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A Standby Letter of Credit (SBLC / SLOC) is a guarantee that is made by a bank on behalf of a client, which ensures payment will be made even if their client cannot fulfill the payment. It is a payment of last resort from the bank, and ideally, is never meant to be used.
An SBLC is frequently used as a safety mechanism for the beneficiary, in an attempt to hedge out risks associated with the trade. Simplistically, it is a guarantee of payment which will be issued by a bank on the behalf of a client. It is also perceived as a “payment of last resort” due to the circumstances under which it is called upon. The SBLC prevents contracts going unfulfilled if a business declares bankruptcy or cannot otherwise meet financial obligations.
Furthermore, the presence of an SBLC is usually seen as a sign of good faith as it provides proof of the buyer’s credit quality and the ability to make payment. In order to set this up, a short underwriting duty is performed to ensure the credit quality of the party that is looking for a letter of credit. Once this has been performed, a notification is then sent to the bank of the party who requested the Letter of Credit (typically the seller). In the case of a default, the counter-party may have part of the finance paid back by the issuing bank under an SBLC. Standby Letters Of Credit are used to promote confidence in companies because of this.
There are many aspects that a bank will take into consideration when applying for a Standby Letter of Credit, however, the main part will be whether the amount that is being guaranteed can be repaid. Essentially, it is an insurance mechanism to the company that is being contracted with.
As it is insurance, there may be collateral that is needed in order to protect the bank in a default scenario – this may be with cash or assets such as property. The level of collateral required by the bank and by the size of the SBLC will largely depend on the risk involved, and the strength of the business.
There are other standard due diligence questions asked, as well as information requests regarding assets of the business and even possibly the owners. Upon receipt and review of the documentation, the bank will typically provide a letter to the business owner. Once the letter has been provided, a fee is then payable by the business owner for each yeah that the Standby Letter of Credit remains outstanding.
It is standard for a fee to be between 10-15% of the SBLC value. In the event that the business meets the contractual obligations prior to the due date, it is possible for an SBLC to be ended with no further charges.
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.
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.
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.
Yes – if it is a transferable letter of credit and it is a deferred instrument then this may be likely. 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.
In order to issue a standby letter of credit, a bank will typically require a pledge of cash as collateral. There is a fee that is collected for this service, which is usually priced at a percentage of the letter of credit value.
The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs the way in which these instruments operate.
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.
When there is 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.