Standby Letter of Credit: A Backup Plan for Payment

Safety Net
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A standby letter of credit (SBLC) can add a safety net that ensures payment for a completed service or a shipment of physical goods. With such an arrangement, a bank guarantees payment to a beneficiary if something fails to happen. The SBLC describes the conditions that would cause the bank to pay.

A bank providing a letter of credit should be a disinterested third party. If the bank's customer fails to satisfy specific terms of an agreement, the bank—not the customer who failed to deliver—pays the beneficiary. Because it is credit, the customer ultimately is responsible for repaying the bank.

SBLCs, like standard letters of credit, are useful for international trade as well as domestic transactions like local building projects. Should something unforeseen prevent terms of a deal to be completed, the SBLC ensures financial obligations to a beneficiary are met.

Examples

There are two main types of SBLCs—those that are financial-based and those that are performance-based:

  • Financial: An exporter sells goods to a foreign buyer, who promises to pay within 60 days. If the payment never arrives, the exporter can collect payment from the foreign buyer’s bank per the terms of the SBLC. Before issuing the letter, the bank typically evaluates the buyer’s credit and determines that the business will repay the bank. For customers whose credit is in question, banks may require collateral or funds on deposit for approval.
  • Performance: A contractor agrees to complete a construction project within a certain timeframe. When the deadline arrives, the project is not complete. With an SBLC in place, the contractor’s customer can demand payment from the contractor’s bank. That payment functions as a penalty to encourage on-time completion, funding to bring in another contractor to take over mid-project, or compensation for the headaches of dealing with problems.

How the Process Works

An importer makes a deal with a vendor to ship him 10,000 widgets on open credit. The vendor wants to protect her organization against the importer failing to deliver on his promises and asks him to obtain a letter of credit as part of their agreement.

The importer asks his bank for an SBLC, and because he has excellent credit and collateral, the bank issues the letter and sends it to the vendor's bank. She reviews the letter to make sure it is acceptable and decides to proceed with the deal.

If the importer fails to meet his obligations, the vendor submits documentation to the importer's bank as required by the SBLC. The importer's bank then pays the vendor, and the importer will have to repay his bank.

Security Provided

By making a third-party bank responsible for payment, the beneficiary becomes more confident that she'll get paid. Using an export transaction as an example, there are numerous reasons why the buyer might not pay:

  • The buyer has a cash-flow crunch and is waiting on payment from his own customers.
  • The buyer goes out of business.
  • The buyer's assets get frozen due to political instability or unrest.
  • The buyer is unhappy with the seller.
  • The buyer is dishonest.

A bank is financially more stable than most buyers, and the bank does not concern itself with disputes between buyers and sellers. Instead, the buyer and seller agree to certain conditions that trigger payment, and the bank follows directions if those events occur.

An SBLC must be paid as long as the beneficiary meets the letter’s requirements and the bank is still in business. If the beneficiary is worried about the issuing bank’s financial stability, she can request a confirmed letter of credit. In that case, a bank that the beneficiary trusts guarantees the payment on behalf of another, less-trustworthy bank.

SBLCs Vs. Other Letters of Credit

An SBLC is similar to a standard letter of credit: A bank promises to pay a beneficiary as long as the beneficiary provides documents and meets the requirements of the letter of credit. Still, there are key differences:

  • Backup plan: An SBLC is a safety net. Like most safety nets, the goal is to avoid using it. When somebody gets paid with an SBLC, it means something went wrong. With a standard letter of credit, on the other hand, everybody involved hopes and expects that payment will occur. For example, those letters pay when an exporter successfully delivers a shipment to an importer.
  • Performance aspect: SBLCs also are unique because they can include a performance component—or negative performance, if you prefer. If a service is not performed, the beneficiary gets paid.
  • In-country: SBLCs are used frequently for domestic transactions. Those might include everything from building projects to receiving electricity services. Commercial letters of credit are more common in international trade.

Obtaining an SBLC

If you need an SBLC, ask your bank to issue one. You most likely need to work with the bank’s commercial division or international trade department. Be sure to take plenty of time to understand how the process works and what circumstances make you responsible for payment. Hire an experienced attorney to review the documents with you.

If you want somebody else to use an SBLC, demand it as part of your agreement and insist on an irrevocable letter of credit. Be sure to work closely with your bank and your attorneys to understand the specific conditions for collecting payment. Letters of credit are complicated, and meeting all of the requirements is difficult. If you fail to meet a minor requirement, you might lose your right to receive payment, which could prove disastrous.

Article Sources

  1. Federal Deposit Insurance Corp. "Off-Balance Sheet Activities." Section 3-8. Accessed April 3, 2020.