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Standby Letters of Credit: Important Protection for Creditors

Good faith is an important concept in the world of business. In fact, without it, very little would probably happen. This is especially true when one person attempts to do business with another, except when problems arise after one party defaults on an agreement regarding payment. It is for these cases that one party (the one being paid) asks for a standby letter of credit, or an SLOC. These are also called non-performing letters of credit.

Origins

Standby Letters of Credit were originally created by legislation that prohibited banks from engaging in business with third parties. Instead, an SLOC in effect stands as a guarantee that a creditor will be paid based on the good credit and payment history of the payer. This way a creditor knows that he will be paid based on the good faith of the bank which is standing by the creditworthiness of the payer.

An SLOC fills the gap when a person fails to fulfill a contractual commitment to a third party. It is for cases like these that the payer’s bank can issue an SLOC, which guarantees payment to the creditor.

An SLOC can be required before a transaction takes place as a guarantee that a creditor will be paid. In these cases, the bank will issue an SLOC to, in effect, underwrite the amount owed to the creditor. This is done after the bank has ensured the payer’s credit quality and repayment abilities.

There are two Standby Letters of Credit, the performance standby, which guarantees the performance of the payer, and the advance payment standby, which guarantees payment by the payer.

Costs

The cost of an Standby Letter Of Credit varies from institution to institution, but ranges from 1 to 8 percent of the face amount owed, annually.

An SLOC can be cashed on demand at the bank if the payer fails to make his payment on schedule as agreed or defaults on the other terms of the agreement. The letter can also be cancelled when the terms of the contract have been met by the payer or borrower.

As explained above, Standby Letters of Credit are an important instrument used in the business world to help protect creditors from payers who default on their obligation to pay.

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