Secrets of Bonding #62: ILOC: What is it? What isn’t it?

Sample #1

Wisconsin Department of Transportation
Motor Carrier Services – IRP Unit
P.O. Box 7955
Madison, WI 53707-7955

We hereby establish our irrevocable letter of credit in your favor for ACCOUNT NAME, in an amount not to exceed $00.00.
All checks written by ACCOUNT NAME payable to Registration Fee Trust, (Wisconsin Department of Transportation) for the remaining registration fees will be honored by BANK NAME up to the irrevocable credit limit.

If ACCOUNT NAME fails to make payments to the Wisconsin Department of Transportation when due, the BANK NAME will allow the Department of Transportation to draw on the Irrevocable Letter of Credit up to the credit limit, provided the BANK NAME receives written documentation from the Wisconsin Department of Transportation stating registration fees have not been paid when due.

This IRREVOCABLE LETTER OF CREDIT expires: _______, ______, ______

Sample #2

Date of Issue: _____ Date of Expiry: _____ Issue Number: __________

The City of Frederick
c/o DPW Projects Division
Attention Linda Dutrow
111 Airport Drive East
Frederick, Maryland 21701

We hereby authorize you to draw on us for account of (name)____________ at (address) ______, up to an aggregate amount of $ _____ (_____) dollars and _ cents) US Dollars, available by your drafts at sight accompanied by a signed statement that the funds are being drawn and required for payment in accordance with an executed Public Works Agreement between the City of Frederick and the party named in this paragraph for (project description) _________________.

Drafts must be drawn and negotiated not later than ______ at our counters. Partial drawings are permitted.

Each draft must state that it is drawn under the Irrevocable Letter of Credit of (name of issuing bank) _____________ Number _____________ dated _______. This Letter of Credit is not transferable or assignable without written consent of (name of issuing bank) ___________________________.

This credit is subject to the “Uniform Customs and Practice for Documentary Credits” (1994, or latest revision) International Chamber of Commerce, Brochure Number 500.

It is a condition of this Letter of Credit that it shall be deemed automatically extended without amendment for one (1) year from the present or any future expiration date of this Letter of Credit unless at least forty-five (45) days prior to such expiration date we notify you by certified mail that we elect not to consider this Letter of Credit renewed for such additional period.

We hereby agree that all drafts drawn under and within the terms and amount of this credit and accompanied by the documents above specified, that such drafts will be duly honored upon presentation to the drawee.

These are two examples of ILOCs. Let’s find out about these, and why they look so different.

“ILOC” stands for Irrevocable Letter or Credit. They may also be called a Standby Letter of Credit. These instruments are only issued by Commercial Banks. The purpose is to enable one party to draw on the account of another in connection with a business transaction. If the beneficiary makes a draft (draw) upon the ILOC, the bank records it as a loan to the account holder who is the subject of the letter (the contractor in a construction scenario). The beneficiary is not required to repay the bank.

A perfect example is the overseas practice to use an ILOC in the same manner we normally use a Performance and Payment Bond in support of a contract. The contract owner is entitled to draw on the ILOC in the event of the principal’s default.

The two examples above are actual suggested formats from those beneficiaries. The Wisconsin DOT is unusual because of its brevity. The City of Fredrick form is more typical of what you may see, particularly if using an ILOC to give collateral to a surety.

What are the important elements missing in the DOT form?

If the duration of the related business transaction is longer than the term of the ILOC, the beneficiary normally demands an “evergreen clause” which provides for automatic renewal. It means if no action is taken prior to anniversary, the instrument does not expire. This gives the beneficiary confidence that they will be formally notified prior to anniversary that the bank intends to non-renew, and they will have sufficient time to draw down (cash out) the entire ILOC so they remain protected.

It is also normal for the instrument to allow partial draws, and require the return of drawn funds that are ultimately unused.

It is important for the document to correctly state the party whose actions are the subject of the guarantee (the principal) and the circumstances under which a draw can be made should be standard.

Beneficiaries of these instruments must scrutinize the financial condition of the issuing bank. In cases where the FDIC rescues a banking institution, they have the ability to unilaterally nullify these instruments to aide in the bank rehabilitation. For bonding companies, this means they can lose their collateral even though they remain “irrevocably” obligated on the P&P bond. Check the bank strength here:

We have covered what an ILOC is, the key aspects and what to look for.

What isn’t it?

For Obligees (the beneficiary of the bond) it may not be a good alternative to a Performance and Payment bond.

1. The bank does not pre-qualify the contractor’s ability to perform the work the way a surety does.
2. In the event of default, the project owner (obligee) must assess the contract status, arrange for a completion contractor and manage the process to a successful conclusion. With a bond, the surety may do all this.
3. An ILOC does not prevent liens against the project or provide the process to resolve them.

Owners may accept an Irrevocable Letter of Credit as an alternative to a surety bond. However, the fact remains that an ILOC does not match the comprehensive protection of a Performance and Payment Bond.

What about for Contractors and Developers?

  1. Bonds are not easy to get.  The contractor must pass a rigorous evaluation by the surety.  Bonded contractors and developers can promote the fact that they have the support of a surety: Bragging Rights!  Many include this info in their brochure along with their banking credentials.
  2. Having cash tied up for indeterminate time periods can put a strain on construction companies.  They need it to finance the start of new contracts and solve problems on existing ones.  Developers may lose out on opportunities to acquire new projects or property.  Reminder: Projects may be completed / released later than expected, meaning the cash remains tied up for how long?

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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