1| What is a standby letter of credit?
A Standby Letter of Credit (called “SBLC”, “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.
2| 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 guarantees.) 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.
3| Who are the parties to the standby letter of credit?
❋ 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.
❋ The Issuing Bank. This is the applicant’s bank that issues the standby letter of credit.
❋ The Beneficiary. This is the party in whose favor the instrument is issued.
❋ 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.
❋ 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.
4| 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.
5| 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.
6| 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.
7| 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.
8| Specifically, what are standby letters of credit?
Bank Obligation. Standby Letters of Credit (called “SLC's or “LC's” or “Standbys”) are written commitments of the issuing bank to pay a sum to a beneficiary on behalf of their customer in the event that the customer himself does not pay the beneficiary pursuant to an underlying obligation. It is important to note that these 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 (i.e. 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 publicly tradable instruments.
Rules of Standbys. The standby letter of credit comes from the banking legislation of the United States , which forbids US credit institutions from assuming guarantee obligations vis-à-vis third parties. To circumvent this rule, the US banks created the standby letter of credit, which is based on the uniform customs and practice for documentary credits (infra). 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.
Transmitted Electronically. Today standby letters of credit are transmitted electronically on a bank-to-bank basis. So one must be very concerned if presented with a hard copy of a standby; it is likely a fraudulent instrument. This is not to preclude pro forma writings of standbys where the parties agree on the terms, and the applicant takes these terms to the bank and has the bank incorporate them into the electronic standby. There is a pro forma standby below.
9| What are the similarities with a bank guarantee?
Like the bank guarantee, the standby letter of credit is abstract in nature, i.e. it is legally separated from the underlying transaction. The SLC stands alone and apart from the contract of which it guarantees performance. For payment, the issuing or confirming bank looks at the four-corners of the instrument as to determine if payment should be made… not to the terms of the underlying contract.
10| Is there fraud associated with standby letter of credits?
Fraudulent Instruments. There are many forged standby letters of credits; i.e. they are NOT issued by the bank that is represented as the issuer. The authenticity should always be checked (See Paragraph d. below for very important warning). The fake financial instrument may have a face value of anything from $5 million to $600 million or even billions of dollars (or other currencies), and they usually give the appearance of being tied to a major international bank. The scheme involves investors being persuaded to buy these standby letters of credits after being offered discounts of over 40%, more or less. The investor would then look forward to redeeming the full face value on maturity (e.g. one year's time), thereby securing a healthy profit. Of course no profit is forthcoming; the investor only suffers the loss of the price paid for the bogus instruments. Banks do not issue standbys for this type of proposition. Standby letter of credits are NOT investment products. Standby letter of credits are issued by banks to cover the liability of its customer to a third party that the bank agrees to pay. Sometimes fraudsters use the discounted Standby letter of credit as bait to secure an advance fee (e.g. 1% of the SLC's face value). The advance fee is represented to pay for alleged due diligence and administration procedures, but is merely pocketed by the perpetrators resulting in a fraud loss to the investor.
Fraudulent Leasing of standby letter of credits. Leasing of standby letters of credits for an upfront fee is invariably a fraud. These standby letters of credits can either be legitimate or bogus, so checking out the authenticity in the long run is not really important (See Warning below on going to the bank to check authenticity of standby letters of credits!). The problem is that after paying an upfront fee there is nothing in the real world that the lessee can do with a leased standby, and the lessor knows it; i.e. the lessor knows that the standby letter of credit will never be called upon. The lessor does this by making the terms of the lease such that the standby letter of credit can never be called up. The lease may provide that the leased SLC may not be used as collateral without the consent of the lessor (which is never given); thus it may not be borrowed against. Or the lease may provide a time limit for use by the lessee that the lessor knows cannot be met (e.g. See c. below “leasing for HYIP).
Leasing For Credit Enhancement. An important warning to potential lessees is that if one leases a standby letter of credit for “credit enhancement” and the standby letter of credit cannot be called upon by the lessee, then any credit or loan issued to the lessee is based on a bank fraud committed by the lessee on the lending bank unless the lessee fully discloses to the lending bank the non-callability element of the standby letter of credit. This is a felony. If you fully disclose, the lending bank will not consider the standby letter of credit as a “credit enhancer”, so the whole idea does not work. Leasing for this purpose is a usually a bad idea that can only lead to a long prison term.
(NOTE: It is, however, important to note that this author has been involved in situations where a standby letter of credit is leased as part of an “investment financing” structure; however, the instrument is always “at risk”, though there are several legal techniques for substantially diminishing the risk (but not eliminating the risk) of the standby being called for payment. The remaining risks are worth the rewards the owner of the standby letter of credit receives for its involvement.)
Leasing for HYIP Use. There is the leasing of standby letters of credits that are issued by legitimate banks and with callable terms; however, the short term of the lease of the SLC is such that the lessee cannot possibly perform (or never perform) within the time limits of the lease. Thus, the lessee does not timely perform and the lessor pockets a large fee. An example of this situation is where a party agrees to lease a standby letter of credit with the agreement that the lessee will place the standby in a performing high yield investment program approved by lessor. The lessee cannot find a performing HYIP within the time limit, because such HYIP's do not exist. The investor loses his fee, and usually cannot do anything about it. But I would sue the lessor, because he knew the whole lease deal would not work in this situation.
Checking Authenticity. Checking authenticity of standby letters of credits. The ICC states: “Anyone offered an investment opportunity supported by a financial instrument can have it checked out by the CCB for a nominal cost. Big warning! What one (other than a very careful and knowledgeable attorney) must NOT due is to walk into a bank (including branch offices) with a standby letter of credit (or bank guarantee or other instrument) to check on its authenticity. There is a high probability (a) the instrument is fraudulent, and (b) therefore one will be arrested “on the spot”, and that probability substantially increases if one is a minority; e.g. African-American, Hispanic, from the Mideast , etc.
Standby Letters of Credits Issued By Small Offshore Banks. Usually standby letters of credits from tax haven banks (unless an affiliate of a major bank) have little or no value. Often there is talk about having these standby letters of credits “confirmed” (i.e. accept liability for the instrument) by a major bank, but in reality, this does not happen for the most part. This is particularly true with U.S. banks, as under the Patriot Act in essence they cannot lawfully do business with these small offshore banks.
London Short Form 3034 (or any other number). If you see this term mentioned as a format for a standby letter of credit, rest assured that you are dealing with a fraudulent situation. Such a form does not exist except in the fraud world. This is an easy tip-off that this is a transaction with which you should not waste your time…and particularly your money.
11| What are the problems in getting standby letter of credits issued?
The primary problem of the applicant is getting the bank to understand the transaction AND then getting the wording right on the instrument. This author has spent many a day trying to get a bank to prepare a letter of credit with the desired terms. Do not leave the preparation of the letter of credit solely to the “SLC people” at the bank; 90% of the time they get it wrong, particularly if it something other than a goods or service import-export transaction. I have spent many a day with bankers working with them to get the application and terms of the letter of credit correct. The worst part is that if they don't get it right and they lose money from your account when the SLC is erroneously called upon, the bank merely says “oops” and basically “go to hell!” You have to sue them to get your money back…even though it is clear that they are at fault. This is the way banks work. They have a license to steal, that they do…as that is their primary business.
12| How does one collect on a standby letter of credit?
The terms of the standby letter of credit itself will advise the beneficiary on the precise terms that must be followed for presentment of the demand and the collection thereof. These terms usually must be precisely followed. Read the instrument carefully!
13| How does the bank handle a dispute?
Usually absent visible obvious fraud, the bank will pay according to the terms of standby letter of credit without regard to looking at the actual performance by the beneficiary of the underlying agreement. If the applicant (bank's customer) feels that the bank should not pay because of non-performance or fraud by the beneficiary, then he should sue the beneficiary and interplead the bank seeking an IMMEIDATE injunction to prevent the bank from paying. The bank will then stand on the sidelines until a court tells it what to do. I had a case in Scotland where the court stood on the sidelines for three years until both sides gave up and settled.