Letters of Credit Don't Guarantee Performance

Letters of Credit (LOC) are frequently viewed as substitutes for performance and payment bonds. However, LOCs are not suited to guarantee performance of contracts which require more than a single delivery of goods or payment of a certain sum. 

One of the reasons given by the Comptroller of the Currency in allowing banks to write municipal bond insurance (which he said was the "functional equivalent" of a standby letter of credit) is that "if a factual investigation as to whether default has occurred were necessary, it would not involve the type of non-banking expert judgement or prolonged litigation needed to determine whether, for example, a performance bond has been defaulted upon."

The Comptroller of the Currency thus recognizes that LOCs are not appropriate substitutes for performance bonds.
Another shortfall of the LOC, compared to a bond, is that the demand or draft on the LOC must be in precise accordance with the terms of the LOC. Substantial compliance is not good enough. This strict adherence is enforced by the courts and, as an example, one beneficiary under a LOC was recently denied recovery because a name in the draft was spelled incorrectly.

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SURETY BONDS: Financial Security * Construction Assurance
Re-printed from the pamphlet "10 Things You Should Know About Surety Bonding" issued by Surety Information Office