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Standby Letter of credit is a promissory note issued by a bank which undertakes to pay one party to a contract to the beneficiary when the other party has failed, or is alleged to have failed to perform the contract. A standby letter of credit is often payable simply on the beneficiary's presentation of a written demand. The demand usually requires the presentation of documents that evidence a default in the underlying transaction between the letter of credit beneficiary and typically a third party that arranges for the issuance of the letter of credit-the letter of credit applicant.
The standby L/C is a bank guarantee of payment which is close to the documentary Letter of credit (L/C) except that it is only a guarantee of payment and not a means of payment. It is used only in the event of non-payment by the buyer. In this case, the seller sends the documents to the bank to be paid immediately.
The Standby L/C is separate from and independent of the underlying contract. The issuing bank will not investigate the underlying facts of the transaction e.g. whether or not there was a default or contract breach. The bank only reviews conditions that are evidenced by a document. The bank's commitment is contingent upon the presentation of the stipulated documents in accordance with the terms and conditions of the L/C. These documents related to agreements and contracts are "for information only" to the issuer of Standby Lc.
The issuer's undertaking to pay creates a primary obligation on it, which is independent of the underlying contract. A standby letter of credit is therefore similar to an on demand bond but differs from a true guarantee.
Now a days, Standby L/C letter of credit and commercial L/C are two main documentary credit types used in international trade transactions. Both standby and commercial letter of credit are irrevocable and conditional payment promises given by trusted financial institutions mostly by banks. Standby L/C and Commercial L/C are governed by International System of Practices 98 (ISP 98) and The Uniform Customs & Practice for Documentary Credits (UCP 600), formulated by International Chamber of Commerce (ICC) and ratified by United Nations Convention (1996) on Independent Guarantees and Stand-by Letters of Credit. The UN convention is also a guideline for member countries to adapt law for Standby L/C in their respective jurisdiction or make the standby L/C compatible with local law.
The ISP, like the UCP for commercial letters of credit, simplifies, standardises, and streamlines the drafting of standbys, and provides clear and widely-accepted answers to common problems. It is issued as a documentary credit with or without confirmation. However, it may be sent directly to the supplier without going through his bank.
ISP98 reflects generally accepted practice, custom, and usage of standby letters of credit. The International Chamber of Commerce refers to ISP 98 as "a distillation of practices from a wide range of standby users-bankers, merchants, rating agencies, corporate treasurers, credit managers, government officials and banking regulators. Like the UCP for commercial credits, ISP98 is destined to become the standard for the use of standbys in international transactions."
ISP98 was published by the ICC and endorsed by the UN after consultation with the International trading community with motive to harmonise trade practices, help define roles and responsibilities of all parties to the instrument and enforce independence principle. These rules supplement the Governing Law applicable to a Standby to the extent not prohibited by that Law.
As a contract of international trade and facilitates exchanges, a Standby L/C does not have to be formatted alike a documentary credit. In some occasions, Standby L/C is used as secondary payment option which means it acts as a guarantee and will be utilised in case another primary payment mechanism does not work. Commercial L/C, on the other hand, is primary payment method in international sales. Also, Standby L/C ensures that suppliers will be paid by the bank just after a complying presentation is made under a commercial letter of credit.
Over the years, Standby L/C has evolved into an all-purpose instrument. Such Standby letters of credit can also be employed to play the role of a Direct Pay tool through the power of which the beneficiary can simply draw funds needed to comply with the requirements of the executed agreement between the two parties.
Standby L/C allows the seller to accept a simple mode of payment such as bank transfer with security of the bank guarantee in the background. Its cost is relatively low compared to documentary credit.
The ISP98 is also intended to be standard practice used in arbitration as well as judicial proceedings similar to the expert based letter of credit arbitration system developed by the International Centre for Letter of Credit Arbitration (ICLOCA) Rules or general commercial ICC arbitration or with alternative methods of dispute resolution.
Standby L/C is practiced in international trade supporting payment guarantee of a documentary L/C and international trade against contract. Apart from this, standby L/C is also instrumental to other categories of transaction and guarantee. These are (1) "Bid Bond/Tender Bond Standby" that supports an obligation of the applicant to execute a contract if the applicant is awarded a bid. (2) "Counter Standby" supports the issuance of a separate standby or other undertaking by the beneficiary of the counter standby. (3) "Financial Standby" supports an obligation to pay money, including any instrument evidencing an obligation to repay borrowed money. (4) "Direct Pay Standby" supports payment due of an underlying payment obligation typically in connection with a financial standby without regards to a default. (5) "Insurance Standby" supports an insurance or reinsurance obligation of the applicant. (6) "Commercial Standby" supports the obligations of an applicant to pay for goods or services in the event of non-payment by other methods.
ISP98 became effective on January 01, 1999. It is currently being used and promoted by major banks that issue standby letters of credit, and is expected to become the world standard within the next few years. Bangladesh has no initiative to introduce Standby L/C. Banks in Bangladesh are still not willing to accept UCP 600 for commercial letter of credit and overseas suppliers are not comfortable with 'standard and old-fashioned' format of L/C.
There are many financial institutions and global corporations not willing to accept documentary L/C from banks in Bangladesh unless there is confirmation from third party or guaranteed by insurance. The non-acceptance of L/C is making our export and import transactions expensive over our competitors in the global market. Standby L/C can be an alternate and cheaper option in international trade. As we are struggling with commercial L/C, we can initiate the process to introduce Standby L/C by amending law and rules in order to gain benefits from the global banking system.
MS Siddiqui is a legal economist.