Standby Letters of Credit in Ontario Business Financing: How They Work

If a landlord, supplier, or counterparty has asked your business for a standby letter of credit instead of a cash deposit or a personal guarantee, it can feel like an unfamiliar and slightly alarming request. A standby letter of credit is a real financial commitment — it ties up your business's credit with your bank — and it works differently from either a cash deposit or a straightforward guarantee.

Here's what a standby letter of credit actually commits your business to, and what to check before you agree to provide one.

What a Standby Letter of Credit Is

A standby letter of credit (often called a "standby LC" or "SBLC") is a commitment issued by a bank, on behalf of its business customer (the applicant), to pay a specified amount to a third party (the beneficiary) if the applicant fails to perform an underlying obligation — for example, fails to pay rent, fails to deliver goods, or defaults on a contract.

Unlike a typical commercial letter of credit, which is expected to be drawn on as the normal method of payment in a transaction, a standby letter of credit is meant to sit in reserve — a backstop that the beneficiary only draws on if something goes wrong. In practice it functions much like a guarantee of performance, but issued by a bank rather than a person.

The parties involved

• Applicant — your business, which asks its bank to issue the letter of credit.
• Issuing bank — your bank, which commits to pay the beneficiary if a draw request meeting the letter's conditions is presented.
• Beneficiary — the landlord, supplier, or counterparty who can draw on the letter of credit if you default on the underlying obligation.

How a Standby Letter of Credit Differs From Other Security

The key distinction from a cash deposit: your money isn't sitting with the landlord or supplier — it's your bank's money that pays out, and your bank then looks to you (often under a separate reimbursement agreement, sometimes backed by its own security over your assets) to be repaid. This means a standby letter of credit ties up your borrowing capacity or collateral with your own bank, even though no cash has left your account yet.

Why a Counterparty Might Ask for One Instead of Cash

• It's often easier to draw on than pursuing a lawsuit. A properly drafted standby letter of credit is usually payable on presentation of specified documents (often just a simple written demand), without the beneficiary needing to prove the underlying default in court first — a real advantage for the beneficiary.
• It avoids tying up the beneficiary's own cash. A landlord holding a cash deposit has to actually hold and account for that money; a standby letter of credit shifts that burden to your bank.
• It signals financial credibility. Because a bank is willing to issue it, a standby letter of credit can be read as a form of vetting — your bank has effectively underwritten your ability to perform.

What Your Business Is Actually Committing To

1. A reimbursement obligation to your bank. If the beneficiary draws on the letter of credit, your bank pays out, and you owe your bank that amount back — usually on demand, sometimes with interest.
2. Collateral or a reduction in borrowing capacity. Banks typically require cash collateral, a security interest, or a reduction of your available credit line to issue a standby letter of credit — it is rarely free.
3. Fees. Banks charge issuance and, often, ongoing fees for maintaining a standby letter of credit — these vary by institution and are not fixed by any government schedule, so confirm the specific costs with your bank.
4. Exposure to a "documents-only" draw. Because standby letters of credit are typically payable against presentation of specified documents rather than proof of actual default, there is a real risk of an unjustified or disputed draw — the bank generally must pay first and let disputes be sorted out afterward between applicant and beneficiary.

Questions to Ask Before You Agree to Provide One

• [ ] What exact documents or conditions allow the beneficiary to draw on the letter of credit?
• [ ] Is the draw "documents-only," or does it require proof of an actual default?
• [ ] What collateral or credit-line reduction will my bank require to issue it?
• [ ] What are the issuance and renewal fees, and how long does the letter of credit need to stay in place?
• [ ] Does my bank's reimbursement agreement include its own separate security interest over my assets?
• [ ] Is there a cap on the amount that can be drawn, and does it step down over time (common in lease-related standby letters of credit)?

Frequently asked questions