Letter of Credit Forum

Standby letters of credit are bank guarantees. However, since passing of the Glass-Steagal Act in 1932, American banks were separated in commercial and investment banks where commercial banks were not permitted to issue guarantees. 

To overcome this competitive disadvantage, Amercian banks circumvented the Glass-Steagal Act by issuing letters of credit, where the beneficiary only had to demand payment but not present commercial documents. Glass-Steagal was repealed in 1999, however, banks continued to offer standbys since their clientele was used to them. 

The name "standby letter of credit" indicates that standbys are governed by the rules for letters of credit. This however is a field for confusion. Letters of credit typically are governed by the Uniform Customs and Practices (currently in force are the UCP 600). The UCP regulate in great detail what type of shipping documents are acceptable and the relation of the banks towards the underlying transaction and towards the other parties. These rules however fit guarantees not like a glove. In a bank guarantee the beneficiary only needs to demand payment. 

To address this issue the Institute for International Banking Law and Practice published the International Standby Practices (ISP98). US banks are very happy with these rules, however, internationally they have not been accepted. When an American company has a standby issued by a foreign bank, most likely the foreign bank will issue the standby according to the UCP 600 or according to local rules for guarantees.

The standby is a "docuemntary promise to pay". Due to its relationship with letters of credit, the beneficiary still needs to present a document. Sometimes this rquirement will be met by presenting drafts (also known as bills of exchange). Most standbys are straight standbys, nameley, the beneficiary cannot negotiate his claim for payment. In this constellation the use of drafts does not make any sense, however, since old habits are dying hard, many standbys still require a draft. 

The issuance of drafts should also be avoided since local laws and standby practices might cause the bank to refuse payment due to a alleged failure to comply with formalities. 

In case you want to read more about the topic, please also visit our articles section or click here to download
the article Competition between international bank guarantee, letter of credit and American standby after coming into force of the ISP 98.