The back-up plan in standby letters of credit

Each year Kenya receives financing assistance from donors, focused more on capacity building than commercial projects. These projects are mostly left to private investors who might lack financial capacity or sustainability over the long-haul which is why project financing is a solution in the development of the investor’s concepts into viable projects.

Project financing solutions are designed to cater for both small and large property developers who wish to construct multiple units either for rent or for sale. One of the major issues in each contract during property development is the payment and how to implement obligations of the parties. Reasonable concerns of the parties in the international trade are more than domestic trade.

One of the most important instruments of security in this trade is the standby letter of credit. If you are a potential investor and want to turn your project idea into reality then here is how to. The standby letter of credit was created in the United States as a payment undertaking primary in form but intended to be used only as a fall-back (“standby”) in the event of default by the principal in terms of the underlying contract. In the United States standby letters of credit are used in a huge range of transactions, such as lease agreements, stock purchases, financial security, commercial paper, trade investments and many other such contracts. Standby letters of credit are useful for international trade as well as domestic transactions like local building projects.

An SBLC can be used as a safety mechanism in a contract for service. A reason for this will be to hedge out risk. In simple terms, it is a guarantee of payment which will be issued by a bank on the behalf of a client and which is perceived as the “payment of last resort”. This will usually be called upon when there is a failure to fulfill a contractual obligation. The use of an SBLC is usually a sign of good faith in a transaction, to provide proof of the buyer’s credit quality and ability of payment. To set up this mechanism, a short underwriting duty is performed to ensure the credit quality of a party that is looking for a letter of credit; a notification is then sent to the bank of the party who requests the letter of credit (who is typically a seller).

The value of an SBLC is the ability to show the credit quality of a company and to repay loans. An SBLC is very much seen as an insurance policy to assist with fulfilling the obligations of a business if they stop operating, there is an insolvency situation and it cannot fulfill payment obligations for any reason. SBLCs as used to promote confidence in companies, those receiving investment or a funding line. In the case of a default, the counter party may have an element of the finance paid back by the issuing under an SBLC.

The main element that a bank will take into consideration in relation to an SBLC is showing that the amount they guarantee can be repaid. It is an insurance mechanism to the company that is being contracted with. Thus, there may be collateral that is needed in order to protect the bank in a default scenario – this may be cash or assets, such as property. The level of collateral required by the bank and size of SBLC will depend on the risk factors and strength of the business. Standard due diligence questions are asked as well as information requests surrounding assets of the business and possibly the owners. Following receipt and review of the documentation, the bank typically provides a letter to the business owner. A fee is then payable by the business owner for each year that the SBLC remains outstanding.

One can also use SBLC to acquire non-recourse loans A non-recourse loan is defined as a loan where the borrower or guarantors are not personally liable for repaying any outstanding balance on the loan. Non-recourse financing is typically found on longer term permanent commercial real estate loans placed on a stabilised and performing asset. However, a common misconception with non-recourse loans is that if a loan is non-recourse then a borrower or guarantor can never be held personally liable in the case of a loan default. This is not always true and there are several exemptions commonly covered under what’s known as carve out provisions.

Where goods are sold to counter-party in another country, they may have used an SBLC to ensure their seller will be paid. In the event that there is non-payment, the seller will present the SBLC to the buyer’s bank so that payment is received. A performance SBLC makes sure that the criteria surrounding the trade such as suitability and quality of goods are met. We sometimes see SBLCs in construction contracts as the build must fulfill many quality and time specifications. In the event that the contractor does not fulfill these specifications then there is no need to prove loss or have long protracted negotiations; the SBLC is provided to the bank and payment is then received.

A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. But a letter of credit is the guarantee of payment when certain specifications are met and documents received from the selling party. Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.

Rodgers Obure Omwamba, CEO & Founder,CapitaLand East Africa Ltd.