Definition of SBLC.
A Standby Letter of Credit (SBLC) is a financial instrument used to guarantee a buyer’s or borrower’s payment obligations to a seller or lender.
Issued by a bank on behalf of the client, an SBLC ensures that the beneficiary receives payment should the client fail to fulfill the agreed contractual obligations.
This tool is particularly prevalent in international trade and finance, offering a safety net that mitigates risk and enhances transactional security.
Standby Letter of Credit (SBLC) Explained.
A standby letter of credit is used in international or domestic transactions where the seller and the buyer do not know each other, and it attempts to hedge out the risks associated with defaults of such transactions. Some of the risks include bankruptcy and insufficient cash flows on the part of the buyer which, prevents them from making payments to the seller on time. In case of an adverse event, the bank promises to make the required payment to the seller if they meet the requirements of the SBLC.
When setting up a SBLC, the buyer’s bank undertakes to verify the credit worthiness and quality of the buyer. Once the buyer’s bank is satisfied that the buyer is in good credit standing, the bank sends a notification to the seller’s bank, assuring its commitment of payment to the seller if the buyer defaults on their agreement. It provides further proof of the buyer’s ability to make payment to the seller.
The global ruleset which governs standby letters of credit (SBLC) – both the Uniform Customs and Practices current revision 600 (UCP 600) and International Standby Practices current revision (ISP98) – define a SBLC as an “undertaking”. An undertaking provides the named beneficiary with an “independent” assurance of payment from the undertaking’s issuer (issuers are most often banks).
The obligations of the SBLC or “undertaking” are supplementary and in addition to any other underlying contract/agreement between the issuer’s client (In SBLC terms, the client is most often referred to as the applicant) and the client’s contract counterparty (In SBLC terms, the counterparty is known as the beneficiary).
In most cases and depending on the nature of the type of SBLC being issued, a beneficiary is typically only authorized to claim payment from an issuer in situations where the applicant is unable to successfully conclude the underlying contract.
While a SBLC may include a reference to an underlying contract between an applicant and a beneficiary; the issuer’s obligations remain fully independent of any underlying contract to which it may be supporting.
How a Standby Letter of Credit (SBLC) Works.
1. Insuance
A client requests their bank to issue an SBLC in favor of a beneficiary, which is typically a seller or creditor. The bank evaluates the client’s creditworthiness, and the risks involved before issuing the SBLC, which may require the client to provide collateral or a cash deposit.
2. Functionality
The SBLC serves as a backup payment mechanism. It is not intended to be the primary method of payment but is drawn upon in the event of non-compliance or default by the client. If the client fulfils their obligations under the contract, the SBLC is not activated.
3. Activation
To activate the SBLC, the beneficiary must present the required documents, typically proof of non-performance or default, to the issuing bank. Upon verification of these documents, the bank is obligated to make the payment to the beneficiary, ensuring they are compensated for the breach of contract.
Who are the parties involved in a Standby Letter of Credit
Applicant
(also known as an instructing party or requesting party) – The SBLC applicant enters a contract with a counterparty. When the contract requires a SBLC to support it, the applicant will make a request, typically to its bank, to issue a SBLC in favour of its contract’s counterparty. In SBLC terms, the counterparty becomes the beneficiary of the SBLC.
In the underlying contract, the applicant and beneficiary terms associated with SBLCs may have very different names: e.g. lender and borrower; buyer or seller; principal and drawer; etc.
It must be noted that an SBLC’s stated applicant may or may not be the issuer’s client. An applicant may receive silent or openly known support to have an SBLC issued. For example, Company AZA may have insufficient credit or collateral to induce an issuer/bank to issue its SBLC. In such a case, it can enlist its parent, a factoring company, etc. to lend support to help Company AZA be named as the applicant in the SBLC. The parent or other company providing the support may or may not be stated in the SBLC; however, it is considered the client/applicant of the issuer versus the applicant stated in a SBLC.
An applicant is not deemed a party to an SBLC. They are the party which requests an issuer to issue its independent SBLC in favour of a beneficiary.
Beneficiary
Is the undertaking party who receives all the benefits of an SBLC. They are the only party who may make a drawing; receive payment against the SBLC and/or accept or reject amendments, etc. In the underlying contract, the applicant and beneficiary terms associated with SBLCs may have very different names: e.g. lender and borrower; buyer or seller; principal and drawer; etc.
Confirmer or Confirming Bank
Confirmation may only be added at the request of an issuer and when added, a confirmer or confirming bank becomes similar to a second issuing bank because, like the Issuer, the confirmer undertakes to honor (or negotiate) or pay a complying document presentation. The confirmer’s undertaking is in addition to the Issuers undertaking, but it may be limited in several manners, such as: a) amount; b) expiry; and c) allowable languages documents may be presented in, etc.
Issuer or Issuing Bank or Opening Bank
Is the party that issues a separate, irrevocable, independent SBLC on behalf of its applicant client. Because it is independent, a SBLC is separate and distinct from any underlying contract on which it may have been based. Because it is irrevocable, a SBLC cannot be amended until all parties agree to the amendment.
Nominated Bank
Is the bank/party authorized by the issuer to undertake honour, negotiate or otherwise make a payment in the event it receives a complying document presentation/demand. A confirmer is most often a nominated bank. A nominated bank which has not confirmed or otherwise committed to pay in some form has no obligation to do so. Unless a confirmer is involved in a SBLC, it rare to see a nominated party as the majority of SBLCs expire and are only available for payment with the issuer.
Key Benefits of Using an SBLC.
1. Risk Mitigation
An SBLC reduces the risk for the beneficiary by guaranteeing payment in case of default. This security is crucial in dealing with new or less established trade partners.
2. Enhanced Trust
The presence of an SBLC signals financial credibility and stability, enhancing the trust between trading partners and facilitating smoother negotiations and agreements.
3. Financial Flexibility
For the issuer, an SBLC provides a way to secure a contract without immediate cash outlay, preserving working capital for other business activities.
Strategic Uses in Business.
1. International Trade
International Trade: SBLCs are extensively used in international transactions where the risk of non-performance might be higher due to distance, differing legal systems, and cultural variations.
2. Construction and Large Projects
In industries like construction, an SBLC can assure project owners that contractors will meet their obligations or pay a financial penalty, thereby ensuring project completion.
3. Credit Enhancement
Businesses often use SBLCs to enhance their creditworthiness when bidding for large contracts or negotiating terms with suppliers, as it provides a guarantee of payment backed by a reputable bank.
Considerations and Challenges.
1. Cost
Obtaining an SBLC can be expensive, involving fees, potential legal costs, and collateral requirements, which might impact cash flow and operational flexibility.
2. Complexity
The process of obtaining and using an SBLC involves complex documentation and strict compliance with banking regulations, requiring specialized legal and financial expertise.
3. Dependence on Bank's Creditworthiness
The effectiveness of an SBLC is highly dependent on the issuing bank’s financial stability and reputation. Changes in the bank’s credit rating can affect the perceived value of the SBLC.
How are SBLCs commonly used?
Banks following BASEL or Dodd-Frank requirements will classify their issued or confirmed SBLCs as supporting either a “financial” or a “performance” obligation. These two classifications are defined as:
1
“Financial” SBLCs are issued to back financial obligation or some form of indebtedness, such as loan repayment, and irrevocably obligate the Issuer in the event the Applicant fails to honor their payment obligation.
2
“Performance” SBLCs are issued to back a company’s performance related duties. These are contractual, non-financial obligations such as: completing the building of a road or wind farm, etc. and irrevocably obligate the Issuer in the event the Applicant fails to perform as agreed.
Common Types of SBLC’s
Banks following BASEL or Dodd-Frank requirements will classify their issued or confirmed SBLCs as supporting either a “financial” or a “performance” obligation. These two classifications are defined as:
1. Advance Payment
This SBLC’s purpose is to ensure the repayment of an advance payment which a buyer has made (or will make at a contract’s closing) to the supplier of goods or services. In connection with large contracts, especially international transactions, the parties will agree that a supplier of goods or services must receive a certain percentage of the overall contracted value, e.g. 10% upon signing of the contract. To safeguard the buyer against losing its advance payment, they will require an SBLC naming them as the beneficiary to secure the repayment of the sum(s) advanced should the contracted goods or services not be delivered or completed. The SBLC ensures the buyer is made whole for any advance made. However, often these types of SBLC’s do not provide remuneration for any loss of interest or profit margins that the buyer may sustain.
2. Bid or tender bond
Supports an issuer’s client’s bid to be awarded for a project/contract mandate. This type of SBLC assures the beneficiary that if selected, the applicant can support/comply with its bid and that they will honour the bid if they are selected as the winning bidder. Most often used by contractors or construction companies, they are typically needed for a portion of the overall project’s value.
3. Clean
A SBLC which generally requires only the presentation of a draft or bill of exchange without the need of any supporting statements whatsoever. From an applicant and/or an issuers perspective, these are considered the riskiest type of SBLC. This is because a beneficiary will be able to draw for any reason and the simple SBLC’s terms with regards to a presentation/drawing requirement makes it difficult to stop an improper drawing.
4. Commercial
Supports an applicant’s payment obligations to pay for goods or services on a one-off or ongoing basis in the event of non-payment by other methods.
5. Direct-pay
Direct Pay LCs are hybrid SBLCs issued to provide a credit enhancement to a bond offering e.g. industrial revenue bond, also commonly referred to as variable rate demand bonds. Most often issued in favour of the bond trustee and unlike the majority of SBLCs, these SBLCs are the primary payment mechanism for the interest and principal due on the underlying bond and will receive periodic drawings for payment.
6. Financial
A large majority of SBLCs will fall into this category. These SBLCS will support any financial payment obligation such as loan repayments, etc.
7. Insurance
These SBLCs address the insurance or reinsurance obligations of the applicant and are used by insurance companies to distribute insurance risks among themselves. Rather than cash collateralizing other insurers/beneficiaries for use of their internal lines of credit, these SBLC’s are used as collateral.
8. Performance
A performance SBLC is used to secure the applicant’s satisfactory fulfillment of its contractual performance obligations toward the beneficiary. For example, should the applicant fail to perform a contracted duty/duties such as: complete a construction project, or repair equipment, or build a home or road, etc. within the contracted specifications and/or timelines then the beneficiary will be entitled to present a drawing statement.
9. Counter-SBLC
An applicant or the beneficiary may require a local SBLC to be issued directly by an overseas, reputable party most often a bank in the same country as the beneficiary. The applicant may not have the means or would prefer not to open another line of credit with an overseas party to facilitate this limited need. In this case, they would request an issuer to issue a counter-SBLC. The counter-SBLC provides collateral to a local party/bank (often a correspondent of the issuer of the counter-undertaking), to induce that bank to issue its own separate and distinct, local undertaking. In these instances, there are two undertakings:
- The 1st is the counter-SBLC between the issuer and the local bank
- The 2nd is the local undertaking between the local issuer and the beneficiary
The undertaking type and/or their governing rule sets do not need to be like for like. Each bank has its own policies toward issuing and receiving counter-SBLCs.
Through the use of counter-SBLCs, a client maintains a single line of credit.
A counter-SBLC may be necessary in the following scenarios:
1
Beneficiary requires/demands a local SBLC or guarantee.
2
Beneficiary requires a “local bank” to issue the final undertaking and will not allow another local bank to advise or confirm it; or
3
The undertaking or guarantee must be subject to laws outside of the issuer’s policies.
The beneficiary of the counter-SBLC is the financial institution requested to issue its own instrument while the beneficiary of the second instrument is the applicant’s counterparty in the underlying contract/agreement.
The drawing requirements for a counter-SBLC generally require a simple statement that the second financial institution received a demand for payment against the instrument it issued,
while the drawing requirements under the second instrument will have ultimately been provided by the applicant of the counter-SBLC issuer.
Example of a typical process flow for a counter-SBLC
What is the difference between an SBLC and a Commercial Letter of Credit (LC)?
Costs
Costs between SBLCs and Commercial LCs usually differ. At a high level both LC types typically require an issuer to consider factors such as: applicant/client size, collateral and required line of credit size, the issuer’s internal LC processing costs, credit establishment and compliance risk costs and the differences for the types of LCs anticipated to be requested.
Depending on the laws applicable to the Issuer, there may be different cash reserve loss requirements needed for commercial LCs vs performance SBLCs vs financial SBLCs, (Note: This is the case for all countries following Basel) which may affect the issuing/opening fee.
Both LC types will require an applicant to pay an issuance fee of some type. However, commercial LCs are expected to have at least one, if not multiple, document presentations and each presentation will typically be assessed by an examination fee of some type. Conversely, most
SBLCs do not receive a beneficiary’s document presentation/drawing and so no examination related fees will be assessed.
Where a SBLC generally covers longer term and ongoing contracts, the issuance fee is needed for the duration of the SBLC.
DISCLAIMER
If you hold a valid SBLC or are sure you qualify for an SBLC (stand by letter of credit MT760), you are welcome to join Fundify Capital Investment. We do not mediate in applying for SBLCs this is due to prevalent fraud happening internationally in applying for SBLCs. We advise that you apply for an SBLC through your home bank as they can make the best assessment of whether you are eligible for this financial instrument or not. If you are approved for an SBLC? Then, Let US help you arrange funding up to 100% value of your legally valid SBLC. For further information for a SBLC Financing from Fundify Capital Investment, please contact one of our specialised consultants directly.