The procedure for obtaining a standby letter of credit involves the applicant applying to a bank, establishing credit worthiness, and usually putting up cash collateral and paying a fee.
A standby letter of credit, commonly referred to as an SLC or LOC, is a written obligation of the bank issuing the letter of credit stating that the bank will pay the beneficiary of the letter of credit in the event that the bank's customer, the applicant for the SLC, fails to pay the beneficiary money due him from the applicant. Essentially, the SLC is a form of backup payment insurance designed to guarantee that the seller in a transaction receives the money due him from the buyer. It is payable to the beneficiary, in accord with the terms of the SLC, upon demand, and the issuing bank cannot refuse to make payment due to any disagreements between the applicant and the beneficiary.
Standby letters of credit are commonly considered as certifications of the applicant's creditworthiness and ability to make the necessary payment to fulfill his contractual obligation to the beneficiary of the SLC. In the event that the bank issuing the SLC ends up having to make payment to the beneficiary, it expects, or at least hopes, to be paid back by the applicant.
The time frame an SLC is in effect is usually about a year, allowing for the applicant to make standard payment to the beneficiary.
If a seller requests a standby letter of credit, he commonly insists that it be an irrevocable letter of credit, meaning that the terms of the SLC cannot be modified without the beneficiary's consent. The applicant then requests the SLC from his bank. The issuing bank typically reviews the creditworthiness of the applicant prior to issuing the SLC. All but the most creditworthy applicants for an SLC are required to post cash collateral with the issuing bank covering at least a portion of the amount of the SLC and they must also pay a fee to the issuing bank, typically 2-5% of the amount of the SLC. The applicant then provides a letter of confirmation to the beneficiary from the issuing bank; this is called a bank confirmation letter.
In addition to the applicant, the issuing bank and the beneficiary, a fourth party involved with an SLC is the confirming or advising bank. This is a bank, usually located near the beneficiary, that pays the beneficiary on behalf of the issuing bank in the event that the SLC becomes payable. This arrangement is more common in international transactions. The beneficiary usually pays the confirming bank a small fee.
An SLC is transferable in that the beneficiary can sell or assign the rights to the proceeds from the SLC, but the beneficiary remains the only party who can demand payment of the SLC. In the event that such an arrangement is made, the beneficiary informs the issuing bank to pay the proceeds of the SLC to the party the beneficiary has assigned to receive payment. There is no public trading of SLCs.
In the United States, SLCs are governed by rules of the Uniform Commercial Code (UCC).