RISK REDUCTION METHOD IN FOREIGN TRADE: STAND-BY LETTER OF CREDIT (Stand-by Letter of Credit)

One of the most important risks encountered in foreign trade is that the promised good is not in the amount, type, and quality specified in the contract or the price is not paid. It is observed that the parties generally tend to keep costs low such as transportation and insurance costs and increase the profit rate. While risk problem in the domestic market can be solved by matters such as guarantee letters and other type of guarantees; in international markets, the system has shifted in other directions.

While letters of guarantee can also be used in international trade, the system encountered in practice is the LETTER OF CREDIT itself. Since in countries such as the USA[1] and Japan, banks are prohibited from giving letters of guarantee abroad, the need for collateral has been tried to be satisfied with STAND-BY LETTER OF CREDIT (Stand-by Letter of Credit).[2] This practice was reflected in world trade similarly.[3]

What are the Types of Letters of Credit?

- Performance-Based Standby Letter of Credit (Performance Standby)

- Advance Payment Standby

- Standby Letter of Credit for Participation in the Tender Bond (Bid Bond / Tender Bond Standby)

- Counter Standby Letter of Credit

- Financial Standby Letter of Credit (Financial Standby)

- Direct Pay Standby Letter of Credit (Direct Pay Standby)

What can a Letter of Credit or Standby L/C include?

- Delivery of goods

- Payment of the cost of goods

- Carrying out the transportation

- Payment of the loan granted

- Payment of customs duties

- Fulfillment of insurance conditions

- Signing the contract

- It may include conditions such as participation in the tender.

What is a Stand-by Letter of Credit (Stand-by Letter of Credit)?

It has a function similar to a payment guarantee. It is a letter of credit confirming that the payment will be made if the contract with the third party is not fulfilled. The bank that issued the letter of credit guarantees the beneficiary on behalf of the third party. But the important point is that the issue of payment conditions is to be clear and precise.[4] If a contract with unclear 1000 articles is submitted and the contract is violated or not will be determined by the judicial authority, then the desired benefit will not be obtained from this letter of credit. Since this type of accreditation is a featured type, it is used in case of fulfillment services or certain works rather than works related to the purchase and sale of goods.

As a type; it is qualified as a letter of guarantee. Also; has a qualification of independence. So; excluding the relations and obligations between them, it includes the issue of making the payment by submitting the document to be shown under this letter of credit.

This letter of credit is often used for construction contracts. There are also areas where it is used to create commitments for transactions made in money and capital markets.

It is stated in the decision of the Supreme Court of Turkey as follows; “Stand-by letter of credit is a kind of letter of guarantee used in matters such as long-term purchases, large business contracts, and borrowings. The bank arranges the letter of guarantee as a letter of credit and secures the transactions in this way. However, a stand-by letter of credit is different from a normal letter of credit, and payment is made upon failure to execute this letter of credit."[5]

Why should use the Stand-by letters of credit?

In case of breach of contract performance; the purpose of compensating the damage is provided. Using this type of letter of credit will force the parties to comply with the contract. Also; in case of damage, the cost of the damage can be collected directly without the need to follow up on the receivables in litigation, arbitration, etc.

What is the difference between a Standby Letters of Credit and a Commercial Letter of Credit?

While the commercial letter of credit is opened in favor of the seller or contractor with the order of the buyer or the employer, the standby letters of credit is opened in favour of the buyer or the employer with the order of the seller or contractor.[6]

Commercial letters of credit are opened only for the purchase of goods, and if the terms of the letter of credit are complied with and this is proven with documents, it gives assurance to the beneficiary. Standby letters of credit (standby L/C) covers all kinds of goods, services, payment guarantee.

In the commercial letter of credit; the issuing bank makes a payment to the beneficiary if it is documented with an invoice, transport document, etc. that the commitment specified in the contract has been fulfilled, that is, the goods have been shipped or the service has been performed. In the standby letters of credit, it undertakes to make a payment to the beneficiary to compensate for the loss incurred by the beneficiary upon failure to fulfill the commitment and in return for the document submitted by the beneficiary to prove it.[7] When evaluated in terms of risk; the risk subject to guarantee is minimized with the invoice for shipment of the goods and the document showing that the goods are loaded in the commercial letter of credit. In the standby letters of credit, on the other hand, since the payments will be made upon the written request of the beneficiary and with a copy of the document issued by third parties, they may contain risks.[8]

In this case; the bank does not have the opportunity to directly audit that the work has not been done, only examines the non-fulfillment of the commitment on the document, and gives the guarantee on the document to the beneficiary. It should not be forgotten that the authority of the bank is limited and that it is not authorized to comment and will only pay by examining the document. However, the issuing bank can appeal with a court decision.

In the opposite case; if the parties have fulfilled each other's commitments within the framework of letter of credit; then the blocked collateral must be returned. Of course, one of the most discussed issues is the loss of interest between the opening and closing of the letter of credit. In this context, banks receive a commission in return for the letter of guarantee they issue. However, if the security deposit has to be paid, the bank may consider it as a loan and apply for the recovery method together with the INTEREST, since there will be money receivable in this case.

Are the Standby Letters of Credit and Letters of Guarantee the same?

Although both methods are the same in terms of their purposes; they differ in terms of procedure.

First of all, it is worth mentioning a few similar points:

1- A certain risk is guaranteed in both.

2- The bank is not responsible for damages that are not covered by the guaranteed risk, therefore it is not possible to claim from the bank.

3- It is within a certain limit of the warranty. In other words, it requires open-ended interpretation and no limit can be set.

4- There is an independent debt bearing situation. The nature of the commercial relations of the parties and the guarantee are considered different from each other.

5- Although it is rare, the bank may not pay by citing its defenses.[9]

Differences are based on the document submitted.

A letter of guarantee is a commitment issued by the guarantor and delivered to the addressee to compensate for the loss of the addressee if the debtor does not fulfill its performance. Technically; it contains the record that will be paid by the bank issuing the letter of guarantee at the first written request of the addressee UNCONDITIONED and UNCONSCRIBED.[10]

A letter of guarantee can also be arranged as a conditional letter of guarantee, as in a standby letters of credit. However, in practice, this method is converted into a standby letter of credit.

Similarly, a standby letter of credit is a commitment issued by the guarantor to compensate for the damage of the party for whom the letter of credit has been issued, taking into account the failure of the debtor to fulfill its obligations and conveyed to the letter of credit beneficiary. The collateral, which includes the application made by the addressee regarding the presentation of the document regarding the condition, and the payment receivable, is named as the conditional letter of guarantee/standby L/C.

As a result; a conditional collateral letter of credit is a method that is frequently used in large-scale projects, tenders, and foreign trade in practice. Letter of guarantee, conditional guarantee, or standby letters of credit, especially in cases where the parties are new to foreign trade or the parties do not know each other, it will both create legal pressure and reveal the necessity to comply with the contract.

Att. BURCU SOLMAZ

(L.LM, University of Hertfordshire)

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[1] According to the National Bank Act of 1864 (National Bank Act)