Standby LCs
In general, a standby letter of credit is a legal promise (undertaking), made by a bank (issuer) on behalf of one of its customers (applicant), to pay on demand a fixed sum of money, in parts or in whole, to a named beneficiary if and when the applicant fails to carry out a certain duty he owes to the beneficiary (defaults).
Hence, it can be argued that a standby LC in essence is a bank guarantee. This would have been true if it wasn’t for the following two major differences that distinguish one instrument from the other:
1. Unlike the guarantees, there is a special type of standby letter of Credit called Direct Pay which does not normally involve a default situation, although it may do so as we will see later on. A Direct Pay Standby LC bounds the issuer to pay, merely on demand, within the letter of credit’s validity period, a sum certain in money to the order of a specified beneficiary.
2. The standby letter of credit has evolved into a complex instrument that encompasses a much wider range of uses than that covered by the guarantees. On this point, it is worthwhile noting the following comment in the ICC Publication 511 Documentary Credits UCP500 and 400 Compared:
“…It was agreed unanimously that the Standby letter of credit is not to be merged with the bank guarantee rules regulated by the ICC’s Uniform Rules for Demand Guarantees (URDG), ICC Publication No. 458. While the Standby Credit is, from a legal point of view, equal to the demand guarantee, there are important differences between the two. The standby credit has developed into an all purposes financial support instrument embracing a much wider range of uses than the normal demand guarantee. For this reason, and since the UCP is the most suitable and compatible set of rules with the basic character of the standby credit, the link between the Standby Credit and UCP was maintained.”
Before we start interpreting the articles of the ISP98, going through the following hypothetical example on standby letters of credit will help the reader to form an over view of this important financial tool and assist him in understanding its mechanisms. A quick note; in real life cases, the text of Performance Standby LCs normally differs from the following one in that it contains more specifications as to the different phases required to consummate an underlying project and allows partial drawings.
Example
“Happy Seasons Supermarket” decided to move into larger premises. They chose to construct their own building to suit their specific storing requirements. To do so, they signed an agreement with “Solid Steel Building Contractors” to construct the desired new building. Amongst other terms, the agreement included the following condition:-
“Prior to the commencement of the construction of the building in question, “Solid Steel Building Contractors” must arrange for the issuance of a standby LC for the value of the contract i.e. USD 5,240,000.00 through a reputable bank allowing “Happy Seasons Supermarket” to draw said value if, and only if, “Solid Steel Building Contractors” fails to deliver the building ready for use on or before 20April2010, and/or fails to deliver the building in accordance with the specifications and terms of the signed agreement between them bearing reference JSCS 279 GTI.
Specifying the terms, “Solid Steel Building Contractors” instructed their bank “National Bank of Azaro” to issue a standby LC in favor of “Happy Seasons Supermarket”. National Bank of Azaro in turn issued the
following LC:
Issuer: National Bank of Azaro
Happy Seasons Supermarket
38 floor, Miami Square
Pierre Ducos Place
Yerevan – Armenia
2March2006
Dear Sirs,
We hereby issue our irrevocable standby letter of credit No. ANSBC7 by order of Solid Steel Building Contractors Ltd., Rasha Street - Terra Sancta Area, Armenia, for an amount of USD5,240,000.00 (five million two hundred forty thousand US Dollars only), which expires at out counter on 20April2010.
This credit is available by payment against presentation to us of the following documents:-
1. Your sight draft drawn on us (National Bank of Azaro) for the amount of your drawing.
2. Your certificate stating that you have effected payment to Solid Steel Building Contractor Ltd. in accordance with agreement number JSCS 279 GTI and were not delivered the building on 20April2010 per said agreement.
Partial drawings not allowed.
All charges under this standby letter of credit are for the account of beneficiary.
Except where otherwise expressly stated, this standby letter of credit is subject to the Uniform Customs and Practice for Documentary Credits (1993 Revision) ICC Publication No. 500. Please quote our reference number on any future correspondence.
Yours faithfully,
National Bank of Azaro – Armenia
From this example, we can deduce that Happy Seasons Supermarket were willing to grant their big project to the building contractors only if they received a reliable and legal assurance that the contractor will deliver the building in accordance with the contract agreement. This assurance was in the form of a standby LC by which a reliable bank, National Bank of Azaro in this case, undertook (legally promised) to honor (pay) any claim Happy Seasons make if the contractor fails to deliver what has been agreed upon (default situation).
Note here that the Happy Seasons Supermarket (beneficiary) need not prove that the contractor failed to deliver, all they need to do is to present a simple direct claim and a demand draft, the two documents are adequate to oblige the issuing bank to honor.
There are vast varieties of other uses for standby LCs. It may be issued by an importer in favor of an exporter to secure the latter’s right for payment if funds were not received directly from the importer. It may also be issued in favor of a bank in another country as a form of security for issuing a counter guarantee or a standby LC, or it may be issued as a form of securing a loan granted by a bank to a borrower. A seller can also issue a standby in favor of the buyer.
Now that we have generally introduced the subject, let us move to interpreting the provisions of each of the ISP98 articles:-
Read Rule 1.01 of the ISP98
This first provision of the ISP98 indicates the situations at which the rules apply (scope). Although the rules were specifically legislated for all types of Standby LCs, they may govern any other similar undertaking, however named or described, provided of course, an express reference to the rules is made in the text of the undertaking. Since we are examining the rules from a strictly banking perspective, this article will only discuss their use in situations related to standby letters of credit.
So subrule (a) states that the ISP98 is intended to apply to standby letters of credit. Subrule (b) clarifies that application of the rules to any standby letter of credit must be made clear by expressly referring to them in the text of the LC. Subrule (b) also allows subjecting undertakings similar to standby LCs to ISP98 – for example it is possible to issue a bank guarantee subject to ISP98, although demand guarantees have a separate set of official rules (URDG – Uniform Rules for Demand Guarantees). Such similar undertakings are called “standbys”, hence, there is a difference between a “standby letter of credit” and a standby.
Same as in all official DCs rules, it is possible to modify or exclude the application of any provisions in these rules by expressly demanding so in the text of the undertaking; subrule c so states.
Subrule a segregated standby LCs into three different types; performance standby letters of credit, financial standby letters of credit and direct pay standby letters of credit. Performance standby LCs are those under which the applicant is required to perform a non-monetary obligation, same as the building contractor in the example explained above. Conversely, the standby letters of credit that require the applicant to pay a financial debt owed are named financial standby LCs.
Direct Pay Standbys are those obligating the issuer to pay principal, interest or both when a financial instrument becomes due. These standbys can also cover a default situation. They are commonly used in issuing financial instruments like treasury bonds and other securities. The default coverage is meant to protect against insolvencies of the issuer of the securities.
Subrule (b) uses the words “however named or described” indicating that the name/designation of a standby LC is irrelevant. It is only the nature of the undertaking that determines its function as a standby LC. This rule was initiated to cover situations where terms such as “Letter of Credit”, “Documentary Letter of Credit”, “Commercial Letter of Credit” or “guarantee” are used to describe a standby LC, which is common in some places.
All rights reseved, www.graincon.com
