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13 Constr. Law. 3 (1993)
They're Back: Letter of Credit Provided in Lieu of Surety Bonds

handle is hein.journals/conlaw13 and id is 3 raw text is: They're Back: Letters of Credit Provided in Lieu of Surety Bonds
Leslie King O'Neal

Construction attorneys
should not consider letters
of credit as arcane docu-
ments used only in inter-
national trade. Current
economic conditions and a
recent policy change by the
federal government' have
increased the use of irrev-
ocable letters of credit in
lieu of payment and per-
formance bonds on con-
struction projects. It is       Leslie King O'Neal
likely that contractors and
subcontractors and construction lawyers will encounter
letters of credit more frequently in the next few years.
Although letters of credit may be used instead of bonds,
they are unique creatures governed by different legal
principles than the familiar contract surety bonds. Con-
struction lawyers and their clients should be aware of
these differences to avoid unpleasant surprises when a
claim on a letter of credit arises.
What Are Letters of Credit?
A letter of credit is defined as an engagement by a bank
or other person made at the request of a customer...
that the issuer will honor drafts or other demands for
payment upon compliance with the conditions specified
in the credit.2 That is, the issuing bank will pay the
letter of credit beneficiary when the conditions specified
in the letter of credit are met. Some letters of credit may
be called upon simply by presenting a draft3 to the bank;
others require additional documents, such as a letter de-
claring a default under the contract.4 If no documents
are required to call upon it, the document must con-
spicuously state that it is a letter of credit.5
Origins and Uses of Letters of Credit
Letters of credit have played a major role in financing
the sale of goods since the twelfth century. There is ev-
idence that letters of credit were used in Renaissance
Europe, Imperial Rome, ancient Greece, Phoenicia, and
even early Egypt.6 Originally used in international trade
to reduce the risk of extending credit to unknown buyers,
letters of credit are also used as a method of guaranteeing
performance of other types of obligations, such as pay-
ment of subcontractors or performance on a construc-
tion contract. Letters of credit used in sales transactions
Leslie King O'Neal is a partner in the law firm of McDonough, O'Neal
& O'Dell at Orlando, Florida. Ms. O'Neal is Chair of the Disputes
Avoidance & Resolution Division in ABA's Forum on the Construc-
tion Industry.

are known as commercial letters of credit, while those
used to guarantee other types of performance are known
as standby or guaranty letters of credit.7
One of the primary differences between commercial
letters of credit used in sales and standby letters of
credit used in construction is that a bank issuing a com-
mercial letter of credit expects to pay the seller's drafts,
while a bank issuing a standby letter of credit does not
expect to pay.8 A claim on a standby letter of credit
means that the parties are in a dispute and sends up a
red flag to the bank.
Anatomy of a Letter of Credit Transaction
When a general contractor provides a letter of credit
to an owner in lieu of a performance and payment bond,
the transaction involves two contracts and the letter of
credit itself. The contracts are the construction contract
between the owner and the general contractor and the
contract between the general contractor and the bank
issuing the letter of credit (for reimbursement if the letter
of credit is called). The letter of credit issued by the bank
to the owner is not a true contract and standard contract
law principles should not be applied.9 Unfortunately,
many judges find letters of credit hard to understand,
which leads to erroneous rulings.
Distinguishing Letters of Credit and Surety Bonds
While letters of credit may be used in lieu of surety
bonds, they are neither surety bonds nor guaranties. The
letter of credit is not a guaranty or surety arrangement
because the issuer is bound to pay the beneficiary and
because this obligation is not subject to the various de-
fenses available to a guaranty or a surety undertaking.0
Standby letters of credit have been attacked as being
illegal bank guarantees; however, these attacks have
failed.I
Letters of credit differ from surety bonds in that with
letters of credit the financial burden of litigation over
whether there was a default is on the contractor. Unlike
a surety bond case, where the surety usually withholds
payment until the issue of its principal's default is de-
termined, in a letter of credit transaction, the beneficiary
(i.e., the owner) usually receives the money promptly
upon presenting the proper documents to the bank. If
the contractor disputes whether it was in default under
the contract, the contractor must sue the owner to re-
cover the money.'2
The Independence Principle
This illustrates one of the unique aspects of letters of
credit-the independence principle. This principle
provides that the bank's obligation to the letter of credit
beneficiary (i.e., the owner) is independent of the owner's

THE CONSTRUCTION LAWYER  3

January 1993

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