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What is 'Standby Letter of Credit (SLOC)'

A standby letter of credit (SLOC or SBLC), also known as a standby or LOC, is a lender's guarantee of payment to an interested third-party in the event the client defaults on an agreement. Standby letters of credit are formal documents that specify the duties and obligations of each party and serve as an act of good faith. The bank issuing the SLOC performs general underwriting duties to ensure the financial credibility of the party seeking the letter of credit. Then it sends a 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 debts. An SLOC helps fulfill business obligations if a business ceases operations, cannot pay its vendors, or becomes insolvent.  They are also beneficial for international trade, which involves significant financial risks due to conflicting national laws.

Small businesses often face difficulty when securing financing. Therefore, standby letters of credit are beneficial as they encourage investors to lend money. In case of default, the bank securing the SLOC assures investors that both principal and interest will be paid.

Obtaining a Standby Letter of Credit

A client, typically a business owner, requesting a standby letter of credit must prove to the bank that he/she is capable of repaying the loan. Collateral may be required to protect the bank in the event of default. The bank typically provides a decision in writing within one week of receiving final documentation to complete the processing of the client's application. The client must pay a SLOC fee for each year that the letter is valid. The fee is typically 1-10% of the SLOC value. Provided the arrangement's stipulations are met, the client is permitted to cancel the SLOC without incurring additional 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 contract requirements are unfulfilled. For example, an exporter sells goods to a foreign buyer who guarantees payment in 30 days. When no payment is received by the deadline, the exporter presents the SLOC to the buyer's bank to receive payment.

A performance SLOC ensures that 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 contractual 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 payment.

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