How Standby Letters of Credit Work
The numbering is commensurate with that shown in the extract below.
1. As with any other trade transaction, an underlying sale contract is agreed between the exporter (seller) and importer (buyer). For the purpose of our example, the contract provides for settlement to be made in an agreed manner and for the issuance of standby to act as security for the exporter in the event of non-payment by the importer, despite the exporter complying with the conditions of the contract.
2. The importer applies to its bank for the issuance of standby in favour of the exporter.
3. Assuming the bank is willing to proceed, e.g., a credit facility exists for such issuance, the standby is issued and advised through a bank in the country of the exporter. At this point, the exporter is referred to as the beneficiary of the standby, and the importer is referred to as the applicant.
4. The standby is advised to the beneficiary. If confirmation has been requested, and added, this will form part of the advice that is sent to the beneficiary.
At this point, the beneficiary should ensure that the conditions of the standby reflect suitable security for it to proceed to perform under the contract. The standby is held by them as security, in the event it becomes necessary to make a claim thereunder.
For example, the standby should (a) be for the amount that may become due under the sale contract; (b) have an expiry date that extends beyond the completion of the contractual terms, including any period in which the applicant would be required to pay by the agreed means; and (c) clearly indicate the document(s) that is/are to be presented in order to demand payment thereunder.
Different Types of Standby
We can assist you with a wide variety of types of Standby Letter of Credit. This are more commonly seen in trade finance transactions. Common Ones are listed below. Most of these will be familiar to those acquainted with demand guarantees.
Performance – agreeing to undertake, deliver and/or complete contractual obligations.
Advance Payment – undertakes repayment of all or part of a percentage of the value of a contract that has been paid by the beneficiary to the applicant as a down payment, advance payment, or deposit, upon the signing of the contract.
Bid or tender bond – ensures a bidder (applicant) cannot alter its tender proposal, or withdraw from the tender process before the tender is awarded.
Counter – a standby issued by one bank, in favour of another bank, to support the issuance of a standby, guarantee, documentary credit or other forms of the undertaking, by that other bank.
Financial – supports a financial obligation to pay or repay.
Insurance – reinforces applicant obligations with respect to insurance or reinsurance activity.
Direct-pay – not necessarily related to default and is likely to be the primary means of payment rather than secondary which is normally the case.
Commercial – acts as a security for payment of goods or services not settled by a buyer under other arrangements i.e., via open account trading or documentary collection.
Benefits and attributes of a Standby
- A standby is often used to cover, and to mitigate, the many risks that can occur in finalising a contract between a buyer and seller. The benefits and attributes of a standby include:
- Independence from any underlying contract.
- Provision of security.
- Protection against non-performance of obligations, as opposed to a performance which results in non-payment (as is covered by instruments such as documentary credits i.e., with the shipment of goods and presentation of complying documents).
- Can cover financial or non-financial obligations.
- Can be used for cross-border or domestic transactions.
- Contains many of the characteristics of a documentary credit e.g., independent from the underlying contract, payment made only if certain conditions are fulfilled, issued by banks, subject to a set of international rules.