Bank-Fronted Standby Letters of Credit May Be Viable Solutions When Surety Bonds Cannot Be

What can surety bond producers do when a client needs a guarantee for a project or other obligation, but the requesting entity will not accept a surety bond? One possible alternative is a standby letter of credit (SBLC), issued by a bank. SBLCs are letters of credit issued on request of a surety company that support a contract between a surety client (the principal that is the customer of the surety) and the beneficiary (the party requiring the SBLC) who can draw down the letter of credit if contractual or performance obligations are not met. The bank issues the SBLC after it agrees upon an SBLC facility or credit line with a surety to cover its risk. An SBLC is also known as a bank-fronted SBLC (BFS bond) and a back-to-back letter of credit (BBLC). Another advantage of a surety using an SBLC is that it enables surety companies to continue servicing their clients in activities where surety bonds are not accepted.

How SBLCs Work

A surety bond transaction involves three parties: the principal, the obligee, and the surety. An SBLC transaction, however, involves four parties: the surety; its client; the beneficiary; and the bank that issues the SBLC.

As part of the process, the surety company evaluates the creditworthiness of the principal, evaluates the underlying obligation, and looks at the terms of the SBLC that the applicant wants to obtain.

“The underlying contractual obligation would need to be one that the surety would support a bond for, if it were an option, and within the scope of surety regulation,” said Nicole Beck, Vice President and Underwriting Director, Commercial Surety at Allianz Trade North America.

“The bank performs due diligence at the start of the relationship with the surety and relies on the surety’s credit and counter guarantee to issue the BFS bonds,” said Gonzalo Videla, Regional Underwriting Officer, Bond & Specialty Insurance at Travelers. “The bank will primarily be concerned with the creditworthiness and stability of the surety company that will provide the bond to them.”

If everything checks out, the surety agrees to request the SBLC issuance via the bank; this may be in the form of a reimbursement agreement or counter guarantee. The bank would then send the issued SBLC to the beneficiary directly.

There is a principle of independence with SBLCs that governs the relationship between the surety, its client, and the bank. The surety’s client never approaches the bank directly; the surety makes the request for the letter of credit to the bank on its client’s behalf. The SBLC issuance is regulated by the issuance arrangements between the surety and the issuing bank.

“The bank does not work directly with the principal, and the surety’s relationship with the principal does not change. The surety underwrites the principal and the obligation as it would on a traditional bond, but, rather than issuing a surety bond, the surety requests the bank to issue a BFS bond,” said Videla.

If the bank receives a valid drawing (claim against the SBLC) that adheres to the language in the SBLC, it must pay the beneficiary by a certain date. The bank, in turn, will seek reimbursement from the surety, which must make that payment by the date defined in the reimbursement agreement. The surety will separately seek a remedy from its principal.

That’s an important distinction between a traditional surety bond and an SBLC. When a project is guaranteed by a surety bond, the surety generally has the right to review or investigate a claim against the bond to determine its validity before it makes any payments to the obligee. With an SBLC, however, the surety doesn’t have the right to do that kind of upfront investigation. It must reimburse the bank regardless of whether the surety believes the claim against the SBLC was appropriate.

Increased U.S. Interest

Although the U.S. surety industry has not used SBLCs extensively, they’ve been employed since the 1990s in other parts of the world. “Their use began as a way to support customers in countries where surety bonds are not issued or not accepted by obligees. However, their use became more popular in the U.S. starting in 2019 and 2020, in part because they can help businesses maintain liquidity,” said Videla.

International banks and surety companies have been introducing SBLCs to their North American customers. “Allianz is a European company, and it’s a relatively normal practice for our colleagues in other regions globally. So that’s how we were able to get comfortable with this structure in the U.S.,” said Beck. “In recent years there is more awareness in the U.S. market about the option to utilize surety to provide an SBLC. As a result, surety users are speaking with their brokers about whether the product is an option for them and whether it would be advantageous for them to explore.”

SBLCs currently provide guarantees for transactions in a wide range of industries. “Most of the transactions in the U.S. are related to the collateral requirement on retroactive paid loss or loss-sensitive insurance programs. In these programs, an insurance carrier typically accepts up to 30% of the collateral requirement in the form of a traditional insurance program bond and the difference needs to be posted in the form of a letter of credit. BFS bonds can be used to fulfill the letter of credit requirement,” Videla said.

Another example would be subdivision obligations to certain municipal governments, or power purchase agreements or interconnector bonds in the renewable energy space, where the owners will not accept surety bonds.

Pros and Cons

SBLCs can offer advantages to all the parties involved in the transaction. Some beneficiaries feel more comfortable having a guarantee from a financial institution than from a surety, according to Adriano Dariva, Executive Director, Global Receivables and Trade Finance – Financial Institutions Group at Wells Fargo Bank. One reason is the set parameters and conditions of payment and the financial strength of the issuing bank. “The SBLC will provide payment once the conditions of drawing are met, whereas in the surety space payment could be a bit different due to the claim review or investigation,” he said.

Another reason that beneficiaries might prefer SBLCs is volatility. “The more volatility you have in the market, the more requirements for instruments like standby letters of credit,” Dariva explained. SBLCs are regulated by international sets of rules, i.e., Uniform Customs and Practice (UPC 600) and the International Standby Practices (ISP 98).

“SBLCs have a generally defined format, and there must be an agreed arrangement between the client and the bank to define the reimbursement obligation in case there is a valid drawing under the SBLC,” said Dariva. “By having a defined set of rules and procedures, SBLCs can bring certainty to all parties involved.”

When people want to diversify their risk, they want more guarantees in place, defined terms and conditions, and the standby letters of credit can provide that sort of support,” Dariva added. For the sureties and their clients, SBLCs can enable a wider reach for the business requirements they may be involved with.

“When a contractor has a requirement for a letter of credit for the performance of an obligation that they have been able to bond in similar previous contracts, obtaining the letter of credit through their surety provides an alternative to using their bank line,” said Beck. “Depending on the structure of the contractor’s bank facility, working through the surety company would increase their available liquidity if they would have been required to post collateral.”

One potential drawback of SBLCs for the applicant is that they may provide less protection than traditional surety bonds if the beneficiary makes a draw under circumstances that the applicant disputes, Beck added. With surety bonds, the surety will investigate claims before making a payment or try to find remedies other than payment to resolve the issue.

For brokers and producers, BFS bonds represent a new source of revenue and an opportunity to offer a new product and solution to clients. “BFS bonds are a nice complement to the retroactive loss paid insurance program offerings the producers are involved with and a solution to the insurance carrier’s collateral requirement,” said Videla. “The advantage for a surety is the possibility of providing a new product to help support their customers and distribution partners. It is a market that sureties didn’t previously have access to and demonstrates innovation in the industry.”

The disadvantage for the surety is that it introduces a fourth party to the typical tripartite surety relationship, which can add a level of complexity to the transaction. From many banks’ standpoint, SBLCs can provide a new reach of business—sureties and their clients—and enable them to provide a value-added service to their customers. “It has brought in a win-win situation, since banks may not have the same client reach as sureties and banks cannot issue surety, but instead banks can issue SBLCs to support their insurance clients that are active in the surety space,” said Dariva.

The Finer Points of SBLCs

Specific language within the SBLC language varies by beneficiary and can sometimes be negotiated, according to Beck. “In my experience, the banks are a great resource to sureties and brokers on this topic. The better the language in the SBLC form, the less risk for the bank, the surety, and the applicant (principal).”

Attention to detail when approving a draft and working with the beneficiary to return the SBLC in a timely manner are important considerations for the customer in order to avoid increased costs and potential capacity constraints,” said Beck. “We’ve had instances where an SBLC draft was approved by the applicant/principal, and we later discovered that the beneficiary address was wrong, so it was sent to the wrong address. In this situation, the customer is charged until the beneficiary sends back the instrument or provides a release, and in some cases, this overlaps with the need for a replacement issuance.”

Pricing for an SBLC is set based on how the bank considers the surety’s credit quality, the underlying obligation, the language in the SBLC, and the bank’s own regulatory capital requirements, Beck said. Sureties pass on to the applicant the costs associated with the bank placement and issuance. The surety’s premium must adhere to filed rates and is impacted by the surety’s assessment of the customer’s credit quality and the underlying obligation. The increasing demand for SBLCs can benefit both the surety and banking industries and their clients’ businesses as well. “Surety bond producers recognize that SBLCs may add a business reach they didn’t have before and enable them to be more relevant and supportive to their clients. Therefore, we have been seeing a growing interest from sureties to learn more about SBLCs,” said Dariva. “It has been a good learning experience for both sureties and banks on the application, solutions, and reach the SBLCs can provide by enabling a collaborative environment between us and the companies active in the insurance/surety space.”