What is a Standby Letter of Credit?

A Stand By Letter of Credit (‘SBLC’) is in many respects seen as a guarantee that is provided to a potential buyer or contractor. An SBLC is payable when called upon by the beneficiary and may be used in international trades or could sit as an element of a construction contract.

How can a contractual SBLC be used?

An SBLC can be used as a safety mechanism in a contract for service. A reason for this will be to hedge out risk. In simple terms, it is a guarantee of payment which will be issued by a bank on the behalf of a client and which is perceived as the “payment of last resort”. This will usually be called upon when there is a failure to fulfill a contractual obligation.

The use of an SBLC is usually a sign of good faith in a transaction, to provide proof of the buyer’s credit quality and ability of payment. To set up this mechanism, a short underwriting duty is performed to ensure the credit quality of a party that is looking for a letter of credit, a notification is then sent to the bank of the party who requests the Letter of Credit (who is typically a seller).

The value of an SBLC is the ability to show the credit quality of a company and to repay loans. An SBLC is very much seen as an insurance policy to assist with fulfilling the obligations of a business if they stop operating, there is an insolvency situation and it cannot fulfil payment obligations for any reason.

SBLCs as used to promote confidence in companies, those receiving investment or a funding line. In the case of a default, the counter party may have an element of the finance paid back by the issuing bank under an SBLC.

How can you apply for a Standby Letter of Credit?

The main element that a bank will take into consideration in relation to an SBLC is showing that the amount they guarantee can be repaid. It is an insurance mechanism to the company that is being contracted with. Thus, there may be collateral that is needed in order to protect the bank in a default scenario – this may be cash or assets, such as property. The level of collateral required by the bank and size of SBLC will depend on the risk factors and strength of the business.

Standard due diligence questions are asked as well as information requests surrounding assets of the business and possibly the owners. Following receipt and review of the documentation, the bank typically provides a letter to the business owner. A fee is then payable by the business owner for each year that the SBLC remains outstanding.

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 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 fulfil many quality and time specifications. In the event that the contractor does not fulfil 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.

Standby Letter of Credit: Frequently Asked Questions

What is a negotiable or transferrable letter of credit?

Letters of credit are sometimes referred to as negotiable or transferrable. The issuing bank will pay a beneficiary or a bank that is nominated by the beneficiary. As the beneficiary has this power, they may ‘transfer’ or ‘assign’ the proceeds of a letter of credit to another company.

Can a letter of credit also be discounted (like an invoice)?

Yes – if it is a transferable letter of credit and it is a deferred instrument then this may be likely e.g. payable after 90 days; then a beneficiary may assign it to be payable to a funder. This is so that the funder will provide the beneficiary with a discounted value just after the terms of the letter of credit have been fulfilled.

How can you fund a Standby Letter of Credit?

In order to issue a standby letter of credit, a bank will typically require a pledge of cash as collateral or other assets. There is a fee that is collected for this service, which is usually priced at a percentage of the letter of credit value.

How are Letters of Credit governed?

The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs the way in which these instruments are to operate.

Could there be non-payment under an SBLC?

An SBLC will be paid in the event that the bank providing the instrument is still in operation and the beneficiary meets the criteria under the letter.

What if the bank fails or I don’t trust it?

If there is a genuine worry that the bank will not pay out, then a confirmed letter of credit may be used. This will be where a ‘stronger’ bank confirms the letter of credit.

BACK TO THE START >> Letters of Credit Guide

Back to Top