Standby Letter of Credit: A Backup Plan for Payment

Safety Net
••• A standby letter of credit is like a safety net: hopefully you'll never use it. Alberto Ruggieri/Illustration Works/Getty Images

Letters of credit come in several varieties. A standby letter of credit provides even more protection than standard letters of credit in situations when a backup plan is helpful. Whether the payment is for a completed service or a shipment of physical goods, things can go wrong in any transaction.

What Is a Standby Letter of Credit?

A standby letter of credit is an arrangement where a bank guarantees payment to a "beneficiary" if something fails to happen. The bank issues a document describing the conditions under which the letter will be paid.

Standby letters of credit, like standard letters of credit, are useful for international trade as well as domestic transactions like local building projects.

A letter of credit provides a promise from a bank, which is presumably a disinterested third party. If the bank's customer fails to do something (like pay on time, complete a project on time, or satisfy certain 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.

Examples

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 a standby letter of credit) the exporter can collect payment from the importer’s bank. The bank evaluates the importer’s credit before issuing the letter of credit, and the bank believes that the importer will repay the bank. Sometimes banks require collateral 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 might work 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.

How the Process Works

  1. 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.
  2. Jill does not want to take the risk of Jack failing to deliver on his promises, so she asks Jack to obtain a letter of credit as part of their agreement.
  3. Jack asks his bank for a standby letter of credit. Because he has sufficient credit and collateral, the bank issues the letter.
  4. Jack’s bank sends the letter to Jill’s bank.
  1. Jill reviews the letter of credit to make sure it is acceptable, and decides to proceed with the deal.
  2. 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).
  3. 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 putting a bank on the hook for payment, the beneficiary can be more confident that she'll actually 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. 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 financial stability of the issuing bank, 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 unique?

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, that might mean an exporter successfully delivered 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 getting electricity services. Commercial letters of credit are popular for international trade.

In addition to standby letters of credit, several other types of letters of credit exist.

How to Get a Standby Letter of Credit

If you need a standby letter of credit, ask your bank to issue one. You most likely need to work with somebody in the bank’s commercial division or international trade department. Be sure to take plenty of time to understand how the process works and under what circumstances you’ll be responsible for payment. Have an attorney review the documents with you.

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 what you need to do to collect payment. Letters of credit are notoriously complex, and meeting all of the requirements is difficult. If you don’t meet all of the requirements exactly, you won’t get paid.