When It Is Used and How Banks Process a Drawing

A standby letter of credit is used when the beneficiary needs security for an obligation, and the applicant is willing to give a bank undertaking as that security. The most common uses are performance guarantees, financial guarantees, advance payment guarantees, bid bonds, and payment guarantees. A performance guarantee secures the performance of a contract, for example a construction contract. A financial guarantee secures the repayment of a loan. An advance payment guarantee secures the repayment of an advance payment if the supplier does not deliver. A bid bond secures a bid, and it is drawn if the bidder withdraws its bid or refuses to sign the contract. A payment guarantee secures the payment for goods or services. In each case the beneficiary holds the standby, and draws it only if the applicant fails. The drawing process is as follows. The beneficiary presents a written demand to the issuing bank, or to the confirming bank, stating that the applicant has defaulted, and presenting any documents the standby requires. The demand must be presented before the expiry date, and it must comply with the standby terms. The bank examines the demand, and it has a maximum of five banking days to examine it, under UCP 600 and ISP98. If the demand complies, the bank pays the beneficiary the amount demanded, up to the standby amount. If the demand does not comply, the bank refuses to pay, and it must notify the beneficiary of the refusal and the reasons, within the five banking day period. The beneficiary may present a corrected demand before the expiry date, if time permits. The documents required for a drawing are normally minimal. The standby will state the documents, and they are usually a written demand, signed by the beneficiary, stating that the applicant has defaulted and that the amount demanded is due. Sometimes the standby also requires a certificate of default, signed by the beneficiary, or a copy of an unpaid invoice, or a copy of a court order. The beneficiary should prepare the demand carefully, because a demand with a wrong amount, a wrong reference, or a missing signature will be refused. The bank examines the documents for compliance with the standby terms, not for the truth of the statement that the applicant defaulted. The bank does not investigate whether the applicant really defaulted, and it does not wait for a court to decide. It pays on the documents. The examination period is five banking days, and it is a maximum, not a target. The bank should examine the demand as quickly as possible, and should pay or refuse within the period. If the bank does not respond within five banking days, it loses the right to refuse on the basis of a discrepancy, and it must pay. This is a strict rule, and it is a common source of error. A bank that takes six banking days to examine a demand, and then refuses it, will be liable to pay, because it missed the deadline. An SME who reviews a standby process should check that the system diaries the five banking day deadline from the date of presentation, and that it prompts the examiner to complete the examination in time. The expiry of a standby is the last date a demand can be presented. A demand presented after the expiry date will be refused, even if the applicant defaulted before the expiry. The beneficiary must therefore diary the expiry date, and must present the demand before it. If the standby has an evergreen clause, the expiry will extend automatically unless the bank gives notice of non-extension. The beneficiary should check whether the standby is evergreen, and should ask the bank to confirm the current expiry date before it relies on the standby. A beneficiary that assumes a standby is still valid, when it has expired, will find that it has no security. A partial drawing is possible if the standby permits it. The beneficiary may draw part of the amount, for example USD 200,000 of a USD 1,000,000 standby, and the standby remains available for the balance, until the expiry date or until the full amount is drawn. The standby should state whether partial drawings are permitted, and whether multiple drawings are permitted. A standby that permits only one drawing, for the full amount, is less flexible than a standby that permits multiple partial drawings. The beneficiary should check this term, and the bank should record the amount drawn and the balance available, so that it does not pay more than the standby amount. For a business analyst, the drawing requirement must cover the presentation, the examination, the five banking day deadline, and the payment. The requirement should state that the system records the date and time of presentation, that it calculates the five banking day deadline, that it prompts the examiner to complete the examination before the deadline, that it records the amount drawn and the balance available, and that it generates the payment instruction when the demand complies. A system that cannot calculate the five banking day deadline, or that cannot record a partial drawing, cannot process a standby drawing safely.