How to use Standby Letters of Credit

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A Standby Letter of Credit is a written obligation of a bank to guarantee payment of a third party. I used the verb “guarantee” since a standby letter of credit is a bank guarantee under another name. Until 1996 banks were not allowed to issue guarantees but only letters of credit. Judges originally invented this no-guaranty rule for banks influenced by how banks were chartered. Under a letter of credit, a bank makes payment against presentation of certain documents. To turn a letter of credit into a guarantee, the beneficiary of the standby only had to present a document availing himself of the guarantee (“Pay me, today! ”).

In 1996 the US Office of the Comptroller of the Currency issued Federal Register / Vol. 61, No. 28 § 7. 1016 Independent undertakings to pay against documents and § 7. 1017 National bank as guarantor or surety on indemnity bond, thus allowing banks to issue guarantees. However, customers were so accustomedto their standbys that they only cautiously used the new-fangled offering called “bank-guarantee”.

Who are the parties to the standby letter of credit? (1) The Applicant: The customer of a bank who applies for a standby letter of credit. (2) The Issuing Bank: This is the bank that issues the standby letter of credit.

(3) The Beneficiary: The party in whose favor a bank issues the standby or guarantee.

Following the rules about letters of credit sometimes additional banks are involved in the transaction. (4) Confirming Bank: A bank (usually located near the beneficiary) that agrees (confirms) to pay the beneficiary rather than have the issuing bank pay the beneficiary. The obligation of the confirming bank is independent of the Issuing Bank, that means that the Confirming Bank cannot refuse payment claiming it has not received payment from the Issuing Bank.

(5) Advising Bank: This bank can be a well-paid mailman which advises the Beneficiary that the Issuing Bank has issued a standby to his benefit.

What are standbys typically used for? (1) Performance Guarantee. This instrument supports an obligation to perform other than to pay money, e. g. obligation to maintain or repair an industrial installation. (2) Advance Payment Standby. This instrument supports an obligation to account for an advance payment made by the beneficiary to the applicant. (3) Bid Bond/Tender Standby. This standby supports an obligation in the applicant to execute a contract in the event the applicant is awarded a bid.

(4) Insurance Standby. This instrument is an insurance or reinsurance obligation of the applicant.

(5) Commercial Standby. This is the most used standby and it supports the obligations of an applicant to pay for goods or services in the instance of non-payment by a business debtor.

According to which rules are standbys processed?
The ICC issued the International Standard Practices in 1998 (ISP 1998, ICC-Publ. Nr. 590). These rules however have never really been accepted by the banking community. Furthermore, standbys can still be issued in accordance with the ICC issued UCP 600 (Uniform Customs and Practices for Documentary Credits, ICC-Publ. Nr. 600). Article 1 UCP 600 states in this regard:

“The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 (“UCP”) are rules that apply to any documentary credit (“credit”) (including, to the extent to which they may be applicable, any standby letter of credit). ”

The limited applicability stems from the fact that rules regarding stale shipping documents are extraneous to a guarantee transaction. In fact, the majority of the UCP 600, which deals mostly with the issuance of shipping documents, is not applicable to standby letters of credit.

Click here, if you want to find out more about trade finance and letters of credit visit the letter of credit forum which has more articles and lively users who can answer any question.

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