What is a standby letter of credit?

A Standby Letter of Credit (called“SLC or “LC” ) are written obligations
of an issuing bank to pay a sum of money to a beneficiary on behalf of
their customer in the event that the customer does not pay the
beneficiary.  It is important to note that standby letters of credit apply
only whenever the issuing bank's commitment to pay is not contingent
on the existence, validity and enforceability of it’s customer’s obligation;
this is called an “abstract” guarantee; that is, the bank’s obligation is to
pay regardless of any disputes between its customer and the
beneficiary.  The issuance of letters of credit is a private transaction
and does not result in the issuance of any public trading securities.

Why do we have standby letters of credit?

The standby letter of credit comes from the banking legislation of the
United States, which forbids US credit institutions from assuming
guarantee obligations of third parties.  (Most other countries outside of
the USA continue to allow bank guaruntees.)  To circumvent this US
banking rule, the US banks created the standby letter of credit, which is
based on the uniform customs and practice for documentary credits.  In
1998 the International Chamber of Commerce (ICC) added ISP98
(International Standby Practices 98) as the rules to guide standby
letters of credit.  These rules are slowly being adopted; however,
many of the standby letters of credit continue to rely on the ICC’s older
guide, Uniform Customs and Practices for Documentary Credits, 1993
revision, ICC Publication 500.

Who are the parties to the standby letter of credit?

(1) The Applicant.  This is the customer of the bank who applies to the
bank for the standby letter of credit.  He must provide collateral to the
bank or have sufficient credit to induce the bank to issue the
instrument.  He also must pay the bank a fee for issuing the instrument.

(2) The Issuing Bank.  This is the applicant’s bank that issues the
standby letter of credit.

(3) The Beneficiary.  This is the party in whose favor the instrument is
issued.

(4)  Confirming Bank.  This is a bank (usually located near the
beneficiary) that agrees (confirms) to pay the beneficiary rather than
have the issuing bank pay the beneficiary.  The beneficiary pays the
Confirming Bank a fee for this convenience.  The Confirming Bank then
collects from the Issuing Bank the amount paid to the beneficiary.

(5)  Advising Bank.  This is the bank that represents the beneficiary.  It
may accept the letter of credit on behalf of the beneficiary and collect
on it on behalf of the beneficiary.  In order for the transaction to be a
bank-to-bank transaction, the advising bank works for the beneficiary
to keep the instrument in the banking system.  Sometimes the Advising
Bank also is the Confirming Bank, but not always.
What is the purpose of the standby letter of credit?

The standby basically fulfills the same purpose as a bank guarantee: it
is payable upon first demand and without objections or defenses on
the basis of the underlying transaction between the applicant and the
beneficiary. It is up to the beneficiary to decide whether he may accept
a standby.
What are the types of standby letters of credit?

(1) Performance Standby.  This instrument supports an obligation to
perform other than to pay money including the purpose of covering
losses arising from a default of the applicant in completion of the
underlying transaction.

(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 of
the applicant to execute a contract if the applicant is awarded a bid.

(4) Counter Standby.  This instrument supports the issuance of a
separate standby or other undertaking by the beneficiary of the
counter standby.

(5) Direct Pay Standby.  This instrument serves to support payment
when due of an underlying payment obligation typically in connection
with a financial standby without regard to default.  This standby is also
used to directly pay an obligation where the only conditions of payment
are the passage of the term and presentment of payment.

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

(7) Commercial Standby.  This is the most used standby and it
supports the obligations of an applicant to pay for goods or services in
the event of non-payment by a business debtor.
Are standby letter of credits transferable?

Assignment of Standby letter of credit proceeds -The beneficiary can
assign the proceeds of a standby letter of credit.  But this assignment
does not assign the rights of the beneficiary as “drawer” on the
standby letter of credit, and only the beneficiary may exercise the
“drawer” rights and present the demand for payment under the terms
of the standby letter of credit unless the terms of the instrument
provide otherwise.  This means that the assignee may receive the
proceeds of the standby, but in order to obtain those proceeds the
beneficiary must first make the demand for payment.  This also means
that the beneficiary can sell by assignment, at discount, the benefits of
the standby.  An assignment of proceeds requires notice to the issuing
bank of this action; otherwise the issuing bank would pay the
beneficiary rather than the assignee.

Transfer of Standby letter of credits.  Standby letter of credits can be
transferred to a third party ONLY with the written consent of the
issuing bank AND the beneficiary.
Are standby letter of credits the subject of trading?

There is no public market for the trading of standby letters of credits.   
Standby letters of credits can only be transferred or the proceeds
assigned in private transactions (as previously noted above).

Standby letters of credit do not have CUSIP or ISIN numbering.  
Standby letters of credits are not trading securities, trading debt
instruments, or trading investment funds, and therefore are not
subject to the rules and regulations of the Security and Exchange
Commission.


Standby Letter of Credit
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