Standby letters of credit (SBLCs) are a way to add security and ensure payment for completed services or physical goods. A bank will guarantee payment to the beneficiary in case of a failure. The SBLC outlines the conditions under which the bank would be required to pay.

The bank issuing the letter of credit must be an impartial third party. The bank pays the beneficiary if the bank’s client fails to meet the terms of a contract. Due to the fact that it is credit, ultimately the customer is responsible for repaying a bank.

 

Like standard Letters of Credit they are useful in international trade and domestic transactions such as local building projects. SBLCs ensure that financial obligations are met to beneficiaries in the event of an unforeseen circumstance.

 

Example

SBLCs can be divided into two types: those that are based on financial performance and those that are based on performance.

 

• Financial The exporter sells his goods to an overseas buyer who promises to make payment within 60 days. The SBLC stipulates that if the payment does not arrive, the exporter may be able to collect the money from the bank of the foreign buyer. The bank will usually evaluate the credit of the buyer before issuing a letter. They determine that the business can repay the bank. Banks may ask for security, or money on deposit to approve customers whose credit has been questioned.
• Performance An agreement is made by a contractor to complete a project in a specified time frame. The project will not be completed when the deadline is reached. The contractor’s client can request payment through the contractor’s bank with an SBLC. This payment can be used as a reward for completing a project on time, to fund the hiring of another contractor mid-project or to compensate you for dealing with issues.

The Process

A vendor agrees to deliver 10,000 widgets at open credit terms. Vendor wants to protect their organization from the importer not delivering on his promises. She asks that he obtain a letter credit as part of the agreement.

 

The vendor asks for an SBLC from the importer’s bank. Because the importer has excellent Credit, the bank sends the letter to the vendor. She checks the letter and confirms that it’s acceptable before deciding to go ahead with the transaction.

 

The SBLC requires that if the importer does not meet his obligations, then the vendor must submit the required documentation to the bank of the importer. The vendor is paid by the bank of the importer, who will then have to reimburse his bank.

 

Security Provided

The beneficiary will feel more secure if she can rely on a third party bank to pay her. As an example, a buyer may not pay for an export transaction.

 

• The buyer is in a financial bind and has to wait for payment from customers.
• The buyer ceases to exist.
• A buyer’s assets are frozen because of political instability or unrest.
• The buyer is not happy with the seller.
• The buyer is dishonest.

 

Banks are more financially stable than buyers. They do not get involved in disputes between buyers or sellers. The buyer and seller instead agree on certain conditions that trigger payments, and the bank then follows instructions if these events happen.

 

SBLCs must be paid so long as both the beneficiary and bank are still operating. A confirmed letter of credit can be requested by a beneficiary who is concerned about the financial stability of the issuing bank. A bank that is trusted by the beneficiary will guarantee the payment for another bank.

 

SBLCs vs. other Letters of Credit

SBLCs are similar to standard letters of credit. A bank will pay a recipient as long as they provide documents and meet the requirements. There are some key differences.

 

• A backup plan: The SBLC is an SBLC. The goal of an SBLC is to prevent its use. If someone gets paid using an SBLC it is a sign that something went wrong. A standard letter of credit is different. Everyone involved expects payment. These letters, for example, pay when the exporter delivers a shipment successfully to an importer.
• Performance Aspect: SBLCs are also unique in that they can include an element of performance–or a negative performance if you prefer. The beneficiary is paid if a service was not provided.
• Within the country: SBLCs can be used for domestic transactions. These could include anything from receiving electricity to building projects. International trade is more likely to use commercial letters of credit. 1

 

How to obtain an SBLC

Ask your bank for an SBLC if you need one. Most likely, you will need to contact the commercial division of your bank or its international trade department. Take your time to learn how the payment process works, and under what circumstances you are responsible. You can hire an attorney to go over the documents.

 

Insist on a letter of credit if you insist that someone else use an SBLC. Work closely with your attorney and bank to fully understand the conditions of payment. It is not easy to meet all the requirements of a letter of credit. You could lose your right to payment if you don’t meet a small requirement. This can be disastrous.