Standby Letter of Credit
A Standby Letter of Credit is a form
of insurance on an underlying agreement or obligation (contract),
insuring all parties to the contract against failure to perform or
pay on the part of one or another party to the contract. Standbys
are issued by banks.
There two basic categories of Standby Letters of Credit: Commercial
and Financial. The Financial Standby is the one most often used by
swindlers in such a convoluted manner as to make it nearly
impossible to explain the scams short of providing an entire course
in credit finance.
Both type of Standby pose a risk to the issuer - the bank. As with
any insurance, there is the potential for loss and the requirement
for the bank to make good on the loss. In other words, the bank is
gambling that it will make money on the transaction in the form of
fees, not make a payout; therefore, Standby Letters of Credit are
not issued casually, and the creditworthiness of the applicant, the
pertaining documents, and the underlying contract are examined prior
to approval.
Other types of Standby include Direct Pay Standby, Advance Pay
Standby, Bid Bond Standby, and Counter Standby.
Commercial Standbys:
A Commercial or Performance Standby Letter of Credit is an
irrevocable commitment [undertaking] on the part of a bank to
guarantee performance in an underlying contract between a Buyer and
Seller or a service provider.
This type of Standby can be used to insure many types of
transactions from international trade to buying or selling a house
or other major purchase.
The Standby stands as a guarantee that the parties to an underlying
contract will perform as agreed. Used in this matter, the Standby
serves as a PERFORMANCE BOND and may be called a Performance Standby
Letter of Credit.
As such, it is an "off the books" instrument because, until there is
a default that causes the Standby to be executed (called upon),
there really is nothing to ledger other than the fee charged by the
bank for agreeing to the Standby and creating it. Neither the bank
nor the bank's customer ever expect the credit to be needed, but
it's there to cover unforeseen circumstances.
Financial Standby
The "Financial" Standby Letter of Credit, also known as CREDIT
ENHANCEMENT depending on its use, serves a different purpose than
the Commercial Standby, albeit they do have a few things in common
inasmuch as each is used as a form of quasi-insurance.
The difference is that whereas the Commercial/Performance Standby
Letter of Credit backs an obligation to perform an action, the
Financial Standby Letter of Credit backs an obligation to pay money
or repay a loan.
For instance, if the Buyer fails to make an obligated payment for a
delivery of product or service, the Financial Standby Letter of
Credit kicks in and the Seller or service provider is paid.
Again, neither the bank nor the applicant ever expect the Standby to
be called upon.
If the Financial Standby is being used to safeguard a portfolio
while the portfolio owner seeks alternate credit lines, then the
portfolio or other liquid assets (depending on bank negotiations)
must be used as the collateral for the Standby, and a minimum value
of the collateral must be maintained. If the value of the collateral
falls below the minimum, the bank can liquidate the owner's assets
or call upon the owner to make up the difference.
It's easy to find definitions and applications for Standby Letters
of Credit on the Internet, but it can be very confusing. The
International Chamber of Commerce book, International Standby
Practices ISP98, is the definitive book for Uniform Custom and
Practice governing Standby.
It's a short booklet, only 76 pages and a mere 8-1/2 by 8-1/2
inches, and is written in legalese. Conditions abound - what to do
under these circumstances, what to do in that situation - teeming
with phrases such as "A claimed successor may be treated as if it
were an authorized transferee of a beneficiary's drawing rights in
their entirety if it presents an additional document or documents
which appear to be issued by a public official or representative
..." © 1998, Institute of International Banking Law & Practice,
Inc., International Chamber of Commerce ICC Publication No. 590,
International Standby Practices ISP98, page 49.
The confusion and misunderstanding by the general public about
Standbys make the term a perfect tool for con artists, particularly
as Standbys can be applied to CREDIT ENHANCEMENT.