Surety Bond vs Letter of Credit

Surety Bond-Surety Bond vs Letter of Credit

Surety Bond vs Letter of Credit

The principle of independent contracts governs the operation of all letters of credit. This principle states that the issuing bank’s obligation to honor or pay upon a properly presented draft is independent of the underlying contract or commercial relationship between the account party and the beneficiary presenting the draft. In other words, the obligation to honor or pay is not contingent upon the existence of the underlying contract or relationship.

So the issuer is obligated to make good on the letter of credit regardless of whether the account party has satisfactorily completed the underlying contract or whether the account party has any defenses to timely performance.

Nevertheless, if either the documentation or the transaction itself are fraudulent, the issuer is not required to honor a draft that is submitted in accordance with a documentary letter of credit.

Because letters of credit are not dependent on the transactions that they are used to support, beneficiaries frequently find them to be more appealing. This is due to the fact that beneficiaries do not need to demonstrate that the underlying contract was breached or the extent to which they were damaged.

A letter of credit is controlled by its own unique set of legal principles. Therefore, typical claims and defenses in contract law do not apply to transactions using letters of credit. This is because a letter of credit is governed by its own unique set of legal rules. Hence, letters of credit are enforceable against an issuer notwithstanding the fact that the applicant may have filed for bankruptcy in the past. This is true from the perspective of a beneficiary.

A surety bond, in contrast to a letter of credit, is attached to the underlying contract, and as a result, its interpretation has to be compatible with that of the underlying contract. The surety bond acts similarly to a guarantee, with the exception that the responsibility of the guarantor is secondary.

This indicates that the duty of the surety does not become legally binding until the primary obligor breaches the underlying contract. In contrast, the issuer’s obligation in a transaction including a letter of credit is considered to be primary.

Since surety bonds do not demand instruments, like letters of credit, an obligee may see them as having a lower level of desirability. In these cases, the surety will conduct an investigation into the underlying default as part of a claim adjustment procedure. The procedure of being reimbursed is slowed down as a result of this. Sureties are obligated to reject allegations that, in their opinion, are baseless.

In the same way that other financial guarantees are appealing to principals due to the fact that they do not show on a corporation’s balance sheet, the usage of surety bonds does not cause a line of credit held by a business to be reduced. This makes surety bonds an attractive option for principals.

In addition to that, obtaining and maintaining surety bonds often costs less than other types of bonds, and the primary obligee may not even be required to deposit collateral with the surety in certain cases.

Surety BondLetter of Credit
ClaimsSent by the obligee to the surety. The surety will then examine the claim, and if it is found to be factually and contractually legitimate, it will pay out the amount owed.Sent by the beneficiary to the bank, which, provided it confirms that the beneficiary has adhered to the appropriate processes for submitting a claim, will pay out the requested amount.
CostA premium that ranges between 2 and 3 percent of the entire amount of the penalty, with the exact percentage determined by the principal based on their credit score and financial history.A charge equal to about one percent of the total amount covered by the letter was paid to the bank.
CoverageThe worth of the deal, or a sum chosen by the obliged party, whichever is moreUsually between 5 and 10 percent of the total value of the contract. However, the needed amount of the letter of credit may be greater in some circumstances. In the event that the contractor has a short employment history, previous surety bond claim payments, a poor balance sheet, or bad personal and company credit, it is possible that such stricter restrictions may be demanded of them.
TermTypically, the length of time that the project will be carried out. However, in certain cases, there may be an extra term thereafter known as the maintenance period. During this time, the contractor will still be responsible for any flaws that appear in the work.Fixed for the duration of the contract, which is usually one year but may be automatically renewed in certain cases.

Frequently Asked Questions

Which Is Better – A Letter of Credit or a Surety Bond?

When it comes to letters of credit, the possibility of fraud is much higher. When a claim is made on a surety bond, the surety company conducts a comprehensive investigation into the claim.

With a Letter of Credit, Who Are the Three Parties Involved?

The financial organization that is responsible for issuing the letter of credit. The individual who is buying the products or services that are being offered by the beneficiary. The individual who will get payment.