Introduction to standby Letters of Credit | 2024 Guide
Standby Letter of Credit
What is standby letter of credit
A standby letter of credit is a crucial financial tool that offers security and assurance in various business transactions. By providing a reliable guarantee of payment, it helps facilitate trust and confidence between parties, especially in situations involving large sums of money or complex contracts. Its structure, combined with its independent nature and documentary requirements, ensures that it serves as an effective mechanism for mitigating risks and ensuring contractual performance.
Purpose and Function
The primary purpose of a standby letter of credit is to serve as a safety net or a guarantee. It is essentially a promise from the issuing bank to cover the beneficiary’s losses if the applicant fails to fulfill their contractual obligations. Unlike traditional letters of credit used primarily for trade finance, an SBLC is often used in non-trade scenarios, such as performance bonds, bid bonds, and other contractual guarantees.
Structure and Issuance
Issuance: An SBLC is issued by a bank on behalf of a client (the applicant). The bank guarantees that it will pay the beneficiary if the applicant defaults on their obligations. The issuance process involves a thorough assessment of the applicant’s creditworthiness and the underlying contract.
Irrevocability: Generally, an SBLC is irrevocable. This means that once issued, it cannot be modified or canceled without the consent of all parties involved—the issuing bank, the applicant, and the beneficiary. This irrevocability ensures that the bank’s commitment remains firm.
Documentary Requirements
Demand for Payment: The beneficiary can draw on the SBLC if the applicant fails to perform as agreed. To make a claim, the beneficiary must present certain documents to the issuing bank. These documents typically include a demand for payment and any other evidence required under the terms of the SBLC.
Document Review: The issuing bank reviews the submitted documents to ensure they comply with the SBLC’s terms and conditions. If the documents are in order, the bank will make the payment to the beneficiary. If there are discrepancies or issues with the documents, the bank may refuse payment, though this is usually rare if the documents meet the specified criteria.
Payment Mechanism
Triggering Payment: The payment under an SBLC is triggered by the presentation of the required documents and a valid claim. Unlike other types of credits where payment is contingent on the presentation of goods or services, an SBLC payment is contingent on the demonstration of non-performance or breach of contract.
Settlement: Upon verifying the documents, the issuing bank will pay the beneficiary the amount specified in the SBLC. This payment serves to compensate the beneficiary for any losses incurred due to the applicant’s failure to meet their obligations.
Independence and Autonomy
Autonomy Principle: One of the defining features of an SBLC is its independence from the underlying contract. The bank’s obligation to pay is not influenced by disputes or issues related to the underlying agreement between the applicant and the beneficiary. This principle ensures that the bank’s commitment is purely based on the terms of the SBLC itself.
Legal Framework: The operation and enforcement of SBLCs are governed by various international standards, including the ICC Uniform Customs and Practice for Documentary Credits (UCP 600) and the International Standby Practices (ISP98). These rules provide a structured framework for the issuance, amendment, and enforcement of standby letters of credit.
Applications
Performance Guarantees: SBLCs are commonly used as performance guarantees in construction and service contracts, where they assure the beneficiary that the applicant will fulfill their contractual obligations.
Bid Bonds: They are also used as bid bonds in competitive bidding processes, ensuring that the winning bidder will enter into a contract and perform as promised.
Financial Guarantees: SBLCs can provide financial guarantees for various purposes, including securing loans or leases.
How can you apply for a Standby Letter of Credit?
There are many aspects that a bank will take into consideration when applying for a Standby Letter of Credit, however, the main part will be whether the amount that is being guaranteed can be repaid. Essentially, it is an insurance mechanism to the company that is being contracted with.
As it is insurance, there may be collateral that is needed in order to protect the bank in a default scenario – this may be with cash or assets such as property. The level of collateral required by the bank and by the size of the SBLC will largely depend on the risk involved, and the strength of the business.
What are the fees for Standby Letters of Credit?
It is standard for a fee to be between 1-10% of the SBLC value. In the event that the business meets the contractual obligations prior to the due date, it is possible for an SBLC to be ended with no further charges.
What is the difference between SBLCs and LCs?
A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.
Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.
How do SBLCs work in Cross-Border trade?
Where goods are sold to a counter-party in another country, they may have used an SBLC to ensure their seller will be paid. In the event that there is non-payment, the seller will present the SBLC to the buyer’s bank so that payment is received.
A performance SBLC makes sure that the criteria surrounding the trade such as suitability and quality of goods are met.
We sometimes see SBLCs in construction contracts as the build must fulfill many quality and time specifications. In the event that the contractor does not fulfill these specifications then there is no need to prove loss or have long protracted negotiations; the SBLC is provided to the bank and payment is then received.