Standby Letter of Credit – Is it a backup plan for ensuring payment

You can’t deny the fact that things may go wrong anytime during any transactions and hence standby letters of credit are kept in place to add a safety net on payments and transactions. Regardless of whether the fee charged is for the shipment of physical goods or a standby letter of credit, a standby letter of credit can always a wise and smart option for a buyer and a seller.

Standby Letter of Credit

Standby Letter of Credit – What is it?

If you don’t know what a standby letter of credit is, it is an arrangement where the bank warrantees payment to its beneficiary in case the latter is not able to pay due to some unforeseen and unavoidable issue. In order to do so, the bank issues a letter where the terms and conditions are described where the bank will be liable to make the payment.

Through a letter of credit, a promise is provided from the bank’s end and this needs to be a disinterested third party. In case the customer of the bank fails to make payments on time or complete a deal on time or satiate the terms of a specific agreement, the bank will be liable to pay the beneficiary on behalf of the customer. However, the funds actually come from the customer who has applied for this LC but the bank becomes responsible for paying the recipient.

Standby letters of credit, just as standard LCs are used especially for international trade and also for domestic transactions like building projects. Nevertheless, the key to such a letter of credit is that something drastic happens due to which the customer is unable to make payments.

Standby letters of credit – How they enhance security

When the beneficiary makes a third-party bank liable for payments, she becomes even more confident about receiving payments. If you use an export transaction for example, there are several reasons why a buyer might not be able to pay. Check them out:

•   The buyer is going through a financial crunch and is waiting for his customers to make     payments to him.
•   The buyer has recently gone out of business.
•  The buyer is not satisfied with the seller.
•  The assets of the buyer get frozen due to political unrest.
• The buyer is found to be dishonest.

It goes without mentioning that a bank is anytime more stable that majority buyers and it doesn’t get involved in disputes between sellers and buyers. Rather than engaging in such petty issues, the seller and the buyer agree to few conditions that trigger payment and the bank follows directions whenever such events occur. A standby letter of credit should be paid provided the beneficiary meets the requirements of the letter and the bank is still in full action.

Standby letters of credit vs. other letters of credit

In most ways, a standby letter of credit is similar in features to a standard LC. But what makes it different from the other types like sight letter of credit?

ü  Backup for payments: A standby LC plays the role of a safety net. Whenever someone is paid with a standby LC, this would mean that something went wrong. On the contrary, with a commercial letter of credit, the parties involved will expect that the payments will occur. Such letters pay when the exporters deliver a shipment to the importer successfully.

ü  In-country: Most often, standby letters of credit are utilized for domestic transactions like obtaining electricity services, completing building projects. For such reasons, commercial letters of credit have become more common for facilitating international trade. 

ü  Performance aspect: Standby letters of credit seem to be unique as they have performance component or negative performance. In case the service isn’t performed, the beneficiary receives the payment.

So, if you require a standby letter of credit, you have to speak to your bank to issue one. You have to work out a plan with the commercial division of the bank or their department of international trade. However, make sure you take enough time to understand the way the process works and on what situations the bank will be responsible for making payments. Try to hire a reliable attorney who can review documents.