Standby Letter of Credit: A Backup Plan for Payment
Things can go wrong in any transaction. With a standby letter of credit in place, you may be able to protect yourself by adding a safety net that ensures payment. Whether the fee is for a completed service or a shipment of physical goods, a standby letter of credit may be a smart option.
What Is a Standby Letter of Credit?
A standby letter of credit is an arrangement in which a bank guarantees payment to a "beneficiary" if something fails to happen. To do so, the bank issues a document which describes the conditions that will cause the bank will pay.
A letter of credit provides a promise from a bank, which should be a disinterested third party. If the bank's customer fails to do something (like pay on time, complete a project on time, or satisfy specific terms of an agreement) the bank—not the customer who failed to deliver—pays the beneficiary. Ultimately, the funds come from the customer who applies for the letter of credit, but the bank is responsible for paying the recipient.
Standby letters of credit, like standard letters of credit, are useful for international trade as well as domestic transactions like local building projects. The key to a standby letter of credit is that something typically fails to happen.
Financial standby LOC: An exporter sells goods to a foreign buyer, who promises to pay within 60 days. If the payment never arrives (and the exporter required the buyer to use a standby letter of credit) the exporter can collect payment from the importer’s bank. Before issuing the letter of credit, the bank typically evaluates the importer’s credit and determines that the importer will repay the bank. But if the customer’s credit is in question, banks may require collateral (or funds on deposit) for approval.
This is an example of a “financial” standby letter of credit.
Performance standby LOC: A contractor agrees to complete a construction project within a certain timeframe. When the deadline arrives, the project is not complete. With a standby letter of credit 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. This is an example of a “performance” standby letter of credit, and a failure to perform triggers the payment.
How the Process Works
- Jack and Jill make a deal. Perhaps Jack is an importer who wants Jill to ship him 10,000 widgets on open credit, or Jack could be a contractor promising to build a bridge for Jill’s city by next August.
- Jill wants to protect her organization against Jack failing to deliver on his promises. As a result, she asks Jack to obtain a letter of credit as part of their agreement.
- Jack asks his bank for a standby letter of credit. Because he has excellent credit and collateral, the bank issues the letter.
- Jack’s bank sends the letter to Jill’s bank.
- Jill reviews the letter of credit to make sure it is acceptable, and decides to proceed with the deal.
- If Jack fails to meet his obligations, Jill submits documentation to Jack’s bank as required by the letter of credit (typically using her bank or other banks as intermediaries).
- Jack’s bank pays Jill (again, possibly indirectly), and Jack will have to repay his bank.
For a visual demonstration of the process, see an example of how money and documents move.
Why Standby Letters of Credit Provide Security
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 that 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.
A standby letter of credit 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.
Differences Between a Standby Letter of Credit and Other Letters of Credit
A standby letter of credit is similar to a standard (or “commercial”) letter of credit: The bank promises to pay a beneficiary as long as the beneficiary provides documents and meets the requirements of the letter of credit. So, what makes standby letters of credit different from other types, such as a sight letter of credit?
Backup plan: A standby letter of credit is a safety net. Like most safety nets, the goal is to avoid using it. When somebody gets paid with a standby letter of credit, it means something went wrong. With a commercial 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: Standby letters of credit are also 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: Standby letters of credit are frequently used for domestic transactions. Those might include everything from building projects to receiving electricity services. Commercial letters of credit are more common in international trade.
In addition to standby letters of credit, several other types of letters of credit exist.
How to Obtain a Standby Letter of Credit
To make a payment: If you need a standby letter of credit, 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 what circumstances make you responsible for payment. Hire an experienced attorney to review the documents with you.
To receive payment: If you want somebody else to use a standby letter of credit, 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 notoriously 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.