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A Standby Letter of Credit (SBLC) is an irrevocable, independent undertaking by the issuer, on behalf of their client, in favour of a beneficiary, stating that an agreed-upon amount will be paid to the beneficiary if the issuer’s client fails to fulfil their obligations to the beneficiary under a separate underlying contract upon presentation of a valid claim by the beneficiary to the issuer as per the terms of the SBLC.
Essentially, an SBLC performs the exact same function as a Demand Guarantee in that it provides a similar independent, irrevocable undertaking by the issuer.
SBLCs are passive instruments as they tend to “standby” in the background and are only claimed upon when things go wrong in the separate underlying contract between the beneficiary and their counterparty i.e. when the beneficiary’s counterparty defaults in their obligations.
In practice, most SBLCs are never claimed on and simply expire on the specified expiry date, as there was no default in the underlying contract between the beneficiary and their counterparty.
Different types of SBLCs can be issued to support any type of underlying contract as long as the issuer is comfortable supporting their client in relation to the particular commercial transaction. Most applicants and beneficiaries would be familiar with the various SBLC types which include:
- Advance Payment,
- Bid/tender bond,
Some considerations, tips and best practices that corporates whether as applicants requesting the issuance of an SBLC or as beneficiaries of an SBLC, need to bear in mind are:
Applicant / Beneficiary relationship
The Applicant should have a comfortable relationship with their counterparty (i.e. the intended beneficiary of the SBLC) as most SBLCs only require a simple demand statement for payment to be made so there is a risk of improper drawing.
The applicant can mitigate any concerns about potential improper drawing by agreeing with their counterparty to incorporate a requirement for the beneficiary to provide advance notice of any intended claims to the applicant. Documentary evidence of such notice (e.g. copy of email) would need to be included with any claim presented to the issuer.
This offers the applicant advance notice of the intended claim as well as the opportunity to rectify the matter with the beneficiary and potentially means the beneficiary may no longer need to present a claim to the issuer.
Contract terms and Standby Letters of Credit
Ensure that the terms of the relevant contract are aligned with those of the Standby Letter of Credit (SBLC), particularly in relation to any payment demands. This is crucial, as the banks assess the beneficiary’s claim solely based on the terms specified within the SBLC document. Payment will be made by the bank as long as the claim adheres to these specified terms.
Specifically, for the beneficiary, it’s important to check that the Standby Letters of Credit terms meet their requirements i.e.:
- Can they provide the claim in the manner specified within the terms of the SBLC, bearing in mind that the issuer will not payout if the claim does not comply with the terms of the SBLC;
- Is SBLC expiry date sufficient or appropriate to cover relevant aspects of the underlying contract?
- Ensure there are no clauses within the SBLC that require their claim to be dependent on approval from/be countersigned by the applicant or their representative. This would be detrimental to the beneficiary should there be a dispute and the applicant refuses to provide the required approval.
Standby Letters of Credit issuer
While the applicant would approach their own bank for the SBLC issuance, the beneficiary needs to ensure they are comfortable with the bank issuing the SBLC in terms of country risk and credit rating. If not, they can either have the SBLC confirmed by an acceptable bank or reissued by a local bank in their own country.
Caution with open-ended expiries
Applicants need to be mindful of the implications of requesting SBLCs with either open-ended expiries or just “expiry events”. Such SBLCs essentially have no fixed expiry date, which can create challenges should there be a need to cancel the SBLC and the beneficiary is unable to be reached to provide the required consent.
The applicant can avoid any potential challenges with an open-ended Standby Letter of Credit by agreeing with their beneficiary to have an “Evergreen/automatic extension” clause in the SBLC. This means there is an initial fixed expiry which is automatically extended for specific periods without the need for amendments.
It will continue to be extended until such a time as a non-renewal notice is sent to the beneficiary in accordance with the notice period stated in the SBLC terms or until any stated final expiry date (where applicable).
As long as the issuer notifies the beneficiary of their intention to cancel the SBLC within the stated agreed notice period, the SBLC can be cancelled on that expiry without any need to receive consent from the beneficiary.
With “expiry events”, the best practice is to also include a fixed expiry date and state that the Standby Letter of Credit terminates upon the earliest occurrence of either the expiry event or the specified expiry date.
Please note, the above does not apply to Customs bonds.
Appropriate governing rule
It is common to see Standby Letters of Credit issued subject to UCP600, even though this rule is more applicable to Commercial Letters of Credit. Most often, this is because the parties are used to mentioning UCP600. However, it is worth noting that there are elements of an SBLC that are not covered by UCP600, and aspects of the UCP600 that are simply not applicable to SBLCs and may create avoidable challenges.
It is recommended that applicants and beneficiaries have their SBLCs issued subject to ISP98 which has rules that are more precise and specifically tailored to SBLCs.
Given the complexity of this topic, corporates should always speak with the SBLC/Guarantees specialists in their banks who will provide them with the relevant support and expertise required for their specific SBLC needs.