What is a Standby Letter of Credit?
A standby letter of credit is a secondary payment instrument. It acts as an additional layer of security to the suppliers (the second party) in case of non-performance of the contract. The issuing banks offer an additional cushion to the receivers of LC on default payments. These are secondary guarantee instruments that work on defaults or non-compliance to certain contract terms only.
A Standby Letter of Credit is a legal obligatory document that ensures payment by the issuing bank to the suppliers. These are irrevocable and confirmed types of LC. These are one of the most commonly used LC types along with Standard (irrevocable) LCs.
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How a Standby Letter of Credit Works
The working mechanism for a standby LC is usually simpler than a standard LC. As it is used as cover and the issuing banks normally issue such LCs to creditworthy clients only. International traders sometimes require additional security with large contracts. The buyers may request to the issuing bank for an LC that enhances their credibility and help them secure better contract terms.
Features of a Standby Letter of Credit
A standby letter of credit covers only the secondary legal obligation in case of default. By characteristics, it serves as irrevocable and confirmed collateral for the suppliers. If the buyers face liquidity crises or sudden trade losses, the suppliers can secure payments through banks. Large corporate clients enjoy higher creditworthiness but may go bankrupt or their assets can be ceased with legal actions. A standby LC can then become backup or insurance against the default.
Usually, a letter of credit is used in international trades. The Standby LC also comes with a special type of financial and performance LC. The performance LCs can help negotiate better contractual terms for domestic parties. A standby performance LC protects both parties as it covers the obligation on performance completion. After completion of large projects, the first party may become financially unable to meet the remaining balances.
Types of Standby Letter of Credit
A standby letter of credit can take several forms as it is used solely as a secondary obligation. However, it remains a contractual obligation in case of non-compliance to the primary contract. Some common types of Standby LC are given below.
Performance Standby LC
It provides the contractual security to the first party on performance compliance from the client as agreed on the contract terms. The performance terms can be delivery of goods under certain conditions or completion of projects within specific dates. In the case of the client (or supplier) failing to meet the due performance, the issuing bank may reimburse the standby LC to cover losses for the issuer (or buyer).
Performance standby LCs are usually helpful in large projects that come with phased completion. The first party may face a financial crunch with changing project costs or lower profits due to unforeseen circumstances. Unfinished projects also serve a bad reputation to the clients. A performance standby can cover the project costs for the first party, in case the supplier or contractor fails to meet the obligation.
Financial Standby LC
A financial standby letter of credit can work in several forms of contractual and financial obligation. It ensures that payment or repayment is made as agreed upon by the two parties. A financial standby in international trade means the suppliers will receive confirmed payments even if the buyer defaults on the financial obligation. Domestic trade or financial contracts may include repayment of borrowed money, business loan advances, down payments, or insurance claims.
A financial standby letter of credit is the most commonly used type of LC. The generalized benefits of a standby LC arise mainly from a financial standby documentary credit.
Other Types of Standby LC
Some other less common types of standby LC include the following types.
- Advance Payment Standby: Required when buyers make large advance payments or down payments to the suppliers. It covers the repayment terms of advance payments only. The Standby LC is irrevocable even if the supplier fails to provide the goods or complete the project.
- Commercial Standby: It covers the secondary obligation on any losses arising other than the primary contract between the two parties. If the buyer (importer) fails on other financial obligations, a commercial standby may recover the payments for the supplier (exporter). These standby LCs come in handy with direct trade contracts outside of the primary LC coverage.
- Counter Standby: It is issued in favor of the advisory (second). It serves as a cover to the other bank on default of financial obligations rather than the main parties.
- Direct Pay Standby: Unlike other standby LCs, direct pay can cover the primary financial obligation. It does not necessarily have to relate with a financial or performance default. It also reduces payment risks.
When does a Business Need Standby Letter of Credit?
A standby letter of credit works more like a bank guarantee than a primary LC. Many importers and domestic issuers use it to enhance their reputation. An additional cover offers them better-negotiating powers. A financially strong and creditworthy business can negotiate better sales contract terms, prices, and timely delivery of goods.
As there are several types of standby LC, a business may consider utilizing any of them. A standby LC may be required by the business in various conditions as:
- As an additional guarantee for the exporter or second party
- Contractually binding the supplier after advance payments on performance and financial obligations
- Securing the project completion confirmation
- It may act as an alternative to large advance payments
- It may act as collateral to secure other financing options with banks
- A standby letter of credit increases the buyer’s credit profile
- It is frequently used in domestic projects unlike other types of LCs
- It may be used to cover the insurance costs of large projects
Advantages of Standby Letter of Credit
A standby letter of credit works well as a secondary financial cover for the exporters. Usually, it covers the default risk but can be used as a primary cover too. Its varied functionality with performance, financial, and advance payment features provide added layers of financial security. A financial standby covers default risks of importers; a performance standby can cover losses for the buyers.
Banks working as third-party have to make the standby LC payments in case of default only. They can still charge the applicants though. The working complexities involved in the Standby LC are fairly simpler than other LC. Banks may also issue a counter standby to provide an extra cover to other banks such as an advisory bank.
Conclusion
A standby letter of Credit works as a secondary legal instrument covering the default risks. Its varied types of features make it handy in both domestic and international trade contracts. In addition, its financial and performance features can provide additional layers of financial security to both parties in the contract. Its working requirements and documentation are simpler than the primary letter of credit.
