Securing Construction of Public Highways and Other Municipal Services: Surety Bonds v. Irrevocable Standby Letters of Credit (Part 1)

By: Quinto M. Annibale, Loopstra Nixon LLP

October 2015

When municipalities accept the dedication of public highways and other municipal services through the development process, these services are typically built by the developer and are assumed by the municipality following a period of maintenance by the developer to ensure that the services function as designed.  The obligation to build is most typically found in either a subdivision agreement, a site plan agreement or some other form of development agreement.  The agreement will describe the services to be constructed by reference to plans and specifications prepared by the developer’s consulting engineer and reviewed and approved by the municipality’s engineers.  The services are typically designed according to engineering design criteria prepared by the municipality and adopted by council.  This ensures that services will be constructed to an acceptable and common standard. 

The agreement will also contain certain financial provisions which are intended to guaranty to the municipality that the services will be completed to the approved specifications and that they will function appropriately. 

In Canadian municipalities, the most common form of guaranty has historically been limited to a very narrow range of instruments.  Most typically, municipalities will require the posting of cash, a certified cheque or an irrevocable standby letter of credit.  However, in the United States, the use of Surety Bonds has become much more widespread, acceptable and commonplace.  This is the first part of a two part series which aims to provide an analysis of the legal basis of both types of instruments and an analysis of the advantages and disadvantages of each for use in the development approvals process. In Part 1 we will discuss the various tools available to municipalities to secure municipal services.

What is a Letter of Credit?

A letter of credit is a document issued by an issuer (usually a bank), whereby the issuer undertakes to a beneficiary, at the request of the issuer’s customer, to honor a documentary presentation by payment or delivery of an item of value.1  Although letters of credit are commonly used to secure an obligation to pay or perform under a separate contract between the beneficiary and the principal, the liability to pay is legally independent from this underlying contract and arises only with reference to the terms of the credit itself.2 This legal separation from the underlying contract is arguably the most important feature of the letter of credit as a tool of international commerce. This is because it ensures that a party will receive payment if a problem arises, simply by presenting to the issuing bank “documents which appear on their face to be in accordance with the terms and conditions of the credit.”3 When presented with such documents the only grounds upon which a draft can be refused is in the case of fraud.4

Since Letters of Credit are not negotiable instruments and the conditions they contain will be subject to strict interpretation when an undertaking to pay is claimed, the exact wording used is extremely important.5 There are several international banking and commerce organizations that have developed standards for letters of credit. The most recognizable to municipal solicitors will be the standards developed by the International Chamber of Commerce (the “ICC”).  However, because letters of credit are essentially three party contracts to pay in certain enumerated circumstances, none of these international standards or agreements apply to them unless they are specifically referred to in the document.

Beginning in 1933, the ICC developed standards for letters of credit to facilitate international trade and commerce.6 It was necessary at the time because of rampant world nationalism and protectionism. “The Uniform Customs and Practice for Commercial Documentary Credits” (as it was then called), has gone through 6 reiterations over the years, (the most recent being UCP 600, which was developed by the ICC Commission on Banking Techniques and Practices and is now called “The Uniform Customs and Practice for Documentary Credits”).7  These terms are widely incorporated into many letters of credit and their use has been consistently endorsed in Canadian jurisprudence.8 UCP 600 came into effect on July 1, 2007.  It contains 39 principles which apply to any letter of credit that adopts UCP by reference in the Letter of Credit.  These 39 principles are important, however many of them are important in the context of international trade and have no application (or at least importance) in the context of securing the construction of municipal services.  For municipalities the most important of these principles are:

  1. Article 4 – The credit is a separate document from the contract on which the credit is based. Therefore the obligation of the issuer to honor or fulfill any obligation under the credit is not subject to any defense or claim as between the obligee and the beneficiary.  This Article is important because it recognizes that payment must be immediate and without regard to the equities between the parties to the contract.  It also recognizes that there are other venues and remedies to determine liability;

     

  2. Article 6 – The credit must have an expiry date and the credit must name the bank at which the draft must be presented for drawing. The credit must state whether payment will be by sight, deferred, acceptance or negotiation. Most municipal letters of credit provide for payment on sight by presentation of a sight draft. A credit must not be issued available by draft drawn on the Applicant (i.e. the demand must be made to the issuer, not the customer);

     

  3. Article 7 – The issuer is irrevocably bound to honour payment as of the time of issuance of the credit.  The stipulated documents are required to be presented to the issuer and provided they comply, the issuer is obliged to pay;

     

  4. Article 10 – A credit cannot be amended or cancelled without the consent of the issuer and the beneficiary;

     

  5. Article 17 – at least one original of all presentation documents stipulated in the credit must be presented, along with copies, if required;

     

  6. Article 31 - Partial Drawings are permitted;

     

  7. Article 33 – Drawings may only be permitted during banking hours;

     

  8. Article 36 – The issuer is not responsible to pay if the inability to pay results from defined acts of force majeure.

What is a Surety Bond?

A surety bond is also a three party agreement between an Obligee (in our case, the municipality), a Principal (the developer) and the Surety (the issuer).9  A surety bond obligates the Surety to answer for the debt or default of the Principal.10  Under a surety bond, the Surety is primarily liable to the Obligee for the debt. As between themselves, the obligations of the Principal and the Surety to the Obligee are joint, several and primary.11 As between the Surety and the Principal, the Principal is primarily responsible for the debt or default of the Principal and the Surety is secondarily responsible.12  However, a Surety Bond is not a form of insurance. One key feature of a Surety Bond is that the liability to pay or perform only exists on the part of the Surety to the extent of the default and actual damages sustained.13

Typically, surety bonds (if they are performance bonds (i.e. surety bonds posted to ensure performance and the most likely to be used by municipalities)) will require the Surety to first determine whether there has been a default under the underlying contract before they will pay out.14 This contemplates a much more active role for the surety as compared with an issuer of a letter of credit wherein the obligation to pay arises on demand rather than default. While the primary concern of a bank, for example, in issuing a letter of credit might be with respect to the creditworthiness or solvency of the principal, in the case of a surety bond the surety must additionally be concerned with whether the Principal is actually capable of performing its obligations in the underlying contract. This will usually require an investigation and then a determination as to whether the Surety agrees with the Obligee that there has in fact been default.  Principals are then required to indemnify the Surety in the event that the Surety must pay out to the Obligee.15 In the event of default, the Surety steps in to ensure that the work is completed.  Typically, a Surety has options when there is default:  it can pay the original Principal to complete the work, it can contract out with someone else to complete the work, it can complete the work itself or it can pay any penal sum provided for in the Bond.16  

Conclusion

As is evident from the above discussion, surety bonds and irrevocable standby letters of credit operate in very different ways and can have very different legal (and financial) impacts on the parties involved. Part 2 of this article, which will appear in the next issue, will examine the advantages and disadvantages of using both instruments in the municipal context. In particular the article will explore the possibility that surety bonds might gain more widespread use by looking at examples from US jurisdictions and a case study of an Ontario municipality where a modified surety bond was recently employed.

 FOOTNOTES

  1. Robinson v New Home Warranty Program, 1994 CanLII 7260 (ON SC), 18 O.R. (3d) 269, [1994] O.J. No. 915
  2. Bank of Nova Scotia v Angelica-Whitewater Ltd. 1987 CanLII 78, [1987] 1 SCR 59
  3. Ibid.
  4. Ibid.
  5. Ibid.
  6. K. McGuinness. The Law of Guarantee, 2d ed (Scarborough: Carswell, 1996)
  7. Uniform Customs and Practice for Documentary Credits Publication No. 600, Paris: International Chamber of Commerce, 2007
  8. Supra, at note 2
  9. Supra, at note 6
  10. Ibid
  11. Ibid
  12. Ibid
  13. I. Goldsmith & T.G. Heintzman. Canadian Building Contracts. 4t ed. Loose-leaf (Toronto: Carswell, 2007)
  14. Ibid
  15. Ibid
  16. Ibid

Related people

All Insights

All Insights