How a Standby Letter of Credit Works
A SLOC is most often sought by a business to help it obtain a contract. The contract is a "standby" agreement because the bank will have to pay only in a worst-case scenario. Although an SBLC guarantees payment to a seller, the agreement must be followed exactly. For example, a delay in shipping or a misspelling a company's name can lead to the bank refusing to make the payment.
There are two main types of standby letters of credit:
- A financial SLOC guarantees payment for goods or services as specified by an agreement. An oil refining company, for example, might arrange for such a letter to reassure a seller of crude oil that it can pay for a huge delivery of crude oil.
- The performance SLOC, which is less common, guarantees that the client will complete the project outlined in a contract. The bank agrees to reimburse the third party in the event that its client fails to complete the project
The recipient of a standby letter of credit is assured that it is doing business with an individual or company that is capable of paying the bill or finishing the project.
The procedure for obtaining a SLOC is similar to an application for a loan. The bank issues it only after appraising the creditworthiness of the applicant.
Letter of Credit
In the worst-case scenario, if a company goes into bankruptcy or ceases operations, the bank issuing the SLOC will fulfill its client's obligations. The client pays a fee for each year that the letter is valid. Typically, the fee is 1% to 10% of the total obligation per year.
Advantages of a Stand by Letter of Credit
The SLOC is often seen in contracts involving international trade, which tend to involve a large commitment of money and have added risks.
For the business that is presented with a SLOC, the greatest advantage is the potential ease of getting out of that worst-case scenario. If an agreement calls for payment within 30 days of delivery and the payment is not made, the seller can present the SLOC to the buyer's bank for payment. Thus, the seller is guaranteed to be paid. Another advantage for the seller is that the SBLC reduces the risk of the production order being changed or canceled by the buyer.
An SBLC helps ensure that the buyer will receive the goods or service that's outlined in the document. For example, if a contract calls for the construction of a building and the builder fails to deliver, the client presents the SLOC to the bank to be made whole. Another advantage when involved in global trade, a buyer has an increased certainty that the goods will be delivered from the seller.
Also, small businesses can have difficulty competing against bigger and better-known rivals. An SBLC can add credibility to its bid for a project and can often times help avoid an upfront payment to the seller.