A Standby letter of credit (SBLC) is a guarantee of payment by a bank on behalf of their client. It is a loan of last resort in which the bank fulfills payment obligations by the end of the contract if their client cannot.
The standby letter of credit is never meant to be used, but prevents contracts from going unfulfilled in the event your company closes down, declares bankruptcy, or is unable to pay for goods or services provided. Standby letters of credit help prove a business’ credit quality and repayment abilities.
A standby letter of credit (SBLC) is a financial instrument used primarily in international trade and domestic construction projects. The SBLC is issued by a bank on behalf of the buyer and guarantees that the seller (beneficiary) will receive payment upon the presentation of specified documents in the event the buyer fails to pay the beneficiary according to the terms of the contract.
A guarantee issued by a bank or a financial institution to pay a beneficiary on a client’s behalf in a situation where the applicant defaults, is known as a standby letter of credit. This was developed as a consequence of legal limitation put by the US regulator on the bank’s authority for issuing guarantees.
A standby letter of credit is considered quite suitable for a wide range of secure payments making it quite a flexible tool. Most commonly, it is used for international trade purposes for providing assurance to the party that it will receive the payment whatever the case it. Having said this, there are quite a few complexities involved in a standby letter of credit. This suggests that it is necessary to have a consultation with an expert in case complete information is not available regarding the procedure.
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There are certain types of a standby letter of credit which are mentioned below:
- A direct-pay standby
- A performance standby
- A bid-bond or tender-bond standby
- An advance-payment standby
- A financial standby
- A counter standby
- A commercial standby
- An insurance standby
Performance standby letters of credit ensure the nonfinancial contractual obligations (quality of work, amount of work, time, cost, etc.) are performed in a timely and satisfactory manner. If these obligations are not met, the bank will pay the third party in full.
Performance standby letters of credit are irrevocable undertakings by a bank to make a payment to the beneficiary in the event that the purchaser fails to perform a nonfinancial contractual obligation. These are considered “transaction-related contingencies” that are converted at 50 percent of the total transaction amount. In practice, performance guarantees often have a stipulated obligation on the face of the standby letter of credit. Performance standby letters of credit, for example, may be issued to a developer to guarantee a contractor’s satisfactory fulfillment of a construction contract. If, for example, the purchaser guarantees the beneficiary to perform some service or to pay a financial penalty for failure to perform, the fact that there is a financial penalty makes it a financial, rather than performance, standby letter of credit, even though the deficient performance triggers the demand.
Financial standby letters of credit ensure financial contractual obligations are fulfilled. Most SBLCs are financial.
Financial SBLCs are often required when performing international trade or other large purchase contracts under which other forms of payment protections (such as litigation in the event of non-payment) can be difficult to obtain.
Standby letters of credit are either financial standby letters of credit or performance standby letters of credit. Financial standby letters of credit are irrevocable undertakings by a bank guaranteeing the beneficiary repayment of the purchaser’s financial obligation. The bank’s guarantee that it will pay an underwriter’s obligation to repay Lloyd’s for insurance losses is a financial standby letter of credit. All financial standby letters of credit have a 100 percent conversion factor. Whatever is owed is paid in full.
Irrevocable Nature of Standby Letters of Credit
An essential characteristic of a standby letter of credit is that it is irrevocable, making it functionally nearly the same as cash. Once issued, the buyer cannot revoke it except in the rare instance of fraud that’s proved in court. The irrevocability of the standby letter of credit is what makes it a powerful financial instrument that allows the purchaser to benefit from the use of funds that the bank guarantees the beneficiary will receive upon a later contingent demand.
How to Obtain a Standby Letter of Credit
The standby letter of credit process is similar to that of obtaining a commercial loan, with a few key differences.
As with any business loan, you will need to provide proof of your creditworthiness to the bank. However, the SBLC approval process is much quicker, with letters often being issued within a week of all paperwork being submitted.
Standby letters of credit can help establish trust with your business partners and be a powerful tool to help meet your business goals. Talk with your banker about how you can use a standby letter of credit for your business.
Requirements for Standby Letters of Credit
As with standard letters of credit (LOCs), SLOCs can come with a variety of requirements beyond that of the buyer paying upon presentation of substantiating documentation. It is best for the buyer to consult with an international shipping specialist on the appropriate “requirement” language to incorporate into the SLOC to assure that all the interests and concerns of the buyer are included and protected.
A Standby Letter of Credit Example
Say a company underwrites $500,000 of insurance written by Lloyd’s of London. Instead of requiring the underwriter to deposit funds at Lloyd’s, the company accepts a bank-issued standby letter of credit. The bank charges the underwriter for the guarantee and requires her to either keep funds equaling the amount of insurance underwritten on deposit or to give the bank unconditional control over her stock account with equivalent or greater assets. If the underwritten policies suffer losses that the underwriter fails to repay, Lloyd’s demands payment from the bank, which then liquidates that amount from the underwriter’s stock account.