What is a Red Clause Letter of Credit (LC)?
A standard letter of credit (LC) is a documented promise from the buyer to the seller regarding future payments on the purchased goods. Adding a red clause into an LC enables sellers to receive advance payments from buyers to cover manufacturing, packaging, dispatching, and shipment expenses. These advances are deducted from the face amount of the original LC while sellers present the LC documents to their banks for receiving payments. While borrowing these funds from the buyer through the buyer’s bank, the seller uses the LC as collateral. In simple terms, a red clause added to an LC indicates that the buyer is providing an unsecured loan to the seller.
Purpose of a Red Clause Letter of Credit
The main reason for adding a red clause into an LC is to increase cash flows and mitigate risks for both buyers and sellers. Micro, Small, and Medium-Sized Enterprises (MSMEs) generally find it challenging to garner credit from banks and NBFCs. A red clause LC offers the requisite credit injection to bolster their working capital and accelerate their supply chain operations. Using the advances received due to the red clause, they can produce goods and make them available for sale quickly and efficiently. Therefore, a red clause LC speeds up their overall logistics and supply chain operations.
From a buyer’s perspective, they are incentivizing their exporters to deliver goods more promptly, perhaps hoping to reduce delays drastically. Additionally, providing advances to sellers may help build a long-term trade partnership between two parties. Moreover, buyers could use this partnership to get discounts on bulk purchases. In simple terms, red clause LCs serve to streamline the supply chain.
How does a Red Clause Letter of Credit Work?
The first step involves the buyer and seller agreeing on the advance payment amount and other details of the LC, after which the buyer drafts an application for a red clause LC. The bank, known as the issuing bank, closely assesses the applicant's credit score before approving or rejecting the LC. The issuing bank also approves the advance payments to the seller specified in the red clause credit list. Information about these advances stays on the LC as a part of the total value of the trade made. The issuing bank deducts these advance payments when the seller presents the red clause LC to collect the payments from the seller.
The relationship between the buyer and seller typically dictates the percentage of advance payments out of the total LC amount made available to the latter by the former. In some instances, the buyer may extend the advance payment amounts to 100% of the trade value of the goods, especially if the buyer deeply trusts the seller to go through reliably with the delivery of the goods.
It is important to note that the advance payments are always made in the seller's local currency. A correspondent bank, known as the nominated bank, makes these advance payments with the issuing bank's authorization. Since this authorization is specified on an LC with red ink, the standard LC gets the 'red clause' prefix. While collecting the payments, the seller doesn’t need to offer collateral from the LC to the issuing bank. Moreover, the issuing bank bears the risks that arise from the advance payments to the seller even though the nominated bank makes the payments.
An Example of a Red Clause Letter of Credit
M/s BNK, an Indian shoe retailer, gets in touch with their main supplier KBQ Enterprises, in London, UK, to discuss their latest deal. After the two parties agree, M/s BNK approaches their bank ABC Ltd based in India to draft an LC in favor of KBQ Enterprises, with the latter listed as the beneficiary of the financial document. The value listed in the LC is £2.5 million, the total purchase price of M/s BNK's order of 20,000 shoes.
As a part of their agreement, KBQ Enterprises requests M/s BNK to enlist advance payments of £1 million on the LC for manufacturing, packaging, dispatching and shipping the shoes to BNK’s warehouse in Delhi, India. M/s BNK obliges and adds the red clause to the LC to provide the payments. The parties are regularly in touch and eventually work out the shipping details, percentage of the total credit to be transacted as advance payments, settlement, and documented evidence from KBQ.
After the bank approves the LC, the advance payments are issued to KBQ Enterprises. Once the shoes are shipped, London-based CBZ Ltd- KBQ Enterprise’s selected bank will pay £1.5 million to the shoe manufacturing company when they receive the LC from ABC Ltd.
Types of Red Clause LCs
Red clause LCs can be classified into two primary formats:-
- Unsecured red clause LCs in which the advance payments are made against no collateral entities.
- Secured red clause LCs in which the seller has to reproduce collateral documents such as the receipts for goods and other documentary evidence along with the bill of lading during shipping.
Advantages & Disadvantages of Red Clause LC
- This type of LC enables buyers to secure better trade deals and discounts from sellers.
- Red Clause LCs create credit reception avenues for sellers and manufacturers of goods.
- It ensures that shipments are delivered on time.
- There is always the risk of payment defaults and no-shows from sellers, especially when the trade takes place across multiple countries.
- Collateral-based red clause LCs add unnecessary repayment pressure on sellers to rush their supply chain operations.
- Red clause LCs are expensive and involve hefty fees.