Can a Letter of Credit Substitute for a Performance and Payment Bond?

An owner was confronted recently with a circumstance in which a contractor that the owner really wanted to use was unable to obtain a bond for the project. The contractor was a small company, but had successfully built other projects for the owner. This project, however, would be the largest ever undertaken by the contractor, and was beyond the contractor's bonding capacity. What to do?

The dilemma was resolved by the contractor by establishing a clean irrevocable standby letter of credit ("LOC") in favor of the owner. While not in the total amount of the contract, the LOC was large enough to give the owner the assurance it needed that if the contractor became stretched too thin and was unable to complete the project in a timely fashion, the owner would have prompt and easy access to funds to complete the project.

If using this device, it is important to make clear in the contract that the LOC will not only be irrevocable but also will be a "clean" LOC, so that the beneficiary (in this case the owner) needs to do nothing more to draw down the LOC than to sign a statement that the other party (in this case, the contractor) is in default under the contract and that pursuant to the contract the owner is entitled to draw down the LOC. (This entry published by Karen Estelle Carey, a member of the Real Estate Development group).