Legal Definitions - standby letter of credit

A standby letter of credit is a financial instrument issued by a bank on behalf of its client (the "applicant") to a third party (the "beneficiary"). It acts as a secondary payment mechanism, providing a safety net or guarantee. Unlike a traditional letter of credit, which is a primary method of payment for goods or services, a standby letter of credit is only activated if the applicant fails to fulfill a specific contractual obligation to the beneficiary. Essentially, the bank promises to pay the beneficiary if, and only if, the applicant defaults on their agreement.

Here are some examples to illustrate how a standby letter of credit works:

• Construction Project Assurance:

  Imagine a city government (the beneficiary) hires a construction company (the applicant) to build a new public library. The city wants assurance that the project will be completed on time and according to specifications. The construction company obtains a standby letter of credit from its bank, naming the city as the beneficiary. If the construction company fails to meet key deadlines, abandons the project, or performs substandard work that violates the contract, the city can present documentation of the default to the bank. The bank would then pay the city the amount specified in the standby letter of credit, compensating the city for the contractor's failure to perform.

  This illustrates the term because the bank's payment is "standing by" and only triggered if the primary agreement (the construction contract) is breached by the construction company, providing financial protection to the city.

• International Sales Guarantee:

  Consider a large electronics retailer in the United States (the applicant) placing a substantial order for custom components from a manufacturer in South Korea (the beneficiary). Since this is a new business relationship and a large order, the South Korean manufacturer is concerned about receiving payment. The US retailer's bank issues a standby letter of credit to the South Korean manufacturer. This SBLC guarantees payment to the manufacturer if the US retailer fails to pay for the components after they have been shipped and delivered according to the sales contract terms. The manufacturer ships the goods, expecting payment directly from the retailer. If the retailer defaults on that payment, the manufacturer can then claim funds from the US bank under the standby letter of credit.

  This demonstrates the standby nature as the bank only pays if the primary buyer (the US retailer) defaults on their payment obligation, assuring the seller of payment even in a cross-border transaction.

• Lease Agreement Security:

  A startup company (the applicant) wants to lease a new office space from a commercial landlord (the beneficiary). The landlord requires a security deposit but also wants additional assurance beyond a cash deposit that rent will be paid and the property will be maintained. Instead of a larger cash deposit, the startup obtains a standby letter of credit from its bank for a specified amount. If the startup fails to pay rent for several months, or causes significant damage to the property beyond normal wear and tear and fails to repair it as per the lease agreement, the landlord can present evidence of these defaults to the bank and draw funds from the standby letter of credit.

  This example shows the standby letter of credit acting as a financial backstop for the landlord, with the bank's payment obligation arising only if the tenant defaults on their lease obligations.