Risks associated with local Standby LC

Recent changes and stringent compliance procedures in cross-border trade has made LC transaction a risky product, so many banks now discourage this transaction. Moreover, the priority of all banks for super centralisation of their operation, massive on-line operation and outsourcing of their operational responsibilities has been increasingly widening the gap between the banks' documentary LC departments and the customers engaged in cross-border trade. Under these circumstances, most business enterprises are engaging in cross-border trade through open account and contract based on Standby LC. Standby LC conveniently supports boosting export of developing countries particularly Bangladesh because payment risk is mitigated and thus both parties feel secure and comfortable in carrying out their regular trade for longer term. Once issued, standby LC remains valid till expiry and no further communication is required. Moreover, this trade finance product does not require any supporting documents, which is an integral part of conventional LC.
TYPES OF STANDBY LC: Standby LC can be classified into different types based on its nature, scope, functionality and underlying transaction. In general, Standby LC can be classified as Non-Financial Standby LC and Financial Standby LC. Non-Financial Standby LC is issued where underlying transaction is involved and payment term is associated with the accomplishment of underlying transaction. Financial Standby LC is more specific in guaranteeing payment obligations. Standby LC issued in favour of tax authority falls under the category of Financial Standby LC. Apart from this, there is another type of Standby LC called Financial Standby LC but categorised as Collateral Standby LC as this type of Standby LC is used as collateral security against granting credit facility to the borrower. This collateral Standby LC is very helpful for multinational companies who carry out business in different countries where local banking facilities are required. Usually, a multinational company approaches its bank in their home country to issue collateral Standby LC in favour of a bank in the country of their operations. Against this collateral Standby LC, local bank can easily grant credit facility in favour of foreign company's local operation. It should be mentioned that in many countries including Bangladesh, there are regulatory restrictions on approving credit facility to foreign companies. In this situation collateral Standby LC plays a very significant role. Additionally, irrespective of Guarantee and Standby LC, this trade finance product is broadly classified into bid bond, performance guarantee and advance payment guarantee. Bid bond is used to participate in a tender while performance bond is required when the bidder wins the bid and work is assigned. Advance payment guarantee is required if mobilisation fund is provided and requirement of securing mobilisation fund arises.
Besides, there are tenure-based classifications of Standby LC. These are: evergreen Standby LC and perpetual or open-ended Standby LC. When Standby LC contains auto-renewal clause, it is called an evergreen Standby LC. Similarly, if Standby LC does not bear any stated expiry, its validity will remain effective for indefinite period until otherwise measures are taken. This instrument is known as perpetual Standby LC. Furthermore, Standby LC may be categorised as Local Standby LC and Counter Standby LC. When a Standby LC is issued against another Standby LC, the former is known as Local Standby LC. The latter is known as counter Standby LC. In fact, at the request of Counter Standby LC, a local Standby LC is issued and the content of the local Standby LC is provided in the text of counter Standby LC. This is also another important structure of trade finance transaction that simultaneously helps both the beneficiary and the applicant. The beneficiary may have preference of accepting Standby LC issued by certain banks. But the applicant, who requests the issuance of Standby LC, may not have access to those banks. Under this situation, a stalemate arises between the beneficiary and the applicant that can be solved with the help of local and counter Standby LC. The applicant can approach his bank to issue counter Standby LC in favour of beneficiary's preferred bank, which then issues their local Standby LC in favour of beneficiary. This type transaction can conveniently be carried out under correspondent relationship among the banks across the world.
EVERGREEN STANDBY LC & EXIT CLAUSE: Standby LC has the limitation of fixed expiry but underlying transaction is an ongoing process. After expiry of Standby LC, its effectiveness ceases to exist and any claim if lodged after the stated expiry is not honoured by the issuing bank. In the practical scenario, it is very unlikely that all business deals undertaken with a Standby LC will be settled full-and-final within the stated expiry. Therefore, beneficiary's risk cannot be fully mitigated with Standby LC. On the other hand, an applicant who requests issuance of Standby LC may assume additional risk if Standby LC is issued with longer expiry, because underlying transaction may be finally settled well ahead of the expiry and there is risk of drawing by the beneficiary even after closing the business deal, especially when business relationship is terminated following trade dispute. Moreover, in the present volatile financial market, most of the banks are reluctant to issue Standby LC with lengthy expiration.
In order to overcome this awkward situation, an evergreen Standby LC has been introduced. This is technically a regular Standby LC with fixed expiry but a specific clause is inserted in the text of the Standby LC. This clause conspicuously stipulates that in spite of having fixed expiry, the Standby LC will be automatically extended for further one year or any other regular period from the next expiry or any other future expiry date. This clause is also known as auto-renewal clause that actually keeps the Standby LC valid year-after-year. However, Standby LC containing this auto-renewal clause becomes a perpetual instrument which continues for indefinite period and as such, is not desired by either applicant or bank. So, another clause known as exit clause is inserted to make it more acceptable for both parties. This clause simply states that notice of non-renewal will be issued if the applicant desires not to further extend Standby LC and such notice is usually served well ahead of the current expiry. This notice is called non-renewal notice where it is clearly mentioned that this Standby LC will not be extended anymore and, under the circumstances, if the beneficiary is required to draw, that claim should be submitted within the current expiry. Usually, such notice is given prior to 30/60/90 or 120 days prior to the current expiry as agreed upon. This agreed-upon time for issuing non-renewal notice is known as non-renewal notice period. Standby LC containing auto-renewal clause and non-renewal notice period keeps continuing as soon as non-renewal notice period elapses. If the beneficiary decides not to continue Standby LC, his bank is required to issue non-renewal notice meticulously complying with non-renewal notice period. As soon as non-renewal notice period is triggered, meaning the last date of issuing non-renewal notice has elapsed, the Standby LC is automatically extended for another year under auto-renewal clause. So, non-renewal notice must be issued prior to the beginning of non-renewal notice period in order to stop further auto-extension. For example, if a Standby LC is issued with expiry on April 30, 2020 containing auto-renewal clause that has mentioned 60 days non-renewal notice period and if non-renewal notice is not received by Mar 01, 2020, this Standby LC will be automatically extended for further one year under auto-renewal clause.
EXPIRY DATE OF STANDBY LC: Expiry date of Standby LC is very important, especially where both local Standby LC and counter Standby LC are involved. Since, local Standby LC is issued against counter Standby LC, two independent instruments are involved. Therefore, two separate expiry dates are used for each Standby LC. It is very unlikely for expiry of both local Standby LC and counter Standby LC falling on the same day. If it happens, it will not be acceptable. These dates will be examined very carefully by the bankers and necessary measures will be taken to mitigate the risk. Usually, there must be at least a 15-day gap between the expiry of local Standby LC and counter Standby LC. Even expiry of local Standby LC must fall at least 15 days prior to the expiry of counter Standby LC. This is required because if beneficiary of local Standby LC submits claim at the last moment of the expiry date, issuing bank will have enough time to lodge counter claim. This gap between the expiry of local Standby LC and counter Standby LC is called window between the expiry of local Standby and counter Standby.
Calculation and reviewing of the window between expiry of local Standby LC and counter Standby LC may apparently seem very simple. It can be, if Standby LC does not contain auto-renewal and exit clause. Transaction can become complicated when both local Standby LC and counter Standby LC contains auto-renewal clause and non-renewal notice period. Key factor of such transactions include (I) expiry date, (II) non-renewal notice period, and (III) last date of issuing non-renewal notice. All these factors will be taken under consideration in order to mitigate the risk associated with local Standby LC.

Nironjan Roy is a banker, based in Toronto, Canada.
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