December 5, 2018 by Siobhan Small
When we think of credit, we usually think of a method of paying for goods or services.
In the construction context, however, credit can serve a role analogous to that of a performance bond. While owners can choose to request various different kinds of performance guarantees from their contractors, the letter of credit is a common one. All contractors should therefore understand the basic function of letters of credit in a construction project and why an owner might make this request.
Every letter of credit involves three main parties – the issuer (usually a bank), the applicant and the beneficiary. The letter of credit itself is an instrument obligating the issuer to pay money to a beneficiary based on terms outlined by the applicant.
There are two main forms of a letter of credit. The first, and most well-known, is the documentary, or commercial, letter of credit, which is used as payment for goods or services. The service provider that benefits from the letter of credit draws on it by presenting to the bank proof of a purchase. The necessary form of proof is set out in the letter of credit, and its presentation obligates the bank pay the service provider as if the bank were the purchaser.
The second type is the standby letter of credit, which acts as security rather than payment. The letter of credit is prepared to secure the obligations of one party to another and is cashed only if the obliged party defaults. In the construction industry, standby letters of credit secure the proper and timely construction of the project.
In practical terms, the difference between these kinds of letters of credit lies in the role of the applicant. Does the applicant intend to pay the beneficiary, or is the applicant going to be paid and intends to reassure the payer that it will perform its service?
Under a documentary letter of credit, all parties expect that the beneficiary will draw on this letter of credit at some point as it is an alternative form of payment. In a standby letter of credit, the applicant is the service provider and has no intention of paying money to the beneficiary, who is the consumer. The standby letter of credit is merely security in the event that the applicant fails to perform its service. The beneficiary is then assured to have the funds it needs to pay a third party to complete that work.
For a construction project, the issuer is typically a bank. The bank is responsible for providing the funds if the letter is drawn upon. The applicant, also known as the customer or the borrower, is the individual or company performing the work the bank is guaranteeing. The beneficiary is the recipient of the work, typically the owner.
The letter of credit represents a unique legal relationship between these parties. The applicant has a relationship with the bank as its customer. The applicant and beneficiary will also have their own agreement that creates the need for this credit, but the letter of credit creates a contract between the bank and the beneficiary that stands apart from these underlying relationships.
While the letter of credit depends upon a relationship between the bank and the applicant, the terms of the letter of credit do not control that relationship. Because the letter of credit dictates the bank’s obligation to the beneficiary, it cannot obligate the applicant to pay the bank back. The parties will therefore come to a separate reimbursement agreement at the same time as the letter of credit application. Remember that the bank cannot refuse to pay the beneficiary based on any outside relationship, so without this agreement, or some form of security, the bank would have to pay with no recourse to recover its funds from the applicant.
The bank’s direct and independent obligation to the beneficiary is why letters of credit are so popular with owners. When deciding whether to pay a beneficiary who says a contractor has failed to perform its work, the bank can only look at whether the beneficiary has presented the documents outlined in the applicant’s instructions without regard to the underlying relationships. If the owner has the right documents, the bank must pay. These conditions are difficult to dispute. Since issuers are reliably solvent, beneficiaries of a letter of credit enjoy a reliable source of cash with little risk of delay.
Siobhan Small practices construction law at Borden Ladner Gervais LLP. This article is for information purposes only and may not be relied on for legal advice. Please send comments to firstname.lastname@example.org.
This column originally appeared in the December 2018 issue of On-Site. You can read through the complete issue here.