Standby Letter of Credit

How a Standby Letter of Credit Protects You

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

Things can go wrong in any transaction, so it's nice to have a backup plan. Whether the purchase is for a completed service or a shipment of physical goods, a standby letter of credit can provide protection.

What Is a Standby Letter of Credit?

A standby letter of credit is a document issued by a bank. This document serves as a guarantee: the bank promises to pay a "beneficiary" if something fails to happen.

Standby letters of credit, like standard letters of credit, can be used for international trade as well as domestic transactions in your home country.

The letter of credit provides security from the 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.

Example of a financial standby LOC: an exporter sells goods to a foreign buyer who promises to pay within 60 days. If the payment never comes (and a standby letter of credit was used) the exporter can collect payment from the importer’s bank. The importer’s bank has already evaluated the importer’s credit, and the bank assumes (or hopes) that the importer will repay the bank. Sometimes collateral is required to get the letter as well. This is an example of a financial standby letter of credit.

Example of a performance standby LOC: a contractor agrees to complete a construction project within a certain timeframe. When the deadline arrives, the project has not been completed. If a standby letter of credit was used, the contractor’s customer can collect payment from the contractor’s bank (those funds might serve as a penalty, funding to bring in another contractor to take over mid-project, or "something for your time").

This is an example of a performance standby letter of credit.

The process works like this:

  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 perhaps Jack promises 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
  5. Jill reviews the letter of credit to make sure it is acceptable, and decides that it is
  6. If Jack fails to meet his obligations, Jill submits documentation to Jack’s bank as required by the letter of credit (possibly using her bank or other banks as intermediaries)
  7. 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.

Who do you Trust More?

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, including:

  • The buyer has a cash-flow crunch and is waiting on payment from his own customers
  • The buyer has gone out of business
  • The buyer's assets have been frozen in political 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 will be paid as long as the beneficiary meets the letter’s requirements and the bank is still in business.

If the beneficiary is concerned about the stability of the bank, a confirmed letter of credit can also be used. The beneficiary just needs to have faith in the confirming bank.

Differences between a Standby Letter of Credit and a Letter 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 produces documents and meets the requirements of the letter of credit.

What’s the difference? 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.

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.

Finally, standby letters of credit are used frequently for domestic transactions. Those might include everything from building projects to getting the electricity turned on. Commercial letters of credit are most often used in international trade.

There are other varieties as well. Read about different types of letters of credit.

How to Get a Standby Letter of Credit

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