What is Standby Letter of Credit?

A Standby LC is a form of irrevocable guarantee for   a payment. Since American Banks are prevented from giving the guarantee in that country, the concept of ‘Standby LC’ came into existence. Standby Letter of Credit is an agreement wherein the buyer’s bank promises full payment of goods/services sold by him if the buyer fails to pay.

Uniform Customs and Practice (UCP) for Documentary Credits is a set of uniform rules developed and published by International Chamber of Commerce (ICC) on the issuance of Letter of credit and method of handling letter of credit in international trade finance. ICC has brought out a set of rules under UCP publication 500 [International Standby Practices 98(ISP 98)], which would govern the issue and other related aspects of ‘Standby LC’. These guidelines  are set out in 11 articles and they are internationally accepted rules governing Standby LC.

In issuing standby LC, the buyer (applicant) should give an undertaking to the bank that he shall not raise any dispute regarding payment made to the beneficiary by the bank at any point of time and the applicant will be liable to the bank for the entire amount paid therein. The applicant should further indemnify the bank from any loss, claim, counter- claim, damage etc. which the bank may incur on account of payment made to the beneficiary.

Meaning of standby LCs of different types

Bid Bond standby LC: A bid bond stand by LC is issued to the effect that bidder would not withdraw the bid before the expiry of bid/tender period or in case the contract is awarded to bidder that he would comply with the terms of the tender and enter into contract. Bid bond standby LC is usually issued for percentage of the contract amount.

Performance Standby (Issued for specific performance): Performance standby LC   is issued by the banks on behalf of a Service Contractor, who has to effectually perform all the conditions of the contract between him and the department/company that awarded the contract.  If the contract is partly or fully not performed by the customer, the bank has to discharge the applicant’s financial liability as agreed in the standby LC. Performance standby LC is usually issued for the percentage of the contract amount.

Counter Standby LC: A Counter Standby LC is also known as the  backstop or protective standby. The counter standby LC is mostly issued by the bank of one country, requesting the bank of another country to issue standby to their local undertakings. The bank which has issued counter standby LC has to reimburse the financial liability of the issuing bank on account of defaults of the obligation from the LC opener (buyer).

Financial standby for Payment for government departments (specific or continuing):  A customer may require a standby LC favouring custom department for payment of custom duty covering import of raw materials. Standby may also require for payment of Tax/Vat arrears etc. to a government department.  Financial standby issued is usually covers custom duty/Tax/Vat to the government department up to the maximum limit of amount stated in the standby LC.

Advance Payment Standby:  Advance Payment standby is issued on behalf of the (i) Supplier of raw materials/finished goods or (ii) on behalf of a contractor for an execution of contract when he receives advance payment.   In case of supply of goods or execution of contract, if any one of the terms of contract is not fulfilled by the supplier, the banks undertakes to pay the amount of advance payment received by the supplier..

Direct Pay Standby: In Direct Pay Standby the banks undertake to pay the beneficiary on demand up to the maximum amount stated in the LC on passage of specified period of time. Direct Pay Standby is irrevocable, the independent obligation of the issuer without any scope for dispute from the buyer /applicant.

Insurance Standby: Insurance Standby is issued to the effect that the issuing bank undertakes to pay the insurance or reinsurance obligation of the applicant.

Lease support standby: Lease support standby is issued by the tenant’s bank in favour of landlord in lieu of large security deposit from the tenant. The issuing bank undertakes to pay the dues of the tenant, in the event of non-payment of rent by the tenant (applicant).

Credit support standby: In Credit Support standby LC, the issuing bank undertakes to pay to third party lender, if the third party lender’s borrower defaults on his obligation to that third party lender.

Generally, banks call for credit reports on overseas supplier and issue stand by LC only after getting satisfactory credit report on the supplier. The buyer has the obligation to provide evidence of import (Bill of entry) for all payments made under LC. In view of standby LC is akin to financial guarantee, the commission charged by the banks on standby LCs, are as applicable to financial guarantee and not as applicable to usual import letter of credit.

Related Articles:

• How well do you know about Letter of Credit (LC) Mechanism?
• Who are the parties in a letter of Credit?
• Know eleven types of Letters of Credits (LCs) used in trade transactions
• Uniform Customs and Practice (UCP) for Documentary Credits: