It is a type of documentary credit that includes a special clause for advance payment to the seller. The buyer extends the facility of advance payment to the seller, in anticipation of on-time goods shipment. It works as a means of managing the working capital needs of the seller. Historically, the clause used to be written in red ink, hence it is named as the red clause letter of credit or simply red clause LC.
What is a Red Clause Letter of Credit?
A Red Clause Letter of Credit comes with a special feature of advance payment for the seller. The buyer extends the facility as an unsecured loan to the seller. It is used to facilitate the seller for pre-shipment expenses.
A red clause LC can take two forms commonly:
- An unsecured red clause LC where the seller does not require to present the documentary proof of goods purchased.
- A secured red clause letter of credit where the seller presents the goods receipts, documentary evidence, etc. Along with the bill of lading at the shipping time.
As the red clause LC is a form of the unsecured loan itself, the buyers usually issue a secured red clause and ask for documentary evidence from the seller.
How Does Red Clause Letter of Credit Work?
The applicant to the red clause letter of credit is the buyer (importer) in an international trade deal as usual. The bank approves the credit facility after appraising the creditworthiness of the applicant. In a special case of a red clause, the bank would further approve the advance payments to the seller.
The advances paid to the seller remain part of the total trade value. The issuing bank will deduct these advance payments at the time of the letter of credit presentation. The advance payment amount is usually agreed upon at the time of the trade deal. The buyer may extend the facility as a percentage of the total trade value. For trusted sellers, it may be extended to the full amount of trade values.
The buyer extends the facility of advance payment to negotiate better pricing and on-time goods delivery. If the seller utilizes the facility for raw material purchases or outsourcing the production of the goods, it can work as a beneficial contract for both parties. However, the red clause LC is an expensive form of documentary credit. The buyer holds the risk of default and bad debt, in case the seller does not ship the documents on time.
Key Points to Note with Red Clause Letter of Credit
A documentary credit is issued in favor of the seller as beneficiary. It includes certain terms and conditions matching the trade deal terms. A red clause includes the special case of advance payments to the seller. The preposition makes it a risky deal for the buyer. As it is used to facilitate the seller, the buyer may utilize it properly to benefit from it as well.
The buyer can take a few important steps to mitigate the risks attached with a red clause LC.
- Buyers may not extend the red clause facility to the new sellers.
- Buyers may ask for a letter of intent from the sellers to clearly keep the purpose of advance payments for raw material purchases only.
- The buyer can ask for a letter of indemnity that secures the buyer from non-shipment of goods risk from the seller.
- A buyer can use other forms of documentary credit such as back-to-back, green clause, or standby letters of credit.
Managing the working capital needs with sufficient cash flow is always challenging for the exporters (sellers). Sellers would want to utilize the red clause letter of credit to keep the cash flows. Hence, the red clause LC can work for both parties if utilized properly. Documentary evidence such as a letter of intent or indemnity can reduce the friction between the new trade deal partners.
Example
A buyer company ABC Co. In the US contacts a supplier in the UK. Once both parties agree on the trade deal, the buyer approaches the bank to issue a documentary credit. The bank issues the letter of credit in favor of the seller as beneficiary.
In a red clause, the seller asks ABC co. to provide them advance payment facility. ABC can add the red clause in the letter of credit to provide the advance payments. Both parties work out the shipping details, percentage of advance payment, settlement, and documentary evidence from the seller.
Once agreed, the bank issues advance payments to the seller. Upon shipping the goods, the bank would deduct the advance payments from the face value of the letter of credit.
Advantages of Using a Red Clause Letter of Credit
Apparently, the red clause LC facilitates the seller only. However, the arrangement can facilitate both parties in large trade deals.
Some key advantages of a red clause letter of credit are:
- Red clause LC provides necessary working capital needs to the seller.
- It helps buyers to negotiate better trade terms and conditions including the pricing.
- It removes the hurdle of non-availability of credit facilities for the seller.
- This LC can help the seller to complete the goods shipment on-time.
- It helps both parties to arrange for regular and large trade deals.
- The buyer can secure the deal with interval payments, documentary evidence such as a letter of intent, and a letter of indemnity from the seller.
Disadvantages of Using a Red Clause Letter of Credit
A red clause LC comes with certain disadvantages to both parties as well.
Some of the main disadvantages of a red clause letter of credit are:
- The buyers bear the risk of default and risk of non-shipment of goods from the seller.
- The red clause letter of credit is expensive and includes a high fixed fee.
- Without a letter of intent, the seller may utilize the advance payments for any purpose, which does not serve the purpose of the red clause.
- The sellers cannot expect the red clause facility by default, they have to offer trust and discounts to the buyers to secure the deal.
- Buyers may not extend the facility to sellers without documentary evidence such as a letter of intent or indemnity declaration.
- Offering discounts to obtain advance payments can result in a costly trade deal for the sellers in a competitive market.
Conclusion
A red clause letter of credit comes with an option of advance payment to the seller. It works as an unsecured loan. The buyer can use it to negotiate better pricing with documentary evidence to mitigate the default risk. It helps the sellers to maintain working capital requirements. However, the red clause does not come embedded with all documentary credits and is an expensive option for the buyer.