Standby Letter of CreditA financial instrument that guarantees payment

Every business owner would know that running a business isn’t always smooth sailing.

Sometimes, you’ll run into issues that, while aren’t entirely impossible to resolve, can be really costly to your business.

For example, when you allow credit sales to accommodate more customers (potentially increasing your sales revenue), you always run the risk of any of them not paying.

When a customer does not pay his/her account, you essentially lose two things: the goods that you sold, and the money you earn from such sale.

Now imagine carrying that risk with international customers. Dealing with delinquent local customers is already a challenge enough.

What more for customers outside of your country of operations?

Customers that are total strangers to you? Customers that follow different laws and regulations?

Let’s just say that it’s much riskier.

In such cases, you might want to opt for tools that can help make that risky sale a bit less risky.

One of these tools is the so-called standby letter of credit (SLOC or SBLC for short).

It is a legal document that essentially guarantees payment to a seller should the buyer default on the agreement/sale.

It is typically issued by a bank, so in a way, the bank guarantees payment to the seller whatever happens.

In this article, we will be going in-depth about what a standby letter of credit is.

We will take a look at its definition.

But more importantly, we will explore how it works.

Should you avail of one for your business?

Let’s find out.

What is a Standby Letter of Credit?

A standby letter of credit (SLOC or SBLC for short) refers to a legal document where a bank essentially guarantees payment to the seller should the buyer (or the bank’s client) default on the sales agreement.

It has the moniker “standby” because the bank only has to pay in the worst-case scenario.

Depending on the amount specified on the SLOC, it may fully or partially cover the whole sales agreement.

A business will require a SLOC if it wants to provide a safety net for the payment of delivery of goods or completion of services to a customer.

Should the customer (buyer) be unable to make payments to the business (seller), the bank will pay instead.

However, certain conditions in accordance with the agreement must be met first before the bank makes the payment.

The business must fulfill its obligations first (e.g. delivery of goods, completion of service).

If there’s a delay in the delivery or a mistake on the business or customer’s name, it may lead to the bank refusing to make payments.

In international trades where both parties (buyer and seller) don’t personally know each other, a SLOC may be what makes the contract go through.

It provides a guarantee of payment to the seller should they fulfill their obligations.

As such, the seller has one less thing to worry about.

The seller is assured of payment, provided they do fulfill their obligations.

As such, the seller is more inclined to push through with the sale.

That’s not to say that a SLOC only works for international transactions though.

It can also apply to domestic transactions if the seller requires a guarantee of payment from the buyer.

It could be because the buyer is a new customer, or that the buyer is a previously delinquent customer.

Understanding Standby Letter of Credit

While a SLOC can work for both international and domestic transactions, it’s much more prevalent in international trades.

Oftentimes, a SLOC may be the very thing a business needs to push through with an international transaction.

Because of the amplified risk of default associated with international trades, sellers will often require a guarantee of payment, which is what the SLOC essentially is.

A SLOC communicates to the seller that the buyer has the capability to honor the contract.

It can be seen as a sign of good faith as it shows the buyer’s credit background.

Even if an unforeseen event happens where the ability of the buyer to pay is curtailed, the seller is still guaranteed payment.

This promotes confidence on the part of the seller as they will get paid whatever happens as long as they fulfill their obligations.

A bank doesn’t grant a SLOC to just anybody after all.

It will only do so after it has performed all the actions it needs to ensure the creditworthiness of the one availing of the SLOC.

As such, a SLOC also acts as proof of the buyer’s ability to make payments and honor the contract with the seller.

The SLOC is just a safety net should the worst-case scenario happens.

Setting up a Standby Letter of Credit

Setting up a SLOC is like setting up a loan.

The process starts when the buyer applies for the SLOC with a commercial bank.

From there, the bank will perform procedures (e.g. credit check) to ensure the creditworthiness of the buyer.

If the buyer’s creditworthiness is sufficient, the bank will likely approve the SLOC even without collateral.

However, if the buyer’s creditworthiness is questionable, the bank may require an asset or cash deposit to act as collateral.

The level of collateral will depend on certain factors such as the creditworthiness of the buyer, and the amount to be secured by the SLOC.

The bank issuing the SLOC will also require the buyer to provide information about the seller, shipping documents, the beneficiary’s (seller) bank, and the period in which the SLOC is valid.

After everything is reviewed and approved, the bank will provide the SLOC to the buyer.

The SLOC isn’t free though.

The bank will charge a fee to the buyer for as long as the SLOC remains valid.

Typically, the fee amounts to 1% to 10% of the total obligation (the specified amount on the SLOC) payable every year.

If the buyer is able to meet their obligations before the contract ends, the bank will then terminate the SLOC without additional charges to the buyer.

But what if the buyer is unable to meet their obligations due to whatever reason (e.g. bankruptcy, insolvency, illiquidity, cash flow crunch, etc.)?

Then the buyer’s bank will have to pay the seller.

The seller is to provide all the documents that the buyer’s bank will require.

If all requirements are met, the buyer’s bank will make the payments to the seller via the seller’s bank.

Types of Standby Letter of Credit

There are two main types of SLOC: the Financial SLOC, and the Performance SLOC.

Of the two, the Financial SLOC is the more commonly known type of SLOC.

The Financial SLOC

A financial SLOC guarantees payment for the delivery of goods or completion of services.

Should the buyer be unable to make payments for whatever reason, the bank (issuer of the SLOC) will have to pay the seller instead (via the seller’s bank).

As an example, let’s say that a crude oil company typically requires a SLOC from its foreign customers.

The crude oil company then ships oil to the foreign buyer with an expectation to receive payment/s within 30 days after the shipment date.

If the buyer is unable to meet such an obligation for whatever reason, the crude oil company will then collect payments from the bank (issuer of the SLOC) instead.

The buyer is absolved of their obligation with the crude oil company.

However, they accumulate a financial obligation with the bank in exchange.

On top of the principal, the bank will also collect interest payments from the buyer.

The Performance SLOC

The lesser-known type, the Performance SLOC guarantees the completion of a project, typically long-term, with a specific timeline.

If the party availing of the SLOC (bank’s client) is unable to complete the project within the scheduled timelines, the bank is then to reimburse the third party to the contract (a specified amount based on the SLOC).

The Performance SLOC is used for projects, usually long-term ones, that have to be completed within a specific timeline.

It serves as a penalty for delays in the completion of the project.

This even more pronounced if the schedule of completion is strict.

It also serves as compensation for the third party (customer) for any inconvenience caused by the delay.