By: Serge Filatov, Esq.
Standby letters of credit are irrevocable agreements for the payment of money. They function like guarantees of obligations and are usually provided by a bank for the benefit of a beneficiary. Standby letters of credit are governed by Article 5 of the Uniform Commercial Code (UCC), which in California is found at Division 5 of the California Commercial Code.
Standby letters of credit should not be confused with commercial letters of credit (not discussed in this blog) which are used as primary payment mechanisms in trade.
Standby letters of credit are generally used to provide third-party support for specific obligations. Where a specific payment obligation is being supported by a standby letter of credit, the standby letter of credit is usually drawn only if and to the extent the applicant fails to satisfy the specific payment obligation. As it involves an extension of credit by the issuing bank, the application process is similar to the process of obtaining any loan. Moreover, as the standby letter of credit involves a possible contingent payment in the future, many issuers require that the standby letter of credit be cash collateralized.
The issuing bank will usually have its own requirements for what a standby letter of credit will contain. Examples of what a standby letter of credit may include are:
- The amount of the letter of credit.
- When drawings are permitted under the letter of credit.
- The drawing conditions under the letter of credit. For example:
- the conditions under which drawings can be made.
- the documents that must be presented for a drawing to occur.
- whether partial draws are allowed, and if so, any limits that may exist on such draws.
- the timeframes for drawing.
The issuing bank pays the beneficiary under a standby letter of credit if and when the beneficiary submits a proper draw request to the issuing bank. Once drawn upon, the individual and/or entity that applied for the standby letter of credit must also reimburse in full the issuer of the standby letter of credit for the amount paid out.
Drawing on a standby letter of credit usually requires delivery of a draft and specified documents to the issuing bank in order to receive payment. Such documents usually include submission of the original standby letter of credit and a separate statement. The letter of credit itself will specify drawing requirements.
Standby letters of credit are unique instruments which are governed by their own distinct rules. As an applicant for a standby letter of credit, one should make sure that they speak to their banker, attorney, or other professional advisor to make sure they are comfortable with all of the requirements for obtaining a standby letter of credit before moving forward with it.
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