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On occasion we have come across a type of Standby LC that, for lack of a better expression, we would call the “2-in-1 Standby”. Usually driven by beneficiary request, it consists of a Bid Standby that converts into a longer- term Performance Standby if certain conditions are met. In other words, instead of issuing a Tender/Bid Standby under ISP98 (or URDG LG) for a BID, and THEN issuing a performance IF the applicant wins the bid, the bid standby “becomes” a performance standby (or incorporates performance default drawdown wording) if the applicant is awarded the bid. Generally speaking, UCP600 would be less suited for such an instrument. More traditional or cautious standby LC practice might reject such an approach outright to avoid unnecessary complexity. However, practices and needs vary, and the mere existence of such a peculiar instrument merits exploring it in greater detail. As samples are quite rare, we will discuss some examples of clauses encountered and discuss potential advantages and disadvantages to such an approach. Finally, we would invite further comments from the DCW community.
To begin, like most standbys, the instrument’s text generally refers to the contract or Request for Proposals/Tender guidelines, pursuant to which the standby is issued. In the discussion of the purpose of the standby the wording includes a description of the initial type of standby, e.g. as a bid standby or to secure an advance, but adds further wording to the effect that the standby “may serve” as performance security or “will continue as” a performance standby should certain conditions arise or after a certain date. Such conditions may be expressed generally, but the text should include clear, documentary conditions to attest that such conditions have been met. The expiration date will generally cover the whole period of the obligations, i.e. the bid process and the performance obligations of the winning bidder (Applicant). In some instances, like many performance standbys, the standby would also include an annual automatic extension clause.
The key part would then be the statement of default and demand for payment wording to be provided by the Beneficiary should it choose to claim. The first statement covers the common events where the Applicant withdraws its bid prematurely or fails to sign the contract should it be selected as the winning bidder. However, it might also include a statement that the Beneficiary did not receive proof or “confirmation”, i.e. notification that the Bid Standby has been “converted” into a Performance Standby or is otherwise effective for a determined period of time covering performance obligations.
The standby also includes a second default statement covering failure of the winning bidder to perform various obligations under the contract. In the event of a demand for payment, the Beneficiary should specify which of the two statements of default apply. Thus, as a the standby already includes a separate default for performance of long-term obligations following the award of the bid, one wonders if such a “confirmation” (notification) is necessary or even counter-productive in the first statement if the standby clearly states that it will also cover performance obligations if the contract is awarded to the Applicant bidder.
The Case for
Before proceeding with a brief discussion about some potential pitfalls of such a standby structure, let us examine why one might prefer such a standby in the first place. From the Beneficiary’s perspective there is the assumed advantage of not having to wait for a second standby to cover performance obligations. Due to the risks of bidders or awardees pulling out of the process and generating further costs to the authority awarding the contract, such an upfront and larger undertaking is likely to signal a greater commitment or solvency of the bidder. As such, it may serve simply as a mechanism to eliminate less committed or “serious” bidders from the outset by somewhat increasing the burden on the Applicant. Whether such a potentially unnecessary burden being imposed on bidding companies is justified is uncertain although it could also guard against failure to obtain issuance of the second (performance) standby due to a recent degradation of the bidder ’s credit since bidding.
Issuing a single instrument for both phases of the process could avoid the pandora’s box of negotiating wording of a new standby text once parties are already contractually engaged. However, when issued in favour of a public authority requiring such specific text, the wording of any separate performance standby would likely also be imposed on the bidders and provided in advance, making this specific concern moot. Therefore, the concern of protracted negotiations on the text seems less relevant for bids with public authorities than amongst private parties, who might be negotiating the texts as they go along in their contract. Putting aside the less common issue of the 2- in-1 Standby among private parties seeking to convert one form of standby to a performance standby, the 2-in-1 Standby could theoretically simplify the issuance process if the text or terms and conditions of any future performance standby are not provided in advance in the Request for Proposals. It is possible that the Beneficiary’s worry is not so much the Applicant’s disagreement with the text of the performance standby, but the opposition of the Applicant’s bank once the performance standby must be issued.
Finally, the Applicant might see the benefit in the issuance of one single standby LC for a larger amount if the commission structure is more favourable for larger amounts or to avoid multiple fixed issuance costs (text drafting, issuance fees, Swift or courier fees, etc.) for each standby. Considering the costs of tying up more capital longer than needed and the small amount of fixed costs in proportion to the overall commission cost of a large standby, this advantage seems mostly theoretical.
The case against
With regards to potential disadvantages or concerns, there is the possibility of highly complex text, the tying up of capital for longer periods than necessary, the prospects of a dispute on one issue or phase of the contract tying up the entire standby for all phases.
First, contemplating a mutating standby that will cover various phases and types of obligations can lead to an overly complex or lengthy standby. As a result, complete understanding of such a standby by all parties might be unlikely or different interpretation on various matters could arise. That said, many of the pitfalls do not result exclusively from the structure of such a standby but by what wording is inserted, and just as importantly, what is left out. For example, to the extent that one accepts a 2-in-1 Standby, it should be made clear how and when the performance portion of the standby is effective. As stated above, it might be doubtful as to how wise it would be to include such a conversion notice, but once required, the standby should be clear as to who issues the notification, how it is issued it, and when it is issued. Otherwise, if an event is the condition for converting the bid standby to a performance standby, a clause indicating that the increased performance portion will take effect automatically on a specific date might be the clearest option.
As the standby is irrevocable, subjecting the 2-in-1 Standby to numerous conditions for the performance portion might simply confuse matters and leave the performance portion in a “dead zone” until expiry. Further, except for a clear date, any such conditions must be documentary and should be verifiable on the banker ’s books, lest the Beneficiary be left unaware and the utility of such a 2-in-1 standby be negated. To require a further notification for converting the Bid Standby to a Performance Standby certainly decreases the Beneficiary’s advantage of requesting the 2-in-1 in the first place. If instead of waiting on a new performance standby, the Beneficiary must now wait on the notification that the standby has been “converted” to a performance standby and consequently, gains little benefit from the 2-in-1 standby. On the other hand, if the text clearly states that it also covers performance obligations and the statement of default covers performance default, why subject it to further notification?
In addition, tying up capital from the outset for a longer than necessary period carries a greater risk when dealing with large public authorities that could potentially delay in releasing the Bank from its obligations even though the bidder ’s proposal was rejected. When the public authority is in another country, with a much less accessible or flexible bureaucracy, obtaining a release before expiry can be nearly impossible.
Further, should a dispute arise over what would normally be covered by the first standby, there is the risk that the entire standby, including the portion covering performance obligations, would be subsumed in the dispute as well. Injunctions, or injunction attempts, are unfortunately a still too common occurrence in standby practice and litigation has been known to impede payment or threaten cancellation of a standby for years beyond the standby’s intended lifetime. In the meantime, the Applicant likely continues to be responsible for commission fees on the standby and sees its credit tied up with its bank, while the Issuing Bank’s obligation remains outstanding or pending.
Conclusion and Call for Comment
At best, such novel approaches are a testament to the versatility of standbys and creativity of their drafters, but they require a high degree of vigilance and attention to detail on the part of all parties involved. Applicants and bankers asked to issue such standbys should be aware of the potential risks. As issuing banks should encourage clarity, simplicity, and functionality in the instruments they issue, while playing a key role in the educated use of standbys, comments and reactions from LC specialists as to the viability of the 2-in-1 Standby and this article’s discussion would be greatly appreciated. Please direct feedback to DCW via email to: info@iiblp.org
* Scott Scrosati has worked in various trade finance positions at National Bank of Canada (Montréal), including as Senior Advisor and as a Manager of Trade Operations, for over 15 years. He holds the CDCS and CTFC designations. His main areas of practice are in standby letters of credit, guarantees and compliance.
** René Bricault has worked in trade finance within various Canadian banks, including National Bank of Canada (Montréal), as Expert Advisor for Standby Letters of Credit and Demand Guarantees for 15 years. He has held the CSDG designation since 2015.
The opinions expressed herein are solely those of the authors and do not necessarily represent the views of their employer or any affiliated organisation.