HOW TO USE A SBLC PROPERLY?

It seems there is much confusion around the topic of How to use a SBLC

This article is being written to try to clear up some of the confusion and misinformation about using a SBLC.

First, let’s define what a SBLC is – it is a Standby Letter of Credit, which means that it is a Guarantee issued by a bank (Bank Guarantee) so that the seller is guaranteed full payment as per the terms of a Buy-Sell Contract assuming that the Seller meets all terms and requirements as stipulated in the Buy-Sell Agreement. If the seller does not meet the terms, the funds set aside for the transaction will not be released. The “frozen funds” will not be released to the seller; they will be returned to the buyer.

M YTH: A SBLC can be leased at a rate of 2% to 5% of the Letter of Credit face value. Then that Leased Financial Instrument can be used to pay for goods. In the end, that the person leasing the SBLC does not have to actually pay for the goods.

It is not clear who dreamed up this scenario but it is simply a fairy tale.

FACT: You cannot lease a SBLC and then use it for anything more than an assurance to the seller of goods. The seller will be paid for the goods upon satisfaction of the terms and conditions of a buy-sell arrangement.

The premise behind the SBLC is this. If the buyer does not pay for the goods as legally required, the bank issuing the SBLC will be liable. The issuing bank must pay the full invoice amount to the seller. As this is the case, you can be sure that the bank issuing the SBLC will take every precaution. The bank will ensure it will not be required to payout on the Payment Guarantee.

Bank Organized SBLC

This more common way for a bank to mitigate the risk is to have the funds due to the seller held in an escrow. This is a type of account where the guaranteed funds are held by the bank.  It will be up to the seller to fulfill the requirement of the Buy-Sell Agreement before it will be allowed to draw down on the Letter of Credit. This is effectively taking the funds which have been held in escrow.

Non-Bank Organized SBLC

When a non-bank company (Alternative Commercial Lender) organizes an arrangement with a SBLC, they will be able to “Lease” the SBLC to the buyer. They will then issue the Letter of Credit to the seller in the Buy-Sell Arrangement. They may not require all the funds to be held in escrow for the transaction. This is because they will mitigate the risk of non-payment by the buyer in a variety of ways.

The most common method to mitigate the risk in a SBLC lease is to structure the transaction as part of an Invoice Discounting Facility or Factoring.

Generally in transactions such as this, the entity facilitating the transaction is not the end buyer. The facilitator is usually a distributor or broker. In a case such as this, Trade Finance Facility or International Accounts Receivable Factoring Facility will be put into place prior to any orders taking place.

Triggering the SBLC to Payout

The trigger in this type of transaction is that when the goods provided by the seller have been delivered to the end buyer and the end buyer accepts and signs off on the delivery of goods. The buyer then becomes the owner of the goods and title then changes hands. An invoice is raised and the buyer then becomes liable to pay for the goods.

Sometime there are net terms for the buyer to pay for the goods. And sometime the payment is due upon acceptance of the goods but in either way, the buyer is then responsible to pay. When the invoice is raised, the finance company then can advance funds against that invoice. In this case, the advance pays the seller of the goods the amount due to them.

Once the buyer pays the invoice when due, the finance company then deducts the amount of funds paid out to the seller and gives the difference to the facilitator, less the finance fee.

This is a simplified Case of How to use a SBLC. If someone tells you a SBLC can do anything more that be a Payment Guarantee to the seller of goods, pause and ask yourself if the deal being presented actually makes sense. If you are unsure, speak with a Commercial Finance Specialist before you pay any Financial Instrument Lease fees. You may be glad you did.

Using Invoice Discounting to Fund a SBLC

As mentioned above, it is possible to use Factoring to make the funds available to organize the issuance of a Standby Letter of Credit.

When the SBLC is required to give payment assurance to a seller so that they will be comfortable to produce and ship goods to an end customer. The intermediary who is brokering the transaction may not have the financial liquidity to back the transaction based on their own assets. This is where Invoice Discounting can be very useful.

USE CASE:

Buyer: ABC Wholesaler Co.

Seller: XYZ Manufacturing Co.

Intermediary (Broker): Export Facilitating Co

For this Use Case, let us assume that ABC is a creditworthy company. Further, we assume Export Facilitating Co has brokered a transaction between ABC and XYZ where ABC must pay the invoice 30 days after delivery and acceptance of the goods. XYZ requires payment on delivery of the goods and Export Facilitating Co does not have the capability to pay for the order when delivered.

Let us also assume that XYZ is a qualified manufacturer and Export Facilitating Co has done similar transactions in the past which can be demonstrated.

The Finance company organizing the transaction would be able to verify the assumptions made in this case and set up Export Facilitating Co with a Finance Facility where the invoice created upon delivery of the goods to the buyer would trigger an advance of funds from the invoice to pay the supplier. In this way, a SBLC can be issued to the seller to guarantee the payment of the goods upon delivery to the buyer, assuming the goods are delivered as agreed.

This is obviously a very simplified Case of how the needful can be done. To be clear, in order to make this happen the following MUST be in place in order for the transaction to be considered:

1. The Buyer MUST be creditworthy;
2. The Seller MUST be a verified manufacturer of the goods to be delivered;
3. The Intermediary MUST have completed successful transactions, similar to the subject transaction.  Where the Intermediary is not able to provide an Audit Trail of prior transactions, this will disqualify the deal. They MUST be able to show successful past transactions.
4. The Seller MUST accept the terms where they are paid upon delivery and acceptance to the Buyer. It is key that the Buyer accept financial responsibility of paying the invoice when they confirm delivery of the goods. There can be no recourse for the Buyer to “Chargeback” to the Seller once they sign-off. It is possible that the Buyer accept financial responsibility prior to the physical delivery. The title transfer must be made clear in the Buy-Sell Agreement between all parties. The Buyer may take financial responsibility at the Sellers dock if desired.
5. Now, a Standby Letter of Credit can be generated and issued. It will be sent to the Seller which will guarantee payment. This is assuming the Seller meets their responsibilities as set out in the terms of the Buy-Sell Agreement and the SBLC.
6. At the moment of acceptance of the goods by the Buyer, the invoice is then generated. The title of the goods now passes to the Buyer.
7. As the invoice is generated, and advance is created from the invoice. This will be done by using Accounts Receivable Factoring and the Seller can draw down on the SBLC.
8. The Buyer pays the invoice to the Finance Company when due.
9. The Finance Company will then deduct the amount paid out to the Seller.  They will then pay the Intermediary the difference, less the finance fee.

NOTE: Changoo & Associates does not provide SBLC services or trade finance services. Article is purely for the consumption of the reader. Changoo & Associates is not a securities dealer or investment advisor. Finance transactions are complicated and the parties involved should always seek independent legal counsel.