When entering a contractual agreement to provide a product or service to another entity, many companies use an Irrevocable Letter of Credit (ILOC) to ensure their performance as outlined in the contract.
The company providing the service (the principal) secures the ILOC from its bank by allowing the bank to place a lien against a line of credit, equipment, real estate, or some other asset that the bank accepts as sufficient collateral. The bank then guarantees to the company receiving the services (the obligee) that funds will be available to that obligee should they need to be accessed. If the obligee determines that the principal has caused a breach in the contract, they will have access to the funds secured by the ILOC to help remedy the situation
Many businesses choose to use an ILOC because it provides stability throughout the transaction. It also offers financial protection for the obligee because the agreement can’t be modified in any way unless all three parties agree to the change.
On the other hand, the principal gives up the right to the asset being used as collateral until their contractual obligations are fulfilled. For example, if the principal uses their line of credit as collateral, they cannot access the funds during the transaction. Furthermore, if a payout is made to the obligee, the principal can lose some or all of the collateral used to secure the ILOC.
Less Risk with Surety Bonds
An alternative form of risk management during business transactions are surety bonds. Surety bonds also involve a three-party agreement, between the principal, obligee and a Surety. Although they operate in a similar manner, a surety bond has many advantages over ILOCs, including better risk management.
For example, unlike an ILOC, surety bonds often do not require up-front collateral in order to secure the bond while an ILOC is a secured bank instrument.
Surety bonds reduce financial risk to the principal in several ways. A claim must be made on the bond and reviewed before any payout would be made. In contrast, the obligee would have direct access to the funds with an ILOC in place with no intermediary. Additionally, the surety bond claim process may result in the issues being rectified without a payout being made. An ILOC does not provide any protections for the principal.
As an insurance related product rather than a financial instrument of the bank, surety bonds also have the backing of the insurance company’s legal team which can protect the principal against frivolous claims. With an ILOC, the obligee only has to request payment from the bank and the bank is obligated to comply. With a surety bond, the obligee must file a claim with the insurance company and provide evidence that contract has been violated.
Surety bonds are especially important in the contracting and building industry. These risk management tools can improve the reputation of contractors by demonstrating their ability to complete the project. Surety bonds with no collateral requirement don’t tie up the principal’s assets leaving them free to be used to grow the business or obtain working capital.
Finally, a surety bond company can offer valuable technical assistance by providing access to professional advice from lawyers, accountants, estimators and engineers, thereby increasing the principal’s ability to successfully complete the project. For a cost-effective risk management tool that protects principals and obligees, surety bonds offer an excellent option.
For more information regarding surety bonds, contact Viking Bond today.
Bonding increases the credibility of your company, as it attests to your excellent financial situation.