Understanding Surety-Backed Letters of Credit

Financial guarantees help mitigate risk and ensure the fulfillment of financial or performance obligations. Two of the most common types of financial guarantees are Surety Bonds and Bank Letters of Credit. Some industries that require financial guarantees include construction, infrastructure, banking, finance, real estate, shipping, logistics, energy, manufacturing and others. Businesses that operate in these spaces routinely provide letters of credit and surety bonds; however, many times they are unaware of a third option that is a blending of the two: Surety-Backed Letters of Credit.

What is a Surety-Backed Letter of Credit?

A surety-backed letter of credit is a financial guarantee issued by a bank or financial institution that is backed by a surety. This arrangement ensures that the beneficiary of the letter of credit will receive payment or compensation if the applicant fails to meet their contractual or performance obligations. The combination of a letter of credit with surety backing offers an added layer of security, making it an attractive option for businesses engaged in various transactions.

How Does it Work? 

In an SBLOC scenario, the surety will evaluate what the letter of credit is guaranteeing along with the creditworthiness of the company (principal). After favorably evaluating the principal and obligation, the surety would issue a letter of credit with a bank to the party who is requiring it. The letter of credit will name the principal and not the surety. Despite the principal being named on the letter of credit, the bank does not typically have a direct relationship with the company. Instead, the bank relies on the credit quality of the surety company that is backing the letter of credit. The surety will pay the fronting fee to the bank and in return charge a premium to the principal for the use of the letter of credit.

What are the Benefits? 

1. Favorable Financial Reporting: When a company replaces its existing letters of credit with a surety back letter of credit, that liability is no longer recorded as a liability on the organization’s balance sheet. Removing those liabilities can improve the company’s overall capital position as well as free up future borrowing capacity.

2. Increased Security: SBLOCs provide a higher level of protection for the principal since the surety will investigate any claims made on the obligation. Many traditional letters of credit contain” demand” language which as a result the bank would be obligated to immediately pay cash when the guarantee is invoked.  Unlike a traditional letter of credit, surety companies can tailor the letter of credit, so they are not obligated to immediately write a check whenever there is a claim. The surety will be able to do their due diligence on the legitimacy of the claim and work with the principal to remedy the situation with the goal of no actual claim arising.

3. Release of Collateral Requirements: Typically, traditional letters of credit require some form of collateral, which can be cash or other liquid assets. With SBLOCs, this requirement is typically not required, and the instrument would be provided based on the underwriting case of the company. The principal uses its Surety capacity to meet these obligations.

4. Flexibility: These instruments can be tailored to meet the specific needs of various transactions. Through the process of evaluating the guarantee requirement, the surety may determine that a traditional surety bond would also be accepted by the requestor. This would provide another potential option for the principal and would be underwritten similarly. As previously mentioned, if a letter of credit is required, the surety can utilize a specific letter of credit form to maximize protection for themselves and the principal. Overall, SBLOCs can be used in almost any industry where security is required for an agreement or transaction.

5. Favorable Pricing: Oftentimes, SBLOCs are provided at a lower total cost than a traditional letter of credit, especially when considering the benefits of freeing up capital and borrowing capacity.

Underwriting Considerations

1. Principal’s Financials: When evaluating a potential SBLOC, the surety will require the underwriting of the principal’s current and past financial statements. They will analyze the principal’s financial position to ensure they are appropriately capitalized to meet the obligations they are guaranteeing. Typically, this form of credit is extended to companies with investment grade balance sheets or large companies included in the Fortune 500. While these are not necessarily the only companies that can qualify, they are where we see this product most utilized because of the surety’s underwriting criteria.

2. History and Expertise: The surety will also evaluate the principal’s experience in these types of obligations/transactions. The expectation will be that this type of obligation/transaction is something that occurs as a part of the principal’s routine operations and is not unknown territory to the principal. Since the surety is backing the guarantee, they will want to ensure the principal’s experience is directly related to the guarantee.

3. Type of Obligation/Guarantee: The surety will underwrite the type of obligation that requires the letter of credit. They will want to get an understanding of the scenario that would cause the letter of credit to be invoked. Overall, the SBLOCs are flexible but each scenario will be underwritten specifically to make sure the surety is willing to guarantee it.

Industries Where SBLOCs Could be Used 

• Automotive
• Aviation
• Chemical
• Energy (Oil & Gas, Solar, Coal, etc.)
• Construction
• Entertainment
• Financial Services
• Healthcare
• Hospitality
• Manufacturing
• Manufacturing
• Professional Services
• Retail
• Transportation
• Wholesale & Distribution

Surety-backed letters of credit are effective financial instruments that provide enhanced security for guarantors in various business transactions. By combining the benefits of letters of credit and surety guarantees, they can offer a robust solution for mitigating risk in uncertain business environments while also improving a company’s balance sheet. Understanding SBLOCs can empower companies to make informed decisions and foster trust in their commercial relationships.

Seubert & Associates is experienced in handling these arrangements and can help to identify any potential uses for SBLOCs or surety bonds in the operation of your business.