Until the payment process in construction gets a major renovation, contractors and suppliers will need to continue to protect their payment rights and do what they can to ensure they get paid. There are several options to protect payments, including bond claims, liens, and lawsuits. In construction, an option that is not as well-known is a letter of credit. They are fairly simple to get and don’t require a lot of paperwork.
We’re going to look at what they are, what makes them different than bonds, and how letters of credit are used in the construction industry.
What is a letter of credit?
A letter of credit, or LOC, is a financial guarantee provided by a bank or other financial institution that ensures a certain amount will be paid if requested. Similar to a construction bond in some respects, an LOC guarantees that the client’s payment will be received by the contractor, in the correct amount on time. If this is not the case, the bank will step in.
There are three parties involved in a letter of credit: the issuer, the applicant, and the beneficiary.
The issuer of the letter of credit is usually a bank or other financial institution, and they are responsible for paying the amount of the letter when requested.
The applicant is the contractor, subcontractor, or supplier who is purchasing the letter, and they are the ones whose payment is being guaranteed.
The beneficiary is the general contractor, contractor, or owner who will be requesting the amount.
How a letter of credit works
As they are less expensive, letters of credit work well with specific transactions where a larger bond may be too much. Everybody needs reassurance when it comes to money, and a letter of credit is a legal tool that provides this financial protection for all parties involved — owners and contractors, buyers and sellers.
Protection for buyers
Letters of credit are often used in place of holding retention on a contract. Retention is held to protect the owner and ensure that the project gets completed to their satisfaction. Holding an LOC provides security that whatever work was purchased is finished as desired or the money isn’t lost, like returning a construction receipt.
Protection for sellers
Contractors can also request an LOC when they’re concerned about their customer’s ability to pay for work. The owner works with the bank that issued the letter to cover any missing compensation. This ensures that the contractor will get paid, regardless of their customer’s cash position.
Letters can also be used when lien rights aren’t clear or aren’t available. Examples include transactions between suppliers, work on public land, or for projects below the bonding threshold. LOCs can substitute for lien rights or bonds when these avenues aren’t available to the contractor or supplier.
Letter of credit types used in construction
There are two types of letters of credit in construction: commercial and standby. While commercial LOCs may be used occasionally in the construction industry, the most common type is standby.
Standby LOCs act as security, guaranteeing payment only if the party who is supposed to pay doesn’t follow through. This type of letter of credit is most often used in construction as a guarantee of payment for work provided.
If the applicant doesn’t perform their work completely or correctly, the beneficiary can request payment of the amount on the letter. The bank reviews the request and supporting documentation and decides whether to pay the beneficiary or not.
Commercial LOCs are used as a guarantee for payment for goods or services. When a sale is made, the purchaser provides a letter of credit to the seller. Once the goods or services have been delivered, the beneficiary asks the bank to pay them.
The bank reviews the request and chooses whether to honor the letter of credit and pay the seller. The letter ensures that the seller will receive payment for their work or material supplied. The purchaser and the bank make a separate agreement for paying back the amount of the letter.
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The bank may choose to dishonor the letter of credit if they feel the claim for funds is fraudulent or they don’t believe the validity of the request. The settlement may help offset costs related to completing or repairing the work but doesn’t cover all costs in full.
Letters of credit in action
Examples of LOCs in construction are typically domestic cases, anytime where there may be a slight uncertainty of either pay or quality. If the previous three buildings worked on by a roofing contractor all have had leaks rain down, it may be wise to secure a letter of credit. Either this time they get their act together and perform satisfactorily, or the bank will step in and ensure that money isn’t lost.
LOCs are also practiced internationally in trade. Banks will often back exporters overseas that they already have a relationship with, and provide buyers with a letter of credit to reassure quality.
Surety bonds versus letters of credit
Letters of credit and surety bonds are similar in many ways. Both protect payments and provide a way for owners or contractors to recover money for substandard or incomplete work. However, they differ in the period of time covered, costs, document review, and how claims are paid.
Surety bonds cover an entire project, from beginning to end. They protect both payments and work performance. A construction letter of credit only covers a small part of a contract — usually 5–10%. Plus, they’re only good for a limited duration — usually a year or less.
As far as costs go, bonds average 0.5–2% of the contract amount, based on the full amount listed in the contract with the owner or general contractor. Letters of credit usually cost about 1% of the amount listed on the letter, which is usually 5–10% of the total contract for that vendor.
When determining whether a company is a good risk for a surety bond, the surety will review the contractor’s experience, workforce, and financial statements to ensure that they’ll complete the work and pay their suppliers. For a construction letter of credit, all that is reviewed is a company’s financial statements. Once the bank or financial institution has determined that the company can pay them back the amount of the letter, they’re approved.
If an owner or general contractor files a claim on a bond, the surety investigates the claim by requesting documents and talking to the applicant. Once it’s determined that the claim has been substantiated, the surety can give the owner payment to cover the cost of completing the work, complete the work themselves, or help the original contractor finish the work.
When there is a claim on an LOC, the financial institution doesn’t investigate, and pays the amount listed on the letter upon receipt of the request. There’s no provision for completing the work or making needed repairs. This means the owner or general contractor may be stuck with added costs.
How to get a letter of credit
The process for obtaining a letter of credit is fairly simple and straightforward. The applicant applies for one at a bank or other financial institution, and the bank will review the applicant’s financial statements to determine if providing a letter of credit is a worthy risk.
If it appears the company can pay the bank back for the amount of the letter, then they’ll issue the LOC to the beneficiary. The bank and the applicant will then create a separate agreement regarding payback.
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Collecting payment against a letter of credit
On a commercial letter of credit, the beneficiary requests the money from the issuer and gets paid right away. There’s no proof or additional documentation required because the agreement states that the bank pays upon request.
For a standby letter of credit, the beneficiary requests the money and provides backup documentation to show that the applicant hasn’t already paid them or fulfilled their part of the contract. Once the request is received, the bank pays the beneficiary.
There are many ways to protect your payments in construction
Preliminary notices and notices of intent to lien are great ways to protect payments when you have lien rights. On public projects, you can submit claims to payment or performance bonds and get paid that way. However, when lien rights aren’t clear or where there are no public bonds, you’ll need another way to protect yourself.
Letters of credit are a great alternative here to protect your payment rights. Ask your customer to provide a letter for all or a portion of the project contract. This way you know you’ll get paid and you won’t have to go through a long claims process, either.