Trade Credit Letter of Credit Magazine Section

standby letter of credit

WHAT IS A STANDBY LETTER OF CREDIT (SLOC)

A Commercial (or Trade) Letter of Credit (L/C,LOC , LC) is generally constructed in such a way that it can be drawn-on only after the required product is shipped by the seller against presentation of stipulated documents to the nominated bank. This type of L/C imposes ‘performance-for-payment’ criteria on the seller.  The beneficiary (seller) has to ‘perform’ by submitting the required documents in a given time frame to a bank in order to get paid. These commercial letters of credit primarily facilitate foreign trade payment transactions.

On the other hand, a Standby Letter of Credit (SLC, SBLC or SLOC) serves as a back-up and a secondary payment mechanism. The trigger for payment in a Standby L/C is usually a ‘default’ on part of the applicant (buyer) which then permits the beneficiary (seller) to draw under the letter of credit. The SLOC is used as a payment of last resort should the buyer of goods or services fail in fulfilling their financial or performance obligation. Since ‘default’ is the trigger for payment and not ‘performance’, SLOC is also known as a "non-performing letter of credit" as it is often intended to be drawn on only when the applicant for whom it is issued fails to perform an obligation for the beneficiary.

The Issuing Bank of the letter of credit is obliged to make payment even if the applicant (buyer) claims to have paid the beneficiary (seller) or performed, provided the beneficiary submits complying documents under the Standby L/C which is usually a sight draft, proof of default and a written demand for payment.

Fundamental Mechanics of a SLOC:

  • A Seller and a Buyer enter into a contract for the sale of goods or services on open account basis and on credit terms. Let’s say ‘Net30 days’.
  • Terms of Sale also require that the Buyer provide to the Seller a SLOC from their bank.
  • Buyer (the Applicant of the SLOC) approaches their bank (Issuing Bank) and applies for an irrevocable SLOC with the Seller named as the beneficiary. {Buyer pays a fee to issuing bank. The Issuing bank gets into some form of reimbursement agreement with the applicant (the buyer).  Mostly this is the regular credit facility or line of credit that the applicant has with its bank which is typically secured by the operating assets of the applicant (the buyer)}.
  • The Issuing bank issues the SLOC with an expiry date of 1 year.
  • Buyer (the applicant) delivers the SLOC to Seller (the beneficiary).
  • Seller delivers goods to Buyer on open account basis. In the normal course of business the buyer keeps paying the seller on Net 30days basis (as contracted). The seller keeps the SLOC only as ‘Standby’( as its name suggests) in the event that the buyer defaults on payment.
  • However, if Buyer defaults (i.e. does not pay as per terms), the Seller then presents the SLOC to the issuing bank along with any documents called for in the SLOC (that typically indicate that a default has occurred).
  • Issuing bank must pay the Seller (the beneficiary) for the default in payment by the buyer.
  • Let’s say that the seller did not have to present the SLOC for a year and the SLOC has expired. Going forward, the Seller will have to solicit a new SLOC from the buyer.

Standby letters of credit are typically used as a substitute for poor credit worthiness, performance guarantees, or to guarantee loans, mortgages, leases granted by one firm to another, thereby securing payment to the seller (creditor) in the event the buyer (debtor) fails to perform on his obligation on the due date. For a creditor it is a strategically smart way to leverage the credit power of their receivable portfolio.

Most commonly SLOC they are used for Performance Bonds, Advance Payment Guarantees, Bid Bonds, Warranty Bonds and to secure financial obligations of obligors.

SLOC can be used for following purposes:

  • To back-up the seller obligations if they do not perform in accordance with the terms of contract.
  • To ensures guarantee of payment after a contract or bid has been awarded.
  • To act as advance funds to the seller by the buyer for purchase of materials for certain project.
  • As a back-up obligations of underwriting.
  • As an assurance assures that a project will run smoothly after completion until warranty period.
  • As a collateral for loan. (It also helps in negotiating a lower interest rate on the loan).
  • For improving credit ratings of bonds, notes, securities or any kind of commercial paper supported by SLOC.

Both SLOC and Guarantees obligate the Issuing Bank to make payment to the beneficiary in the event of a default. However, the distinction between a Guarantee and SLOC is attributable to the rules and laws under which the instrument is issued. Guarantees are generally subject to local laws while SLOC are issued subject to Uniform Customs and Practice Rules (UCP) or International Standby Practice Rules (ISP).

Articles 1 of UCP 600, states that the UCP600 set of rules are also applicable to standby letter of credit.

However, in 1998 the International Chamber of Commerce (ICC) added ISP98 (International Standby Practices 98) as the rules to guide exclusively for Standby letters of credit. It is observed that majority of the SLOCs are subjected to UCP 600 and very few to ISP 98.

Example to illustrate the use of a Standby Letter of Credit:

A Canadian importer of chemicals, Glopec Inc., has signed a one-year contract with a supplier in India, Concord Chemicals Ltd. Concord agrees to sell the chemicals on open account basis to Glopec Inc in Canada. The average off-take of Glopec is valued at USD $10,000/month. Under the open account arrangement, the payment terms are Net 30 days. To guarantee payment, the exporter/seller (Concord Chemicals Ltd) requests that the importer/buyer (Glopec Inc) open an Irrevocable Standby Letter of Credit with an expiry date of one year from the date of issue, be issued in favour of Concord Chemicals Limited for USD $10,000.

Sample Standby Letter of Credit from Glopec Inc’s (Importer) bank in Canada

TO: (…ADVISING BANK…in India) [since the Seller is in India]

FROM: THE CANADIAN BANK [Buyer’s bank in Canada]

AT THE REQUEST OF OUR CUSTOMER,  Glopec Inc

WE THE CANADIAN BANK, GLOBAL TRADE FINANCE-DIVISION, 10 BLOOR ST, CALGARY, ALBERTA, CANADA T2C 1S1

HEREBY ISSUE IN YOUR FAVOUR OUR IRREVOCABLE STANDBY LETTER OF CREDIT IN THE TOTAL AMOUNT OF USD 10,000

WE AUTHORIZE YOU TO DRAW ON THIS BRANCH UNDER THIS STANDBY LETTER OF CREDIT IN THE FORM OF A DEMAND FOR PAYMENT WHICH DEMAND WE SHALL HONOUR WITHOUT ENQUIRING WHETHER YOU HAVE A RIGHT AS BETWEEN YOU AND THE CUSTOMER TO MAKE SUCH DEMAND AND WITHOUT ACKNOWLEDGING ANY CLAIM OF THE CUSTOMER.

PROVIDED, HOWEVER, THAT YOU ARE TO DELIVER TO US AT THE ABOVE ADDRESS, THE FOLLOWING DOCUMENTATION:

  • YOUR SIGHT DRAFT DRAWN ON US
  • THE ORIGINAL OF THIS STANDBY LETTER OF CREDIT AND ANY AMENDMENTS (IF ANY)
  • COPY OF UNPAID INVOICES
  • ACERTIFICATE PURPORTEDLY SIGNED BY AN AUTHORIZED OFFICER OF YOUR COMPANY STATING THAT Glopec Inc IS IN DEFAULT AND THAT THE MONIES DRAWN BY YOU ARE DUE AND PAYABLE TO YOU BY BENEFICIARY

PARTIAL DRAWINGS ARE PERMITTED

IT IS EXPRESSLY UNDERSTOOD THAT NEITHER THIS STANDBY LETTER OF CREDIT NOR ITS PROCEEDS ARE TRANSFERABLE OR ASSIGNABLE TO ANY THIRD PARTY

THIS STANDBY LETTER OF CREDIT IS ISSUED SUBJECT TO UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY CREDIT, 2007 REVISION ICC PUBLICATION NO. 600.

THE ABOVE DOCUMENTATION MUST BE PRESENTED AT THIS BRANCH ON OR

BEFORE 3:00 P.M. OUR TIME ON _(Date: one year from the date of issue)_, AT WHICH TIME THIS STANDBY LETTER OF CREDIT SHALL EXPIRE.

 Author: Puru Grover © Credit Guru Inc | CreditGuru.com

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