5. What’s a better practice to guarantee performance, a bond or a letter of credit?

A better practice is to permit different types of acceptable, in the sole discretion of the municipality, security. Smaller contractors may be assisted because, for example, a small contractor may be better able to obtain an acceptable line of credit from a local lender but may not be able to secure an acceptable bond in time to meet an RFP submission deadline. A bond and a Letter of Credit (LoC) are both forms of a performance surety (financial guarantee) by the contractor to satisfactorily complete the work. The surety amount should cover additional costs for service, tender and administrative expenses, above ongoing operating costs, if the contractor defaults.

If surety amounts are set too low, the municipality risks paying for some or all of a major default, if set too high small/local contractors may be unable to bid. Typical ranges are 25% – 75% of 1 yr. total contract bid price.

Under a bond, a claim must be made using a formal procedure, to the 3rd party bonding company which then investigates to find out if the contractor failed to perform its obligations. This can be a lengthy procedure involving litigation.

Banks will pay a LoC upon a formal demand. LoCs cost more than bonds but may be easier to obtain for small companies. (Bond 0.5% to 1% vs. LoC 2% to 4% of surety value annually)

Bonds are not as liquid as a demand LoC or cash on deposit so if time or emergency funds are short in your municipality then a LoC may be preferable.

 

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