Standby Letter of Credit: a Worked Example

The standby grew up in the United States, where banks were long restricted in issuing guarantees and wrote the same promise as a letter of credit instead. It stayed in use after those limits eased, because beneficiaries across borders liked what came with it: a familiar form and published international rules. In New Zealand, Australia and the UK a domestic counterparty is more likely to take a bank guarantee. A standby appears more often when the beneficiary is overseas, or when its own bank or policy asks for one by name.

It may support a payment, such as a supplier's invoices, a lease or a loan from another lender, or a performance, such as delivery under a contract. The distinction reaches bank capital. The Basel standardised approach applies a 100% credit conversion factor to a standby that serves as a financial guarantee and 50% to one tied to a particular transaction; each regulator sets its own version of that table.

Three parties matter: the applicant, who is the bank's customer; the issuing bank; and the beneficiary. A bank in the beneficiary's country may advise it or add a confirmation. The text states which rules apply. ISP98 was written for standbys alone. UCP 600 extends to standbys so far as its articles can apply, and suits them less well, having been designed around documentary credits. URDG 758 is written for demand guarantees, though a standby can adopt it.

Whichever is chosen, the bank's obligation stands apart from the commercial contract. It examines what is presented, and a dispute between buyer and seller does not ordinarily stop payment. Four terms carry most of the risk: the amount; the expiry; the drawing condition, which may be nothing more than a signed statement; and any automatic extension, known as an evergreen clause, which renews the standby each year unless the bank gives notice. Some standbys let the beneficiary draw if the bank gives that notice and no replacement arrives.

An importer of solar panels, constructed for this page like every figure in it, buys on 60-day terms from an overseas manufacturer, which will extend up to US$600,000 of credit only with a bank behind it. Its bank issues a standby for US$600,000 subject to ISP98, for twelve months, renewing unless the bank gives 60 days' notice. It is drawn by a signed statement that invoices are unpaid, with copies of those invoices. The fee is 2.0% a year, or US$12,000. The importer also has an overdraft with a limit of US$1.2m, of which US$1.05m is drawn. Rates and amounts are the example's.

In month nine the importer disputes the quality of a shipment and stops paying. The manufacturer presents a statement and invoices totalling US$440,000. The importer asks the bank to refuse, on the ground that the panels are faulty. The bank replies that the presentation complies, pays, and debits the importer's account.

The total has not moved, which is the point. From the day of issue the bank had counted the full US$600,000 as exposure. What changed is the form of it: contingent exposure became funded, the importer is now US$290,000 over its overdraft limit, and the argument about the panels has become the importer's to pursue against the manufacturer.

The bank now wants out, and gives notice that it will not renew. That does not close the matter. In this standby, non-renewal entitles the manufacturer to draw any remaining balance if no replacement arrives, so the US$160,000 is likely to be called, and the funded balance rises to US$1.65m. A lender cannot end a standby on the terms it might end an overdraft.

A commercial letter of credit is how a sale gets paid, and the bank expects to pay. A standby is what happens if something else fails. Against an on-demand guarantee the difference is mostly form and rule set: both are independent promises paid on a compliant demand, and a lender reads them in the same way. A guarantee governed by local law may also behave differently from one under international rules, so the wording and the governing law both need reading.

DEFINED IN ONE PARAGRAPH → · BANK GUARANTEE VS LETTER OF CREDIT → · PRODUCT FILE: BANK GUARANTEE →

The issuing bank approves a standby as lending to its customer, and asks the same question it would ask of a loan: if this is paid, how does the customer repay? The drafting then matters more than it would on most facilities. A drawing condition that needs only a statement gives the customer little protection, an evergreen clause can keep the exposure alive for years, and a beneficiary's right to draw on non-renewal limits the bank's way out. Each is worth negotiating before issue, because afterwards the beneficiary has to agree to any change.

A lender can also be on the receiving end, as when a standby from a parent's bank supports a loan to a local subsidiary. Then the question is the issuing bank's credit and country, the expiry against the loan's maturity, and whether the lender can draw in time if the standby is not extended. The diary for that date is the lender's own responsibility.

PERFORMANCE BONDS → · THE CREDIT CONVERSION FACTOR →