that the winning bidder will undertake the contract under the terms at which they bid.
2. Lien Bonds
Generally speaking, if a sub-contractor or supplier to a project is not paid for their work in a timely manner, a construction lien against the property provides them with a legal claim on the land and property where they are working. Construction liens can be cumbersome to a project owner because they are unable to sell the property or refinance a loan secured by the property while a construction lien is clouding the title to the property.
Additionally, most owners will not release any additional project funds to a general contractor while liens are in place essentially halting a project. To remove a lien registered against a property, an applicant has to deliver to the court acceptable security which stands in place of the lien registered on such property. In certain situations, a construction lien bond can be used in place of cash or a letter of credit to remove a lien against a property.
3. GST 114, Bond for Non-Resident Person Without a Permanent Establishment in Canada
Often a non-resident person who does not have a permanent establishment in Canada must provide and maintain security in an amount and a form satisfactory to the CRA. This security is required to ensure that the non-resident person pays or remits all amounts payable or remittable by the person under Part IX of the Act. Security in Canadian funds may be in the form of cash, certified cheque, money order, or bond.
4. Environmental & Remediation Bonds
Any contractor that does projects that could have environmental consequences need to provide either Letters of Credit or Environmental bonds, when fulfilling federal, provincial or municipal contracts. These bonds are commonly used in asbestos & lead abatement contracts, mining site remediation works (future clean-up and remediation of contaminated sites), landfill construction and hazardous waste companies.
5. Ministry of Environment Financial Assurance Requirements
The M.O.E. often requires financial assurance to ensure compliance with environmental objectives, including the timely completion of projects and the availability of funds for future clean-up and remediation requirements. Surety bonds are an acceptable form of financial assurance along with Letters of Credit.
6. Utility Bonds
Many businesses in Canada that are considered high consumers of hydro are required to provide the utility provider with a financial guarantee as deemed necessary to ensure payment of all utility services. Surety bonds can be issued in place of Letters of Credit to fulfill this requirement.
7. Advanced Payment Bonds
An Advanced Payment Bond is a guarantee that is supplied (in place of a LOC) by a party receiving an advance payment (principal) to the party advancing the payment (project owner). It provides that the advanced sum will be returned if the agreement under which the advance was made cannot be fulfilled.
How much does a bond cost?
Costs vary depending on the type of bond needed, the amount of the bond and the duration of the bonded commitment. To obtain the best rates, we recommend working with a bond professional as they have the best understanding of the ‘bond market’ and they will know which company will provide you with the best rate for your class of business.
Replace your Letter of Credit today!
If you are unsure of whether or not this could be an option for you please contact us today to find out. We would be more than happy to assist you with this!