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Standby Letters of Credit: The Private Primary Market    
Source: Hawthorne-Sterling & Company, Inc.

Designed to provide much of the information required for conducting a due diligence investigation.

Lender/Investors are skeptical of opportunities that offer above-market returns. If significant capital is required, little information is readily available with which to conduct a due diligence investigation, there is little motivation for committing funds.

Issues Covered

  • A letter from the Securities and Exchange Commission, (S.E.C) stating that letters of credit are exempt from registration under the Securities Act of 1933.

  • An opinion from the U.S Supreme Court stating that letters of credit, when acquired for cash, are the equivalent of a deposit liability.

  • A legal historical example of a clean standby letter of credit, the text of which is clean of any requirements of documentation of nonperformance or default for the beneficiary to obtain payment.

  • A discussion of the role of the International Chamber of Commerce in encouraging more equitable practices in the area of standby letters of credit.

  • A discussion of case law and legal writing showing that pertaining law has developed away from domestic concepts and structures, and that it is a fallacy to think in terms of a comprehensive body of domestic law on LOC and especially in terms of diversity of national laws.

  • A discussion of transmission, authenticity and the operative instrument; how it is determined when a transmission is authentic and legal.

  • The issuance of standby LOC involves the separation of many of the services associated with lending, such as credit risk evaluation and underwriting, from funding.

  • Banks argue that they are in the risk management business - whether on or off the balance sheet.

  • An important difference between a standby LOC and conventional financing with uninsured depositors is that a standby LOC beneficiary retains the loan in the event of bank failure as opposed to having to stand in line with the FDIC and other creditors to recover the remaining assets of the bank.

  • The greatest motivation for off-balance sheet banking is the opportunity cost of funding assets with reservable deposits without a binding capital constraint.

  • In issuing an off-balance sheet instrument, the bank acts as a third party in a commercial transaction, substituting the bank's credit worthiness for that of its customer to facilitate exchange while sharing some of its risk with the lender/investor.

  • In effect, banks are willing to rent their credit standing or borrow credit analysis to lender/investors by guaranteeing the payment of principal and interest-which may be of value to a bank customer who is not well known or established. This enables a bank to receive an underwriting fee that can bolster current profits without tieing up capital.

  • A bank may not be asked to issue a guarantee unless it is perceived by the market to be strong.

  • How a standby LOC is similar to an uninsured deposit and subordinated note in that it's value varies inversely with the credit risk of the bank.

  • The incentive to the lender/investor? The return on this arrangement is likely to be greater than that of a deposit while still maintaining insurance against loss.

  • The types of entities who acquire standby LOC.

  • A discussion of repurchase programs and credit-enhanced loan transactions.


Recommended further reading:
ICC endorsement of the UNCITRAL Convention on Independent Guarantees and Stand-by Letters of Credit
The mechanics of prime bank SLCS and guarantees
Letters of Credit (LC, ILC & Pay Order)
Stand By Letters of Credit (SBLC's)