BASIC UNDERSTANDING OF STANDBY LETTERS OF CREDIT

A letter of credit (LC) is a bank instrument that is issued to protect the beneficiary in a transaction. It is not a contract although there are usually contractual undertakings that underlie the credit. (It is important to reserve in your mind that the contract on which the credit is based cannot be referenced in the credit itself and cannot be a decisive factor when the credit is presented for payment. This is “The Independence Rule” which will be discussed later.

Technically a letter of credit is not a guarantee although it does, in fact, guarantee payment of an obligation to a beneficiary.

There are laws and rules that govern letters of credit. The Uniform Commercial Code (UCC) Article 5 covers letters of credit and is law. The Uniform Customs and Practice (UCP), which is distributed by the International Chamber of Commerce (ICC), has a series of publications that are the accepted rules for credits. The ICC/UCP500 and the ISP98 are their two most current publications for letters of credit. The ICC/UCP500 is entitled, ICC Uniform Customs and Practice for Documentary Credits and has been in force as of January 1, 1994.

The ISP98 is called the International Standby Practices ISP98 reflects generally accepted practice, custom and usage of standby letters of credit and has been in force since January 1, 1999.

There are three basic parts to a letter of credit transaction.

First, there is an agreement between the customer (other names for the customer: applicant, account party, buyer, debtor, importer, clien t) who will open the letter of credit at the bank and the beneficiary (other names for the beneficiary: creditor, exporter, seller, supplier, manufacture r) who will be allowed to draw down the letter of credit. Their agreement outlines the transaction between them and specifies the obligation the customer will have to the beneficiary allowing him to receive payment under the letter of credit.

Second, there is an agreement between the account party and the issuer of the credit, which is usually a bank. This agreement specifies the obligation of the bank to pay and how the account party will collateralize the credit with the issuer, which is usually in cash or property.

Third, the letter of credit obligation is drafted in accordance with the rules of an ICC/UCP publication, or the UCC. The credit therefore, obligates the issuer to pay or honor the drafts attached to the credit when presented by the beneficiary in accordance with the term s, conditions and procedures outlined in the credit.

Following are the parties to a letter of credit transaction with relevant terms and convenient definitions .

Issuer – This is the entity that will issue the credit. It usually is a bank but it can be any financial institution of substance. The issuer assumes the full obligation to pay the beneficiary upon the presentation of the documents specified in the credit.

Applicant – The applicant is also known as the account party or customer. He requests from the issuer the credit he wants for his beneficiary. He pays the issuer for the credit with cash or collateral so as to secure the issuer the funds necessary for the reimbursement obligation to the beneficiary.

Beneficiary – The beneficiary is the party that will be identified in the credit as the entity entitled to draw or demand payment under the letter of credit.

Advising Bank – The role of the advising bank is to notify the beneficiary that a credit has been issued by another bank. It assumes no responsibility other than notifying the beneficiary. However, its obligation is limited to accurately advising the terms of the credit that has been issued. In this capacity it is only playing “post office”. (UCP500 Article 7).

Confirming Bank – The responsibility of the confirming bank is that it becomes directly obligated on the credit and now assumes the rights and obligations of the issuer. (UCP500 Article 9, a, b, c, d). Typically the confirming bank's role is one for geographic convenience, i.e., a bank located close to the beneficiary. However, it can also be a well-known bank that will assume the responsibility for a lesser-known bank by confirming their credit, therefore, rendering the credit more acceptable to the beneficiary.

Independence Rule – This principle of independence clearly states that the obligation of the paying bank is in reading the text of the credit, which is wholly independent from sales or other contracts on which the credit may be based. The issuing bank is not required to evaluate if the beneficiary has performed under the underlying contract or if it is contractually entitled to payment. The issuer is only obligated to pay upon presentation of documents that conform to the requirements of the letter of credit. (UCP500 Article 3, a, b, Article 4).

Strict Compliance Rule – The beneficiary must make presentment in strict compliance with the terms, conditions and procedures of the credit. Further to this, since the adherence of the requirements must be strictly applied to the beneficiary, the beneficiary must know precisely and unequivocally what those requirements are. Although the Independence Rule above, is “rule” the Strict Compliance Rule is considered “law” since this standard has been applied and followed by a majority of federal jurisdictions and state courts.

Transferable Credit – A transferable credit is a credit under which the first beneficiary requests the paying bank to make the credit available in whole or in art to one or more beneficiaries. A credit can be transferred only if the text clearly states that it is transferable. (UCP500, Article 48, a-j; ISP98, Rule 6.0-6.05).

Every letter of credit must address the following:

Terms: Dollar amount to be paid for the transaction by the applicant to the beneficiary in accordance with the specifications listed in the letter of credit within the period of validity and date of expiration.

Conditions: Beneficiary must satisfy the terms above in order to qualify and to be able to draw the proceeds on the credit.

Procedures: Applicant opens the letter of credit with the issuing bank. Issuing bank advises beneficiary that the credit is available to his account. Particulars of underlying contract must be clearly stated in credit (although contract itself is not cited nor will it be evaluated when credit is presented to bank for payment.

QUANTIFIERS

Every letter of credit, as with all contracts, must address the following quantifiers: Who The parties involved with the transaction (applicant, beneficiary, issuing bank, confirming bank). What ype or name of transaction (commodities, supplies, services, funding). Why Needs on both ends of transaction (buyer, seller, lender, borrower). Where Banks involved (where credit is to be opened, confirming bank, paying bank, jurisdiction of applicant and beneficiary). When Time frames (date credit is issued, periods of validity and expiration, ETD for shipment or release of funds, ETA for shipment or draw of funds, partial or full shipments allowed). How Much Amount of transaction, if partial draws allowed.

THERE ARE TWO CATEGORIES OF LETTERS OF CREDIT USED TODAY

1 - Documentary Letter of Credit (DLC or L/C)
2 - Standby Letter of Credit (SBLC or SLC)

The Documentary Letter of Credit is conditioned on performance by the supplier, whose acceptable and satisfactory performance makes him the beneficiary of the credit. The Standby Letter of Credit is conditioned on default or non-performance by the account party or applicant who opened the standby letter of credit.