In commercial calculations of enterprises, deferred payment is very common. If the contractors have been cooperating and trusting each other for a long time, then they calmly deliver the goods without first issuing a bank guarantee. But if the company doubts the solvency of its counterparty, it has the right to demand a guarantee of payment for delivery.
Definition
A letter of credit is a guarantee of payment to the supplier after fulfillment of the agreed terms of the transaction. If the client made the delivery and can confirm this with documents, the bank pays him a certain amount of money. This can be a “reserved” amount in advance on the client’s account or a bank loan.
Standby Letter of Credit (Stand-By) is a type of bank guarantee, which is drawn up according to the rules of the International Chamber of Commerce (ICC). It is used to finance trade with countries in which it is forbidden to use a bank guarantee in transactions, or in transactions with international organizations.
A standby letter of credit is a monetary obligation of the issuing bank to pay a certain amount of money to the beneficiary on behalf of the client if the latter cannot fulfill the financial obligation on their own. Payment will be made even in case of insolvency of the client. According to this parameter, a bank guarantee and a standby letter of credit are similar.
History of occurrence
One of the conditions for concluding an international transaction for the supply of goods is confirmation of the buyer's solvency. In such cases, Russian and European banks draw up a classic bank guarantee.
Letters of credit first appeared in the USA, where the issuance of bank guarantees by law does not apply to one of the types of activities of a credit institution. Following US market trends and customer requirements, US banks have developed a letter of credit. With its help, customers were able to draw up additional security for their obligations, and banks received a source of additional and large income, since in the USA there are no restrictions on the use of this payment document.
Application
In international practice, a standby letter of credit and a bank guarantee are interchangeable documents. Both are a guarantee of financial solvency of the client.
A letter of credit used in trade transactions between the two countries may be a loan guarantee for a company that has decided to expand its business and enter international markets. The letter of credit can be reissued to another beneficiary upon the written order of the first, but it will not work to withdraw the document after it has been authenticated in the SWIFT system.
Work principles
Consider the examples of the principle of the document:
- The importer and supplier have entered into a contract under which the seller agrees to sell the goods. He may require the buyer to guarantee payment of the order in the form of a bank guarantee or letter of credit. If the client does not pay for the delivery on time, then this will be done by the guarantor - the bank that issued the letter of credit.
- Under the terms of the contract of sale, the seller can only ship goods after paying the advance payment. In this case, the buyer may demand an additional guarantee that the goods will be delivered on time, in full and in proper quality. In such a scheme, a standby letter of credit is used as security for the obligations of the supplier.
In both cases, the beneficiary transfers the risk of non-compliance of the delivery with the terms of the contract to the financial intermediary. The Bank draws up a letter of credit, which serves to protect the interests of the beneficiary.
Legislative regulation
In the Russian Federation, all issues related to the use of a conventional letter of credit are regulated by Ch. 46 GK. The Russian legislation does not comment on the use of a standby letter of credit, but there is no ban on its use either. At the international level, the “Convention on Independent Guarantees and Standby Letters of Credit" is in force, the Unified Rules for Documentary Letters of Credit ICC UCP 500 and ISP 98, published by ICC. According to the rules presented in these documents, disputed issues are resolved.
Registration
When issuing a letter of credit, the bank will require documents presented in the unified rules. This will provide protection to all parties to the transaction. The letter of credit is a guarantee "in reserve", which is activated only in the absence of payments from the buyer.
The list of documents includes:
- An application for opening a letter of credit is filled out in the form established by the bank. A client’s refusal to fill out certain details may serve as a basis for refusal to complete a transaction.
- The payer must know the name of the country of destination and the beneficiary's bank.
- The client will need to confirm their solvency, otherwise the bank will refuse to complete the transaction.
- The credit institution begins to consider documents after signing the contract for payment of services.
Since in Russia the use of a letter of credit is not documented, banks prefer to deal with a guarantee. Only if Stand-By provides a solid foreign bank, then there are no problems with its use.
Features
A standby letter of credit, like any other letter of credit, has the following features:
- Bank's obligation to make payment in case of non-fulfillment by the client of the delivery conditions;
- guarantee of payment to the supplier in full;
- covering the entire duration of the contract with one document;
- Indication in terms of the contract of the possibility of using a letter of credit for settlements;
- the need for a statement;
- Submission to UCP international law.
Letter of credit VS bank guarantee
- The standby letter of credit of the USA is used in case of failure by the customer to fulfill the terms of the contract, while the ordinary letter of credit provides for payment only after checking the shipping documents.
- A letter of credit refers to additional security for a transaction. It guarantees the exporter to receive payment for the goods, and the importer - the return of the advance payment in case of violation of the terms of delivery. Standby letter of credit is more universal in application than usual.
- The validity of the document is not regulated by national legislation, which makes it more reliable in international settlements.
A standby letter of credit, the origin of which is due to legislative restrictions in the United States, differs from a regular letter of credit in terms of nature of obligations. Usually, the beneficiary must provide documents that confirm the shipment of the goods in full accordance with the terms of delivery. Only after a detailed check of all documents does the guarantor transfer the payment to the beneficiary. In the case of a standby letter of credit, the basis for payment of the bill is a document confirming the failure to fulfill obligations to the beneficiary.
Scheme of work
The possibility of using a letter of credit must be prescribed in the contract. The document is issued by the issuing bank (importer's bank) in favor of the beneficiary (exporter). If the supplier draws up the document on his own, then he will assume the functions of bailor, and the payer will become the beneficiary.
If the parties timely and fully complied with the terms of the contract, then the need to use a letter of credit disappears. In case of violation of the terms of the transaction by one of the partners, a letter of credit helps to resolve conflict issues.
If the payer has not paid for the goods, the seller submits to the bank an application for non-receipt of payments along with copies of the documents on shipment.The issuing bank makes payment without agreement with the payer. Then the counterparty must reimburse the bank for the payment made. This is the essence of unconditional payment. Most often, the document is used in international deliveries, but it can be used in any sales transactions.
The document works as follows:
- The Russian importer signed a contract with the exporter.
- The contract stipulates payment for deliveries on bills.
- The importer receives from the supplier the requirements for the SWIFT standby letter of credit and concludes an agreement with his bank.
- The issuer sends a letter of credit to the advising bank through SWIFT and receives a payment confirmation.
- The first delivery is carried out after signing the standby letter of credit.
- In case of violation of the terms of payment, payment is made at the written request of the beneficiary, who transfers it to the issuer through the advising bank.
In international practice, a confirmed standby letter of credit is also sometimes used. This means that responsibility for the fulfillment of obligations by the issuing bank adds the responsibility of another credit institution. That is, the issuer advising and confirming banks is involved in the transaction. The need for such a document arises if the customer has doubts about the solvency of the issuing bank.
Repayment of a letter of credit
According to statistics, the standby letter of credit is paid off much less frequently than usual. It is often used in financial rather than commodity transactions. In practice, there have been cases when a letter of credit was issued between banks.
Payment according to the document is carried out upon submission to the bank of the requirement to make a payment. The funds are written off in favor of the beneficiary without evidence of non-compliance by the customer with the delivery conditions. This item is clearly stated in the document.
This implies the main risk that banks face - making unreasonable claims against the customer. Therefore, when working with these tools, a technology must be established that allows to reasonably reduce the amount of the claim. Such a scheme already works in transactions with ordinary letters of credit. Cases of unreasonable write-offs of funds for such transactions were not recorded.