Standby Letter of Credit: New Amazing Introduction

Introduction

Look at a scenario where a person wants to complete a construction project. You have a contract with a contractor who initially resisted doing business with you because he didn’t know you and was worried about getting scammed. Still, you gave them a standby letter of credit and a safety mechanism. Now the contractor agrees, and he is happy and relieved.

But how? Let’s understand.

What is a Standby Letter of Credit (SBLC)?

A standby letter of credit is a legal document that guarantees a bank’s payment commitment to a seller in such a case where the buyer defaults on the agreement and the seller demands payment from the bank.

This standby confirmed letter of credit assures the seller that the amount will be paid irrespective of the circumstances, according to the agreement and that no risk is involved.

This instrument is irrevocable and hence can’t be changed or cancelled without the permission of both parties.

Parties Involved in a Standby Letter of Credit

The following parties are involved in a standby letter of credit:

• Advising Bank – When a beneficiary requests for SBLC, the issuing bank can either send the SBLC directly to the beneficiary or decide to send the SBLC through another bank with whom the beneficiary has a relationship. In the latter case, the bank that receives the SBLC from the issuing bank becomes the advising bank. 
• Applicant – This is the entity that applies for SBLC and which initiates the process involved in the SBLC issuance. 
• Beneficiary – This is the undertaking party that receives all benefits associated with SBLC. Here, the beneficiary has the right to receive payments and accept or reject any amendments related to SBLC. 
• Confirming Bank – The confirming bank gets involved at the request of the issuing bank. Once requested, the confirming bank becomes the second issuing bank and confirms the SBLC. Further, the confirming bank undertakes to pay a complying document presentation in relation to the SBLC as well. 
• Issuing Bank – This is the bank that issues an irrevocable, independent, and separate SBLC on the applicant’s behalf. 

How to Get a Standby Letter of Credit?

To obtain an SBLC, the buyer requests for SBLC from the bank or financial institution, then by which the bank assesses the buyer’s creditworthiness and performs due diligence. If it doesn’t seem to meet the standards, the bank may ask the buyer for the collateral, in the form of a fund or asset, based on the level of risk as a last resort.

Once the background checks are done and verified, the bank promises payment by issuing SBLC to the buyer, who is then given to the seller, and if the amount is not paid, the seller can present the SBLC to the buyer’s bank and get his payment. 

The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits usually govern how SBLC operates.

How do Standby Letters of Credit Work?

Once the buyer and seller get into a contract, the buyer requests the SBLC from a bank (called an issuing bank) which then intimates the advising bank (called as seller’s bank) about an SLBC being issued, which further communicates it to the seller. The contract is executed.

In the event that the buyer fails to pay, the issuing bank processes the payment to the seller after receiving the copy of the bill of lading, unpaid invoices, and a written statement of non-payment from the buyer.

They are frequently used in domestic transactions, irrespective of the nature of the business.

What is the Cost of SBLC?

SBLC cost varies from 1-10% of the amount issued SBLC. It is charged yearly to the time the SBLC is charged and is subject to extension. However, if the payment has been made before, it can be cancelled without additional charges.

Main Types of SBLC

Financial SBLC

Used as a guarantee for payment due to the seller’s goods and services as per the contract.

For example: If a seller has shipped to you from a foreign country and the buyer defaults on the payment, then the seller can present the financial SBLC to the buyer and irrespective of the buyer defaults, the seller can collect payment. 

Performance SBLC

Performance SBLCs ensure performance when the service provider fails to complete his work or any non-financial contractual obligations.

This will guarantee the completed service and compensate you as a safety net, depending on the circumstances.

Advance Payment SBLC

Acts as a guarantee for a client who makes an upfront payment that his project will be completed as per the contractual terms. 

Bid bond/ Tender SBLC

Acts as a security in case the party defaults on completion of the project after he has been awarded the tender to the bid for it. 

Counter SBLC

Commonly known as a backstop or protective SBLC, this is issued by a letter of the credit provider from one country to another to request them to issue a local undertaking to the beneficiary and supported by a separate SBLC. SBLC is typically issued in international transactions, and since SBLC is issued in another country, it holds less value than if issued in the beneficiary’s country.

A counter SBLC is especially common in the following scenarios:

• Where the beneficiary demands/requires a local SBLC/guarantee.
• Where the beneficiary demands/requires a local bank to issue a final undertaking. 
• Where the guarantee/undertaking must be subject to laws outside of the issuer’s policies. 

Direct Pay SBLC

The issuer honours the draft by paying the beneficiary as soon as the requirements of the documents are met. The payment might or might not be related to performance or financial default. 

Clean SBLC

In this kind of SBLC, only a bill of exchange or a draft is required to be presented without any supporting statements. From the issuer’s perspective, this may be considered the riskiest form of SBLC since the beneficiary can draw for any reason, giving rise to the possibility of improper drawing. Therefore, this type of SBLC is not common. 

Insurance SBLC 

This kind of SBLC helps in supporting the applicant in cases where they have committed to the insurance but failed to make any payment. Here, SBLCs help distribute insurance risks among insurance companies by using SBLCs as collateral. 

Advantages and Disadvantages of SBLC

Advantages

• Secure Contracts – SBLC provides the client with easy and convenient access to financial coverage, both internationally and domestically, and ensures that the parties involved can fulfil their financial obligations. This facilitates international trade by assuring guaranteed payments and bridges the gap between two countries (buyer and seller) due to different laws and regulations. 
• Reduced risk of default – SBLCs help offer assurance against any non-payment since the beneficiary can claim payment without having to prove the underlying contract. 
• Currency stability – SBLCs help reduce the risk of currency fluctuations and political instability, which can affect international transactions. 

Disadvantages

• Standby Letter of Credit only protects the seller.
• Fraudulent Demands – One of the main risks of SBLCs, is that they have the potential for fraudulent demands from beneficiaries. In such cases, the applicant can lose the SBLC amount. 
• Difficult to obtain and/or renew – This is especially the case if the financial situation or credit rating of the applicant has deteriorated. In such cases, the issuing bank is unwilling to provide an SBLC. 
• Expensive – Having an SBLC can be expensive for applicants since they are required to make payments to the issuing bank. Additionally, security deposits might sometimes be necessary, which adds to the costs. 

Key Differences Between a Standby Letter of Credit and a Bank Guarantee

SBLC has a limited scope since it is only used for long-term contracts and primarily for international transactions. However, bank guarantees have broader scope since they are used for both long-term and short-term contracts and domestic and international transactions. SBLC provides protection to receive payment against the sellers as the only party, while bank guarantee protects both parties. SBLC has to adhere to banking protocols, while bank guarantees are subject to civil law.

Standby Letter of Credit vs Bank Guarantee

Standby Letter of Credit Examples

Sonya, a Miami-based homeowner (foreign buyer), wants to purchase 1000 Bohemian bags from Mark, an Indian resident, but Mark wants assurance that Sonya will make the timely payments. Obliging to this request, Sonya approaches the bank, and the bank issues an SBLC, which Sonya passes to Mark.

If Sonya fails to make payments or faces a cash flow crunch, Mark can still get his payment from the bank that issued the SBLC.

What is a Letter of credit?

LC, also known as a payment guarantee letter and credit letter, is a standard document that guarantees a seller that payment will be made and all contractual obligations will be met.

LC charges range from 0.75% to 1.50%, depending on the amount involved. Letter of credit is issued for a short term, expiring in 90 days, while SBLC is commonly issued for more than a year. 

In an SBLC, UCP600 or ISP98 governs the instrument and provides default resolutions where SBLC is silent. However, in the case of a Bank Guarantee, the Uniform Rules for Demand Guarantees (URDG 758) governs and provides for the default resolutions. Usually, default resolutions are referred to in the following cases where the SBLC/Guarantee is silent:

• Force Majeure situations
• Document examination period and approach
• Confirmation
• Payment tenors
• Required notifications to an applicant
• Governing law and jurisdiction
• Replacement of an undertaking lost by a beneficiary
• Terminology differences

Key Regulations and Codes Governing SBLCs

• International Standby Practice (ISP98) – ISP has been approved and endorsed by the International Chamber of Commerce (ICC). It is a set of rules that, if incorporated into an undertaking with direct reference to ISP98 or ICC publication 590, would deem the undertaking to be an SBLC. 
• Uniform Customs and Practice (UCP 600) – UCP has been developed by the International Chamber of Commerce (ICC) Banking Commission. It is a set of rules that, when incorporated into an undertaking, deem the undertaking a letter of credit. These are more common in commercial letters of credit. 
• Uniform Rules for Demand Guarantees (URDG 758) – These are a set of rules which, when incorporated into an undertaking, deem the undertaking to be a demand guarantee. 

How Do You Monetize a Standby Letter of Credit?

Monetization means raising money from legal instruments like SBLC, drafted to raise cash. 

Let’s understand this problem with an example. 

You need $1000 urgently and request your bank issue an SBLC (a bank instrument) of $1200. You transfer the SBLC through swift or other trending platforms (monetizer) and ask for cash against it. To monetize, after performing the due diligence and verifying the instrument, the monetizer issues 70-80% of the face value of that instrument to you instantly or within a few weeks.

After one year, the monetizer will submit this legal instrument to the issuing bank and demand $1200 from the bank.

In another case, the monetizer can use the standby letters in case the applicant fails to make the payment by the due date, despite the completion of the project outlined. In such a case, SBLC works as a letter of monetization.

However, before transferring it to monetization, you must take care of the following things: 

• SBLCs need to be issued by top-rated AAA banks, and SBLCs issued by unrated banks are rejected or require a corresponding bank
• The face value of the financial instrument should not exceed five million dollars, and it must be valid for at least 11 months before expiration.

Conclusion

Standby letter of credit relieves the worries of new businesses that cannot have overseas clients who are afraid of losing money and cannot compete with bigger and well-known competitors. SBLCs allow people to transact stress-free and to have overseas clients, even when large amounts of money are involved, in good faith.

Frequently Asked Questions (FAQs)

What is an example of SBLC?

Sonya, a Miami-based homeowner (foreign buyer), wants to purchase 1000 Bohemian bags from Mark, an Indian resident, but Mark wants assurance that Sonya will make the timely payments. Obliging to this request, Sonya approaches the bank, and the bank issues an SBLC, which Sonya passes to Mark.

If Sonya fails to make payments or faces a cash flow crunch, Mark can still get his payment from the bank that issued the SBLC.

What is a Letter of credit?

LC, also known as a payment guarantee letter and credit letter, is a standard document that guarantees a seller that payment will be made and all contractual obligations will be met.

LC charges range from 0.75% to 1.50%, depending on the amount involved. Letter of credit is issued for a short term, expiring in 90 days, while SBLC is commonly issued for more than a year. 

What are evergreen clauses in SBLCs?

The Evergreen Clauses allow SBLC’s expiration date to be extended further for a fixed period of time automatically. Further, these clauses provide the applicant with an exit period (where the issuer notifies the beneficiary about the issuer’s intention not to extend the SBLC), wherein it becomes possible for the SBLC to expire with a simple cancellation notification instead of an amendment. 

Is it possible to borrow an SBLC?

This depends on the policies of the lending institutions. In some cases, borrowing an SBLC may be allowed by providing some additional documentation.