A guaranty letter of credit serves as a guaranty of performance of an obligation. A guaranty letter of credit is one under which the issuer must honor demands for payment only if there is a default on the underlying contract between the issuer's applicant and the beneficiary, or if the beneficiary presents documentation indicating that the applicant has defaulted. It serves as a secondary payment mechanism and is often used to guarantee performance or to strengthen the credit worthiness of a customer. The difference between a guaranty letter of credit and a traditional letter of credit is that traditional letter contemplates payment on performance, while a guaranty or standby letter contemplates payment on the failure to perform. A guaranty letter of credit is meant to be drawn upon only in the event that its applicant fails to make a direct payment to the beneficiary.
A bank will issue a guaranty letter of credit on behalf of a customer to provide assurances to perform under the terms of a contract between the beneficiaries. The beneficiary is able to draw under the credit by presenting a draft, copies of invoices, with evidence that the customer has not performed its obligation. The bank is obligated to make payment if the documents presented comply with the terms of the letter of credit.
Generally, guaranty letters of credit are issued by banks to:
stand behind monetary obligations;
insure the refund of advance payment;
support performance and bid obligations; and
insure the completion of a sales contract.
The domestic guaranty letter of credit is governed by the Uniform Commercial Code. Procedures required to execute a guaranty letter of credit are less rigorous than those required for commercial letter of credit.
A guaranty letter of credit is also known as a standby letter of credit.