Viable Alternatives to Payment and Performance Bonds

Reprinted from Construction Executive’s, Risk Management eNewsletter, Jan. 23, 2013. Copyright 2013. All rights reserved.  

Owners and general contractors constantly worry if the entity hired to perform work on a project will complete it properly and pay their subcontractors and suppliers.

A standard practice to deal with these risks requires parties to post a performance or payment bond. A performance bond essentially guarantees work will be done as described in the contract; if not, the owner has the right to make a claim. A payment bond guarantees all of the monetary obligations incurred by the contractor (e.g., payments to employees and suppliers) will be covered. If they aren’t, the bonding company steps forward to pay the obligations. In theory, this system works smoothly and all parties receive the necessary bonds. However, the reality is much different.

First, sureties impose rigorous financial criteria on the contractors to which they issue a bond. They often require full collateralization of a bond amount, personal guarantees and indemnification provisions, as well as impose strict limitations on the amount of bonding a contractor will receive. If the surety believes the construction company’s financial capabilities are not adequate, it will refuse to issue a bond or increase the bonding capacity.

Second, collecting against a bond is not always easy. Over the years, numerous defenses to claims against bonds have been developed, such as strict notice requirements and time limitations. A factor that can complicate matters is if the bonding company owes an obligation not only to the person protected by the bond (the owner of the project), but also to the potential third-party claimants against the bond (subcontractors or suppliers) and the principal on the bond (the company that is providing the bond).

These competing interests often result in paralysis, when a bonding company delays or refuses to provide the protection that should be covered by the bond. A claim against the bond often leads to years of protracted, expensive litigation and unpleasant endings.

Contractors and owners recognizing the potential problems associated with bonds often try to develop alternatives. Usually, this is not possible on public jobs due to statutory requirements for federal, state and local projects; however, options exist for owners on private projects and general contractors that want to obtain bonds or equivalent protection from their subcontractors.

Real or Personal Property
One alternative is for the contractor to provide a secured interest in real property to guarantee the performance and payment obligations. This requires developing a document that clearly describes the obligation being secured by defining performance metrics and what will be considered a breach or failure to perform. This obligation is secured by a deed of trust on a piece of real property and accomplishes the same goal as a bond—creating a source of security other than the contractor to pay for the contractor’s obligations.

The challenge is to find property with adequate equity that is not encumbered by superior claims. Performing proper title searches and confirming ownership of the property can be difficult and costly. Also, property is not necessarily a liquid asset. Even if the property has equity in it, a claimant must still go through the foreclosure procedures set forth in the deed of trust. Such procedures must be strictly followed to realize the goal and turn the property into cash.

Security interest in personal property, such as equipment, is another option. Again, strict requirements on the documentation must be prepared and filed to perfect this interest. This particular method is seldom used because construction equipment typically is subject to prior claims and security interests. Conduct a proper Uniform Commercial Code (UCC) search and review all title documentation to ensure equipment is a viable source of protection.

Letter of Credit
One increasingly popular method of providing security is obtaining letters of credit from a bank on behalf of the construction company. Letters of credit offer owners and contractors certain advantages over performance and payment bonds. However, these financial tools are subject to a distinct body of law. While letters of credit are based on the concept of “pay now, argue later” (unlike bonds, which are “argue now and perhaps pay later”), significant risks remain.

A letter of credit essentially promises to pay a third party on behalf of a second party. They typically are issued by banks and governed by the provisions of the UCC. With a letter of credit, the bank agrees to pay a stated amount upon presentation of the required documentation and compliance with the terms in the letter of credit. In theory, the person obtaining the letter of credit has provided the bank with enough financial resources that the bank believes it can pay a letter of credit and then re-collect the funds.

A standby letter of credit calls for payment in the event of non-performance. But unlike a performance bond, the issuing bank does not presume it will pay under the standby letter of credit, which may lead to a more vigorous assertion of defenses on the part of the bank. While both a payment bond and a standby letter of credit exist to protect against non-performance, the standby letter of credit is triggered by the presentation of documentation rather than the default of the underlying performance. This means the bank should not be able to re-litigate the cause of the failure of performance, which a surety can do with a bond.

Letters of credit can be revocable or irrevocable. An irrevocable letter of credit cannot be amended or cancelled by the issuing bank without the beneficiary’s consent until the term of the letter expires. The converse is true of a revocable letter of credit, which makes it the best replacement for a performance bond. Letters of credit are assumed to be irrevocable unless they state otherwise.

Crucial Principles
Letters of credit are independent of other agreements and are viewed as a separate and complete obligation of the issuing bank. This makes it difficult for the bank to point to deficiencies in the other documents or agreements that underlie the transaction protected by the letter of credit. This is one of the reasons issuers of letters of credit cannot re-open underlying disputes. The issuing bank is relieved of any obligation to investigate before paying, whereas a surety issuing a bond has an obligation to properly investigate. A bonding company often will use this duty to investigate as a reason for delaying payment until all underlying factual issues are resolved by a court of law.

On the other hand, a bank issuing a letter of credit has no such obligation and instead must make immediate payment if all of the documentation is in order. The exception is if an underlying fraud or forgery occurred, which can stop payment if the fraud is material to the issuing of the letter of credit.

Letters of credit also require strict compliance with all of their terms. Most cases dealing with this issue revolve around the form of the demand and the documentation that is delivered proving compliance and entitlement to be paid.

Finally, be cautious of who issues the letter of credit. Is the bank well-known in the United States? Is it a financial institution other than a bank? How does one get jurisdiction over the letter of credit in the event of a dispute? A letter of credit—even though it may be preferable to a bond—is still a promise by somebody or an entity to make a payment. If that entity is not good for the money or is not a viable financial institution, then the letter of credit is worthless.