Red clause letter of credit is an unsecured loan that a buyer extends to the seller, considered an advance. Learn more about its features and types in this blog.
In international trade, it is important to obtain a set of required export documents and licenses to run a seamless and hassle-free business. One of the key documents is Letter of Credit (LC), which has different types based on factors like the type of agreement, mode of transportation, etc. An LC is a written document provided by a bank that guarantees payment for goods from the importer to the exporter.
What is a red clause letter of credit?
A red clause letter of credit is a form of legal document in payment methods that allows an importer to pay the exporter in advance. Since the importer is confident that the exporter will deliver goods as per schedule, the importer offers to make the payment in advance. Since the clause is traditionally printed in red, it was named as ‘Red Clause LC’. The LC serves as collateral for the exporter’s loan to the importer’s bank to cover the cost of the importer’s purchase1.
Features of a red clause letter of credit
It might be difficult for MSMEs to obtain financing from traditional lending institutions like banks and non-banking financial companies (NBFCs) in certain cases. Obtaining a Red Clause LC can provide necessary credit to strengthen cash flow and speed up supply chain activities for exporters. This can also speed up production and logistics. For an importer, providing incentives to exporters can accelerate the delivery time, hoping for no or reduced delays. This kind of LC can also strengthen the relationship between the two parties.
Types of red clause letter of credit
There are 2 main types of Red Clause LCs2:
Unsecured red clause
The unsecured lines of credit in which the seller is not required to provide proof of purchase documents.
Secured red clause
The secured red clause guarantees payment if the seller provides proof of shipment or ownership of goods.
Since the red clause LC represents a type of unsecured loan, purchasers typically provide a secured red clause and need supporting documentation from the vendor.
Documents required for a red clause letter of credit
Some of the documents required for a red clause letter of credit are as follows3:
The two parties – importer and exporter, negotiate the terms of an LC, including payment and any additional conditions. Once the agreement has been finalized, the importer prepares an entry for a Red Clause LC. Before deciding whether or not to issue an LC, the issuing bank reviews the applicant’s credit history. When the exporter produces the Red Clause LC for collection, the bank deducts these prepayments. In most cases, the percentage of the entire LC amount that the importer advances to the exporter is determined by the nature of their business relationship. If the importer has faith in the exporter’s ability to reliably deliver products, the importer may agree to pay a sum equal to the entire trade value of goods as an advance payment. The exchanges and cooperation are always made in the exporter’s currency. These advance payments are made by the correspondent bank, and are authorized by the issuing bank. Since this permission is written in red ink on a letter of credit, the regular LC is prefaced by the term ‘red clause’.
Example of a red clause letter of credit
Here’s a red clause letter of credit example: Company A in the United States of America contacts an Indian vendor. Once a trade agreement is reached, the importer might contact a bank to provide a documentary credit. The exporter will receive the bank’s LC, which the bank will issue on the exporter’s behalf. The exporter requests that Company A gives an advance payment provision under a red clause. It also provides payouts by including the red provision in LC. The terms of shipment, down payment amount, terms of settlement, and production of seller documentation are all agreed upon by both parties. When everything is settled, the bank will provide the exporter with advance payments. The bank would subtract prepayments from the face amount of LC when goods are sent.
Advantages and disadvantages of a red clause LC
With this LC, importers can negotiate more favorable terms with their suppliers. Essentially, a Red Clause LC opens up new lines of credit for traders and producers. It guarantees on-time delivery of all packages.
When managing business across international borders, importers might have a fear that the exporter will not pay or deliver. Red Clause LCs based on collateral put pressure on sellers to speed up their supply chain processes to meet the LC’s payback terms.
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The risks include bad debts due to irresponsible use of advancement. Also, a Letter of Credit with a red clause is usually a high-priced financial instrument.
When Red Clause LC is used?
Red Clause LC is used when an exporter requires funds for working capital.
What is the purpose of a red clause letter of credit?
The key purpose of a Red Clause in a letter of credit is to enhance the cash flow and, thus, reduce risk for buyers and sellers. Also, it particularly benefits MSMEs by boosting working capital and expediting supply chain operations.
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