The standby letter of credit for termination liability

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1. A bank promise in place of a cash reserve

A Foreign Military Sales purchaser normally prepays termination liability (TL), cash fenced each quarter for potential termination costs (FMR Vol. 15, Ch. 4, para. 6.0). A standby letter of credit (SBLC) offers another route. The Financial Management Regulation authorizes the Defense Security Cooperation Agency (DSCA) to approve an SBLC in place of TL prepayments for partners eligible for a dependable undertaking (SAMM C9.9.1.5.4). The value of the purchaser’s TL is then offset by the amount of the SBLC.

This is a different instrument from the letter of credit a partner may use for routine payments, which is covered in paying with a bank letter of credit. The SBLC covers termination liability only. "The SBLC may only be used to offset the TL requirement and cannot be used to satisfy other financial obligations" (SAMM C9.9.1.5.4.5.1).

2. Scope and eligibility

The SBLC applies at country level and covers every implemented case for which TL applies (SAMM C9.9.1.5.4). Its value does not have to cover the whole cumulative TL amount. It does not cover other amounts owed to the government, such as working capital. Partners receiving and using Foreign Military Financing (FMF) grants cannot use an SBLC in place of TL.

The paying obligation rests with the bank, but the purchaser stays liable to DSCA for what it owes, reduced by anything the bank pays (SAMM C9.9.1.5.4.5.2.3). DSCA still assesses the purchaser’s stability, because a higher risk of termination events raises the chance of a demand on the bank. The manual names two factors DSCA may use: the purchaser’s payment and termination record, and its rating under the government’s Interagency Country Risk Assessment System. The DSCA Director may review the variables of any arrangement to make sure there is no unreasonable risk to the government.

3. The documents

Three documents make up the arrangement. The SBLC itself is a formal and independent undertaking by a bank to DSCA as beneficiary (SAMM C9.9.1.5.4.1.1). In effect it serves as the bank’s guarantee of payment to DSCA if a case is partly or fully terminated by the purchaser or the government. A Memorandum of Agreement between DSCA and the purchaser governs setting up, reviewing, changing, drawing on and ending the SBLC, and must be signed before implementation (SAMM C9.9.1.5.4.1.2).

The third is the demand for payment, an attachment to the SBLC that DSCA presents to the bank, for no more than the SBLC amount (SAMM C9.9.1.5.4.1.3). A demand is issued when the purchaser’s Federal Reserve Bank or trust fund accounts lack the funds to cover the required TL.

The legal frame is fixed. Each SBLC must be subject to the International Standby Practices (ISP 98), governed by New York law and applicable federal law (SAMM C9.9.1.5.4.2). It must also consent to the exclusive jurisdiction of the federal courts in New York for any dispute. Terms not otherwise defined take their meaning from ISP 98 (SAMM C9.9.1.5.4.3).

4. Who does what

DSCA is the beneficiary and calculates quarterly TL for each program, which it passes to the purchaser in the billing statement (SAMM C9.9.1.5.4.4.1). Its Chief Financial Officer approves or denies applications and generally signs SBLC documents as beneficiary (SAMM C9.9.1.5.4.4.1.2). Its general counsel reviews every document for legal sufficiency before it is issued (SAMM C9.9.1.5.4.4.1.4). The Defense Finance and Accounting Service records any payment from a bank to the purchaser’s trust fund account and checks that it matches the demand (SAMM C9.9.1.5.4.4.2).

The issuing bank has an independent, documentary obligation to pay DSCA against a complying demand (SAMM C9.9.1.5.4.4.3). Fees and any reimbursement arrangements are settled between bank and purchaser, apart from the SBLC. "Under no circumstances may articles delivered or services performed under the FMS program be used as collateral for securing arrangements associated with the SBLC" (SAMM C9.9.1.5.4.4.3).

A confirming bank is needed when the issuing bank alone does not give DSCA adequate assurance of payment (SAMM C9.9.1.5.4.4.4.1). The manual’s examples are an issuer without the needed credit rating, or one located in a country that is not acceptable in terms of country risk. The purchaser pays all bank fees, and no fee may be folded into the SBLC amount (SAMM C9.9.1.5.4.4.6). Once an SBLC is in place, the implementing agency modifies the cases to take TL out of the payment schedules (SAMM C9.9.1.5.4.4.7).

5. Which banks qualify

Bank eligibility is checked before implementation and every quarter afterwards (SAMM C9.9.1.5.4.5.2.4). Banks must be rated at a mid-tier investment grade or better, using ratings from Moody’s, Standard & Poor’s or Fitch (SAMM C9.9.1.5.4.5.2.4.2). Long-term ratings are preferred, and the rating outlook must be positive or stable (SAMM C9.9.1.5.4.5.2.4.2.1). The manual allows no exceptions for banks that miss these standards. If the Chief Financial Officer wants more credit support, the confirming bank must be an American bank or an American-based branch of a foreign bank that meets the same criteria (SAMM C9.9.1.5.4.5.2.4.3).

6. How much the SBLC covers

Before any solicitation, DSCA calculates the total TL on the cases involved and a recommended SBLC amount that would cover all of it (SAMM C9.9.1.5.4.5.1). The amount needs division chief approval before the purchaser is told. TL changes every quarter over the life of a case, and the country finance director must account for that each quarter. The purchaser then decides the SBLC amount. If it falls short of full TL, the difference is held in TL reserves and deducted from the partner’s available cash. A purchaser may also ask for a higher amount, which DSCA can accept and records as the purchaser’s request.

Key terms

Standby letter of credit (SBLC)	A bank’s independent undertaking to DSCA, used in place of termination liability prepayments.
Termination liability (TL)	The amount held against the cost of terminating contracts on a case.
Confirming bank	A bank that adds its own obligation to pay when the issuer alone does not give adequate assurance.
ISP 98	The International Standby Practices, the rules every SBLC for these sales must follow.
Memorandum of Agreement	The agreement between DSCA and the purchaser governing the whole life of the SBLC.

Every statement above links to the document behind it. The full source list for this piece is on the sources page.

This page describes public United States government programs for general information. It is not legal, regulatory or procurement advice, and it does not address the facts of any particular case.

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