A clean letter of credit or simply clean LC is one form of various letters of credit. It does not specify any terms and conditions as strictly as in a documentary credit. It does not contain the condition of presenting the bill of exchange from the exporter to demand the payment.
In a clean letter of credit, the trading partners can negotiate and execute the payment terms directly. The issuing bank does not possess control over documentation and presentation of documentary evidence as in a documentary credit such as commercial LCs. This type of credit arrangement is often seen between two established trade partners. The banks also issue a clean LC to established businesses only.
What is a Clean Letter of Credit?
A clean LC is a type of credit that is payable to the beneficiary upon demand. It does not attach any performance obligation clause. Unlike a documentary credit that requires a performance obligation and needs backing through document presentation.
As a clean letter of credit does not attach any obligatory performance clause, it does not require any specific documents presentation before the issuing bank. Both parties can arrange shipping of the goods independently of the issuing bank’s verification process. The only documents required for clearance of clean LC are the payment draft and any set of agreements between both parties as specified in the trade contract. However, it does not contain any performance obligation and confirmation required by the issuing bank.
A key difference between a clean letter of credit and a commercial letter of credit is the primary function of utilization. A clean LC is used as a mode of payment in international trades. Whereas a commercial letter of credit is issued as a means of financial security to both parties.
How Does Clean Letter of Credit Work?
The approval of a clean letter of credit from the issuing bank is harder than a normal commercial letter of credit. The issuing bank may be at risk of default from the applicant, and the chances of non-performance from the beneficiary are riskier too. The issuing banks approve clean LC for established clients and reputable beneficiaries usually.
The formal process of issuing a clean LC starts with the buyer approaching the bank. The bank appraises the creditworthiness of the applicant. As the clean letter of credit is a riskier option for the bank, the appraisal process may require stricter scrutiny by the bank.
Once the bank approves the credit facility, the applicant can issue drafts of payments to the beneficiaries. Both parties can negotiate the trade terms and set the review time for the credit clearance. Usually, the buyer would hold the draft until the goods are shipped. The buyer can independently verify the shipping documents such as the bill of lading, invoices, and warehousing receipts, etc.
The seller’s advisory bank will inform the seller about the availability of the draft payment and the release of payment upon demand will be made available. The draft payment can be held until the goods arrive with the buyer. However, the bank will make the payments upon draft presentation to the beneficiary without asking for further documentation verification.
Important Points to Note with a Clean Letter of Credit
A clean LC arrangement is a riskier option for the issuing bank than the trade parties. Hence, issuing banks issue a clean letter of credit for the applicants with higher integrity and established creditworthiness.
Some key points to note with a clean letter of credit include:
- It is primarily used as a mode of payment rather than financial security.
- The bank is obliged to make the payment upon the presentation of the payment draft by the beneficiary.
- The verification process by the bank is largely the signatory verification of the applicant.
- The bank cannot withhold the payment on the default of the non-performance clause by the seller.
- The buyer can secure the terms by entering into a separate trade contract other than documentary credit.
A buyer company Green Star in the US approaches a seller company Blue Tech in the UK. Once both parties initiate the trade terms, they decide on the mode of payment being the clean letter of credit.
The green star will approach a bank ABC in the US to obtain the clean credit facility. The ABC bank will appraise the creditworthiness of Green Star. If the bank approves the clean credit, say for $100,000, Green Star can proceed with issuing the payment drafts.
Blue Tech will receive information from the bank on the availability of the draft payments. Once Blue tech ships the required goods to Green Star, it can approach the bank to demand the payment. The bank will release the payment without the title of goods or bill of lading verification. The buyer, Green Star can independently verify the shipment of goods, however.
Advantages of Clean Letter of Credit
A clean LC is a riskier option for the issuing bank; however, it offers several benefits to the trade parties.
- It primarily acts as a mode of payment with a simplified process.
- The sellers prefer a simpler and faster payment process than a commercial letter of credits that require several document verifications.
- The buyer can negotiate better trade prices with a quicker mode of payment.
- The buyer can secure the terms with a separate trade contract including the terms for issuing the bill of lading before the presentation of demand drafts.
Disadvantages of Clean Letter of Credit
A clean LC is a simpler payment option for buyers; however, it comes with certain limitations too:
- Clean letters of credit are difficult to obtain from the issuing banks.
- It can work well with established trade partners only.
- Both parties in trade deals bear the risk of financial security.
- The bank may be at a larger risk of default from the applicant.
- The risks of forgery, fraud, and counterfeit documents are higher in a clean letter of credit.
- The banks may charge higher interest rates with a clean letter of credit approval for its unsecured nature.
A clean letter of credit is primarily used for a quicker mode of payment in international trades. It does not require significant goods shipping document verifications by the issuing bank. The bank releases payments upon demand draft presentation by the beneficiary. It remains a riskier credit facility option for all parties including the issuing bank.