What is a 'Standby Letter of Credit - SLOC'
A standby letter of credit (SLOC) is a guarantee of payment issued by a bank on behalf of a client that is used as "payment of last resort" should the client fail to fulfill a contractual commitment with a third party. Standby letters of credit are created as a sign of good faith in business transactions and are proof of a buyer's credit quality and repayment abilities. The bank issuing the SLOC performs brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then sends notification to the bank of the party requesting the letter of credit (typically a seller or creditor).
BREAKING DOWN 'Standby Letter of Credit - SLOC'A standby letter of credit shows a company’s credit quality and ability to repay loans. Although a SLOC is not intended for use, it helps fulfill business obligations in case the business stops operations, cannot pay its vendors or becomes insolvent.
Small businesses often face difficulty when securing financing. For this reason, standby letters of credit may be especially beneficial for encouraging investors to lend money to a company. In case of default, investors are assured they will be paid principal and interest from the bank through which the SLOC is secured.
Obtaining a Standby Letter of Credit
When requesting a SLOC, a business owner proves to the bank he is capable of repaying the loan. Collateral may be required to protect the bank in case of default. The bank typically provides a letter to the business owner within one week of receiving documentation. The business owner must pay a SLOC fee for each year that the letter is valid. The fee is typically 1-10% of the SLOC value. If the business owner meets the criteria outlined in the contract before the due date, the business owner can cancel the SLOC without further charges.
Examples of Standby Letters of Credit
A financial SLOC, the most common type, is typically used in international trade or other high-value purchase contracts where litigation or other non-payment actions may not be feasible. A financial SLOC guarantees payment to the beneficiary if criteria outlined in the contract are left unfulfilled. For example, an exporter sells goods to an overseas buyer who guarantees payment in 30 days. When the payment does not appear by the deadline, the exporter presents the SLOC to the importer’s bank and receives the payment.
A performance SLOC ensures the time, cost, amount, quality of work and other criteria are fulfilled in a manner acceptable to the client. The bank pays the beneficiary if any of the written obligations are unmet. For example, a contractor guarantees a construction project will be finished in 90 days. If work remains incomplete after the 90-day period, the client can present the SLOC to the contractor’s bank and receive the payment due.