Standby Letters of Credit and Bank Guarantees Guide

What Is a Standby Letter of Credit?

A Standby Letter of Credit is an independent undertaking issued by a bank or other eligible financial institution in favor of a beneficiary.

It normally supports an obligation owed by the bank's customer, called the applicant. The beneficiary expects the applicant to perform the underlying contract. The SBLC exists as a fallback if the applicant fails to do so.

The U.S. International Trade Administration describes a standby letter of credit as an instrument that can be drawn when a contractual default occurs, including when a buyer fails to pay invoices when due. Standbys can also support bid bonds, performance obligations and advance payments.

U.S. International Trade Administration Trade Finance Guide

For example, suppose a trading company agrees to pay a supplier USD 5 million 60 days after delivery. The supplier agrees to extend those terms only if the buyer provides a USD 5 million SBLC from an acceptable bank.

If the buyer pays normally, the standby expires unused.

If the buyer fails to pay and the supplier submits the documents required by the standby, the issuing bank examines that presentation and determines whether it complies with the instrument.

That is fundamentally different from the bank simply guaranteeing that every disagreement between buyer and seller will be resolved in the supplier's favor.

What Is a Bank Guarantee?

The expression Bank Guarantee can describe several forms of bank-issued credit support, so the terminology must be used carefully.

In international trade and project transactions, one of the most important forms is the independent demand guarantee.

Under ICC's Uniform Rules for Demand Guarantees, known as URDG 758, a demand guarantee is an irrevocable undertaking by the guarantor, normally a bank, to pay the beneficiary when a complying demand is presented.

ICC Academy Guide to URDG 758

The applicant might be a contractor building a power plant. The beneficiary might be the project owner. The bank may issue a performance guarantee for part of the contract value.

If the contractual conditions represented by the guarantee are not met and the beneficiary makes a demand that complies with the guarantee, the bank examines that demand according to the guarantee's terms.

URDG 758 has become an important international framework for these instruments. The rules have applied since July 1, 2010 and cover the guarantee lifecycle from issuance and counter-guarantees through presentation, examination, payment and termination.

ICC Guide to the Uniform Rules for Demand Guarantees

Standby Letter of Credit vs Bank Guarantee

Economically, SBLCs and independent demand guarantees can perform remarkably similar jobs.

Legally and operationally, they come from somewhat different traditions.

The practical choice often reflects geography, transaction type and banking convention.

Standby letters of credit are particularly familiar in the United States and are widely used internationally. Demand guarantees are deeply established in Europe, the Middle East, Asia and international construction and infrastructure markets.

ICC developed ISP98 specifically because standby practice had become sufficiently distinct from ordinary documentary credits to justify its own framework.

ICC International Standby Practices ISP98

The Main Parties

A beneficiary concerned about issuing-bank credit or country risk may, in an appropriate structure, seek confirmation from another acceptable bank for a standby.

Guarantees can also involve an indirect structure. The applicant's bank issues a counter-guarantee to another bank, usually in the beneficiary's jurisdiction, and that second bank issues the local guarantee.

This is common where a beneficiary requires a domestic bank guarantee or local regulation makes local issuance preferable.

The Main Types of Standby Letters of Credit

The U.S. Department of Commerce specifically notes the use of standbys as bid bonds, performance bonds and advance-payment guarantees in international trade.

Common Types of Bank Guarantees

These structures are common in EPC contracts, infrastructure projects, commodity trading, equipment supply and government procurement.

The terminology varies between countries and contracts, so the underlying commercial purpose matters more than the label.

ISP98, UCP 600 and URDG 758

One of the first questions when reviewing an SBLC or Bank Guarantee should be:

For Standby Letters of Credit, ISP98 is specifically designed for standby practice. It addresses obligations, presentations, examination, notices, transfers, cancellation, reimbursement and timing.

A standby can instead be expressly made subject to UCP 600. UCP 600 primarily governs documentary credits, but Article 1 expressly allows it to apply to standby letters of credit to the extent the rules are applicable when incorporated into the credit.

For independent demand guarantees, URDG 758 is the major ICC framework.

The rules do not automatically apply simply because an instrument is called a Bank Guarantee or SBLC. The instrument generally needs to state which rules apply.

Local law also remains relevant. ICC rules do not eliminate questions involving fraud, sanctions, legal capacity, injunctions or other issues governed by applicable law.

What Does MT760 Mean?

Few areas of trade finance generate as much misinformation as the term MT760.

An MT760 is a SWIFT message type used for the issuance of a demand guarantee or Standby Letter of Credit.

SWIFT's documentation calls MT760 the message for the "Issue of a Demand Guarantee/Standby Letter of Credit." It can also carry counter-guarantees and related undertakings.

SWIFT Category 7 Message Reference Guide

Similarly, references to "MT760 monetization," "leased MT760s" or an instrument somehow becoming legitimate solely because an MT760 is mentioned should be treated carefully.

The commercial and legal substance remains the undertaking issued by the bank.

How Banks Issue Standby Letters of Credit and Guarantees

A real issuance begins with bank underwriting.

The applicant approaches a bank with an existing or proposed credit relationship and asks the institution to issue an undertaking for a specified amount, beneficiary, purpose and tenor.

The bank reviews the applicant's financial strength, transaction, requested wording, jurisdiction, sanctions exposure, reimbursement ability and collateral.

From the bank's perspective, an issued SBLC or guarantee creates a contingent credit exposure. If a complying demand occurs and the bank pays, it expects reimbursement from its customer.

That is why these instruments normally consume credit capacity.

A strong corporate borrower may obtain issuance under a committed credit facility. Another applicant may have to provide cash collateral. Other structures can involve securities, deposits, receivables, real estate, guarantees or other collateral acceptable to the bank.

How Much Does an SBLC or Bank Guarantee Cost?

There is no universal SBLC or Bank Guarantee price.

Pricing depends primarily on the issuing bank's assessment of the applicant.

A bank may consider the applicant's balance sheet, credit rating, collateral, relationship, face amount, tenor, instrument type, jurisdiction, beneficiary, wording and transaction risk.

Costs can include issuance commissions, facility fees, advising charges, confirmation costs where applicable, amendment fees, SWIFT fees and legal or documentation costs.

A fully cash-collateralized standby for an established bank customer presents a very different credit profile from a USD 50 million unsecured performance instrument requested by a thinly capitalized special-purpose vehicle.

What Happens When the Beneficiary Draws?

The exact process depends on the wording and applicable rules.

The beneficiary submits the demand and any required supporting documents to the place and bank specified in the instrument before expiry.

The bank examines the documents against the undertaking.

For an independent standby, ISP98 emphasizes that the obligation is documentary. The issuer is concerned with the presentation of documents and whether they comply on their face with the requirements of the standby.

Similarly, URDG 758 demand guarantees operate according to the guarantee and complying presentation rather than requiring the guarantor to adjudicate the entire underlying commercial dispute.

Under URDG practice, a demand normally includes a statement indicating how the applicant is in breach unless the guarantee provides otherwise.

This independence principle is one of the reasons beneficiaries value bank undertakings.

It is also why applicants must pay extraordinary attention to drafting.

Expiry, Automatic Extension and Cancellation

An SBLC or guarantee should clearly establish when and how it expires.

Some instruments use a fixed expiry date.

Others contain automatic-extension provisions under which the undertaking renews unless the issuer gives notice that it will not extend.

Informal descriptions such as "evergreen" should never replace precise wording. ISP98 itself notes that terms such as "evergreen" do not have a single accepted meaning unless their context gives them meaning.

Parties should understand the expiry date, place for presentation, extension mechanics, notice periods and what happens to the underlying obligation if the bank declines to renew.

Major Risks for the Applicant

Applicants often focus exclusively on whether they can obtain the instrument.

They should pay equal attention to what happens after issuance.

Poorly drafted drawing requirements can expose the applicant to an easier call than originally intended. Open-ended extension clauses can consume credit lines for longer than expected. An instrument issued in another jurisdiction can create unexpected litigation and enforcement issues.

The applicant also has to manage the reimbursement obligation.

If the bank honors a legitimate draw, the applicant cannot normally expect the bank to absorb the loss simply because the applicant disputes the beneficiary's commercial position.

The instrument was issued precisely so that the beneficiary did not have to rely solely on the applicant's credit.

Major Risks for the Beneficiary

A beneficiary should not accept an instrument simply because it says "Standby Letter of Credit" or "Bank Guarantee."

The issuing institution matters.

So do the bank's jurisdiction, creditworthiness, sanctions status, wording of the instrument, expiry, presentation requirements and applicable rules.

The beneficiary should determine whether the instrument is authentic and whether the advising route makes sense.

It should also ensure that the required documents are realistically producible.

Fraud and Fake SBLCs

SBLCs and Bank Guarantees are frequently misrepresented in fraudulent financial schemes.

Common warning signs include claims that an unknown intermediary can arrange enormous instruments without meaningful underwriting, requests to pay substantial fees to unrelated parties before any bank engagement, promises of guaranteed "monetization," unexplained references to SWIFT messages and refusal to identify the regulated issuing institution through appropriate banking channels.

When Should You Use an SBLC Instead of a Bank Guarantee?

There is no universal answer.

An SBLC may make more sense when the counterparties, banks or jurisdiction are accustomed to standby practice, especially where ISP98 provides an appropriate operational framework.

A demand guarantee may be preferable where the contract, beneficiary or jurisdiction expects a URDG 758 guarantee, as frequently happens in construction, infrastructure and international procurement.

Sometimes the decision is effectively made by the beneficiary.

A government tender may prescribe a specific guarantee form. An EPC contract may require a performance guarantee from a local bank. A commodity supplier may accept only an SBLC from a bank meeting predetermined rating criteria.

The best structure is therefore the one that satisfies the commercial contract while remaining issuable by the applicant's bank.

The Most Important Point

They are mechanisms through which a bank can transform the beneficiary's exposure from the applicant's credit risk toward the issuing bank's independent undertaking, subject to the wording, rules, documents and applicable law.

That transformation is valuable precisely because banks do not issue these instruments casually.

The applicant must have sufficient credit capacity or collateral. The beneficiary must understand the undertaking it is accepting. The banks must approve the transaction and wording. All parties must understand what constitutes a valid draw.

When structured correctly, SBLCs and demand guarantees can support transactions that would otherwise require cash deposits, advance payments or unacceptable unsecured counterparty exposure.

When structured poorly, they can create disputes, trap credit capacity or provide far less protection than either party expected.

For sizeable transactions, the instrument should therefore be considered part of the broader financing and risk-allocation structure from the beginning of negotiations rather than an administrative document to arrange shortly before closing.