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Standby Letters of Credit Explained
A Standby Letter of Credit (SLOC) is seen as a financial guarantee and is used regularly in cross border trades. It is important to explain first what a Letter of Credit (LC) is and then move on to the explanation of an SLOC. The reasons these mechanisms are in place is due to allowing the flows of international trade to work in a sustainable and secure way.
In relation to LCs, typically we see a buyer and seller open Letters of Credit and when the terms within such LC are fulfilled, it will permit an international trade to take place. The main points of interest relate to loading vessels/modes of transport, title documents, specification of goods. They allow trust within international trade, so that when conditions are fulfilled – a trade can be established. This allows large flows of goods around the world to be managed and permits trust to be built up. Thus when conditions are fulfilled, payment is then released and made.
An SLOC differs from a typical LC. In contrast to an LC, an SLOC acts is a guarantee of payment that is issued by a bank on behalf of a client or borrower as a “payment of last resort” if the client fails to fulfil a contractual commitment with another company.
The reason to have an SLOC is as proof of the good faith element in a business transaction, which displays the clients’ ability to re-pay and their credit quality. The financier who issues an SBLC usually does it on the basis that it is a guarantee and will not be drawn upon.
A typical example is seen within a building contract – where one party agrees to provide a bond or SLOC for 10% of the amount of the contract. This allows the other party to feel comfortable that if there is a condition or specific trigger that is not fulfilled, then they can draw upon this mechanism embedded within the contract.
A potential borrower will approach their bank and apply for an SLOC; there is then a short underwriting process to make sure that the quality of the applicant is satisfactory. The aim of an SLOC is to assist in completing business activities if a company ceases trading, payment cannot be made or there is an insolvency event.
SLOCs are usually seen as a guarantee to back up a potential investment or show that the owner of a company is able to re-pay a loan. It may be a requirement of the financial institution that collateral needs to be posted in the case of a default or calling of the SLOC. There is usually a fee from the borrower for this services which is charged yearly. In terms of the price, it will usually be 1-10% of the value of the SLOC value per annum and in the event that the policy that an applicant is guaranteeing against is fulfilled prior to the end date, then there is the possibility to cancel the SLOC at no later cost.
An SLOC is used within international trade or high value agreements where the outcome may be a dispute and the potential of litigation and further action may be difficult to enforce. This may be due to jurisdictional or related enforcement difficulties.
An SLOC will in effect guarantee that payment to the ultimate beneficiary or intended recipient of funds will be made. On a commodities transaction where there is the agreement to pay for the underlying goods in 60 days and this is not made then with an SLOC; having the backdrop of a financial guarantee allows it to be called upon if the agreed conditions are not fulfilled. This is usually done on presentation of the SLOC to the financial institution that has provided it.
There are intricacies that are needed to be understood within this system, as a performance SLOC will have further details and specifications within the document. It may specify that elements have to be met, such as the value, quality, time, are all fulfilled to a level of acceptance to the client. In the event that any of these specifications are not met, then a funder will pay the beneficiary when this performance SLOC is presented to the funder. This is usually seen in the building industry where a developer has guaranteed that a project will be finished in a certain number of days.
We see this as a loan of last resort and guarantees payment on behalf of a client. It is in effect, a promise that the bank fulfills the payment obligations at the end of an agreement if the borrower is not able to do so.
It promotes trust in transactions as it mitigates risk of non-payment or a business closing down. It will allow repayment ability and credit quality to increase.
What are the different types of Standby Letters of Credit?
A performance SLOC pre-determines the specifications of a contract, by setting out the non-financial contractual obligations such as the quality, value, fees and timing element are to be fulfilled. In the event that the specifications are not fulfilled the funder will be called upon to make payment.
Financial standby letters of credit ensure financial contractual obligations are fulfilled. We see them most frequently in bulk purchase orders and trades with cross border elements where payment protection is difficult to receive.
To get an SLOC it will be the same process of getting a standard loan and there will need to be proof of the creditworthiness to the financial institution. For a creditworthy client, the shortest time scales quoted are usually a week to two weeks. It is thus seen as much quicker than the processing times on a standard loan.
It is important to note that in the event that an SLOC is paid out, it will be the issuer or ultimate borrower who will be required to re-imburse the financial institution.
1. Bid Guarantees (referred to as bid bonds)
2. Retention Guarantees
3. Performance Guarantees (referred to as performance bonds)
4. Advance Payment Guarantees
a. Cash flow is enhanced and no other security is needed to be put up
b. May allow diversification in cash cycle with prepayment not needed
c. The use of bid bonds allows lucrative contracts to be won by providing security
SLOCs come from the banking legislation of the United States, which prevents US credit institutions from taking on the obligations in relation to guarantees of third parties. This was the reason for the creation of SLOC, which are based on the uniform customs and practice for documentary credits.
In 1998 the International Chamber of Commerce (ICC) added ISP98 (International Standby Practices 98) to act as the guidelines underpinning these financial products. However, many still use the ICC’s older guide, Uniform Customs and Practices for Documentary Credits, 2007 revision, ICC Publication 600.
– An applicant is the ‘borrower’ who requests the guarantee. In order to do, he provides collateral to the financial institution to prove credit worthiness. There will also be an annual fee; as outlined above
– The Issuing Bank provides the guarantee by way of an SLOC
– The beneficiary is the party who the guarantee is in favour of
– The confirming bank is the bank that confirms to pay the beneficiary as an alternative to the issuing bank making payment. The confirming bank will collect the amount that is owed from the Issuing Bank and the beneficiary will pay the confirming bank to do this
– The advising bank acts as a representative of the beneficiary and may accept an LC on behalf of the beneficiary; and collect on it. In some circumstances, the advising bank may be the confirming bank
We usually talk about the ‘proceeds’ of the SLOC and the beneficiary is able to do this. However, only the original beneficiary may exercise the drawer rights under the instrument and demand payment unless something different is agreed.
Only when the beneficiary has demanded payment, will the assignee then receive the proceeds (after an assignment has taken place). The Issuing Bank will need to be provided with notice or the issuing bank would pay funds to the original beneficiary and not the new assignee. Conversely, the only way an SLOC can be transferred is with consent of the written agreement of both the beneficiary and the issuing bank.
Read our Letter of Credit Guide here
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