Standby To Safeguard Payment

Author:Ms Rebecca Downes
Profession:Andrews Kurth LLP

Originally a product of the United States of America, standby letters of credit ("standbys") have, in recent decades, attracted global recognition, which has been marked by their adoption and implementation on an international scale. They are employed by oil and gas companies in asset and business acquisitions and disposals, as well as in the development and commercialisation of projects. Their popularity often sets them apart from other financial instruments, such as commercial letters of credit, performance bonds and demand guarantees, as the preferred form of security.

This article briefly analyses two different, but related, bodies of international trade rules which can be applied to standbys; considers the fundamental DNA of standbys; and provides some food for thought to those responsible for their preparation and execution.

Letters of credit

A letter of credit is a written obligation (as its name suggests, in letter form), which is issued by a bank to a specified beneficiary, on an applicant's behalf, pursuant to which the issuing bank is obliged to make a monetary payment to the beneficiary or trustee against the presentation of specified documents or a written demand. In return, the issuing bank is paid its costs for setting up the letter of credit, as well as receiving reimbursement from the applicant for any debt it incurs as a result of the credit being drawn down.

Letters of credit largely fall into two baskets: traditional commercial letters of credit and standbys. The commercial letter of credit acts as a payment mechanism, which is put in place to safeguard payment of the purchase price by the buyer to the seller in consideration for the sale of goods or provision of services. Standbys, however, have a slightly different function. They typically provide collateral support for particular financial obligations owed by one party to another under an underlying contract. Despite their subtle difference in purpose, both types of credit are triggered by a contingent event, create a primary obligation on the issuing bank and are a form of documentary credit.

Although this article does not refer to performance bonds and demand guarantees in any detail, it is worth noting that a letter of credit performs a similar function, and is often described as being equivalent, to a performance bond and demand guarantee. Like letters of credit, performance bonds and demand guarantees safeguard a beneficiary against a failed performance, or an alleged failed performance, by an applicant under an underlying contract.

Trade rules: UCP 600 v ISP98

Bodies of international trade rules for letters of credit have been published by the International Chamber of Commerce ("ICC") in a successful attempt to standardise their terms and conditions. Most letters of credit are either subject to the ICC's Uniform Customs and Practice for Documentary Credits ("UCP") or the ICC's International Standby Practices ("ISP").

UCP is currently in its sixth edition ("UCP 600"). UCP 600 was implemented on 1 July 2007 and evolved from, and superseded, the UCP's fifth edition ("UCP 500"). Although there are notable similarities between UCP 600 and ISP98, such as their inclusion of rules relating to presentation and examination of credits, it is important to recognise that ISP is a separate set of specific uniform rules.

ISP98 was originally approved on 6 April 1998 by the ICC Commission on Banking Technique and Practice whose objective was to plug the hole it felt had been created by the UCP in respect of standbys, and to provide more detail and clarification around the rules relating to such form of credits. ISP98 provides custom rules for standbys, and has been an alternative body of rules to UCP for the past sixteen years.

The applicant and the beneficiary have the freedom to decide which set of rules to incorporate into their standby, and it is important that the standby expressly states that it is issued subject to whichever set of rules have been chosen. A standby can also expressly modify or exclude particular parts of the selected body of rules from its application. Often this is addressed in the standby by...

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