What it is and how it works
Sometimes business transactions go awry. Each day millions of business deals are made across the globe, so it would stand to reason that some of those agreements and contracts do not end successfully. As a form of protection, standby letters of credit can be issued by a bank to help ensure the contract. Standby letters of credit are common, but many people don’t know what they are.
What is a Standby Letter of Credit?
A standby letter of credit, in its most straightforward definition, is a letter issued by a bank that promises to pay a beneficiary if the originator fails to do so. Standby letters of credit can be issued for domestic and international transactions and can be used for sales contracts related to both goods and services.
A standby letter of credit is not a line of credit. The bank itself does not put up the money required to complete the transaction. Instead, the bank promises the requesting party that if you do not pay your debt, they will. You, the originator, are expected to pay the debt without the involvement of your bank.
How does a Standby Letter of Credit Work?
If you are the originator of the letter, you are the person who has agreed to pay for goods or services. A standby letter of credit may be issued directly by your bank, who will send the letter to the requester's bank. The banks will both keep the letters on file in case you, the originator, fail to pay back your debt.
If you fail to pay back the debt or fail to deliver on the terms of the sales contract, the bank will pay the debt once the requester submits documentation that the sales contract was not fulfilled. The bank then will require you, the originator, to pay back the debt directly to the bank, either in a lump sum or over a series of payments.
If you are requesting a standby letter of credit from a potential business contact, the sales contract must include a stipulation that a standby letter of credit is required. Once your business contact agrees to get the documentation, your bank will receive the documentation. You can begin the work outlined in the sales contract at this time. If the originator of the letter fails to fulfill the obligations of the contract, it is your responsibility to provide documentation to the issuer of the standby letter of credit to prove the requirements of the agreement have not been fulfilled.
How do I Get or Request a Standby Letter of Credit?
If you need to obtain a standby letter of credit, you’ll need to contact your bank directly and ask what the protocol is for receiving a letter. You will likely be required to go in-person and speak to a loan or credit specialist. In some cases, collateral will be needed for a letter to be issued. In other cases, a bank may provide a standby letter of credit without the originator putting up collateral. Whether or not collateral will be required depends on the amount of money the letter covers, as well as your credit history and your history with the banking institution.
If you’d like to request a standby letter of credit from a business contact, you’ll need to include the requirement in the sales contract. If your business contact fails to provide the letter, the sales contract is considered null and void. It is suggested never to send goods or begin work on the contract until the letter has been received and you approve the terms.
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