In order to understand the green clause letter of credit one has to understand first the red clause letter of credit.
A Red Clause LC will have the following information written in it.
- The letter will contain a clause typed in red which authorizes making advance payment to the beneficiary.
- It states the amount that can be advanced to the beneficiary however funds need to be provided to the seller prior to shipment. When the shipment is actually made and the documents are presented subsequently, the advanced amount will then be deducted from the proceeds of the export bill.
- The bank that has lent the amount will have the right to demand payment with interest from the issuing bank in case of non-shipment and non-presentation of documents in compliance with LC terms and conditions.
- Such an LC authorizes the designated negotiating bank to make clean advances (a percentage of the LC amount) to the beneficiary and such a negotiating bank is under no obligation to such advances. It makes such advances by relying on the issuing bank for reimbursement. If the beneficiary fails to make the required shipment, then the negotiating bank will reimburse it from the issuing bank.
- Proceeds of the drawings will be applied to the previously advanced funds, plus interest and other charges, any surplus paid over to the beneficiary unless specified otherwise in the letter of credit.
Green clause letter of credit is a type of LC that is commonly used in the transactions associated with the commodity markets such as rice, gold, wheat, etc.
It is basically an extension of the red clause letter of credit which means it not only provides the advance for buying the raw materials, processing, and packaging of goods, etc. but also for insurance expense and pre-shipment warehousing at the port of origin.
An important point to note here is that the documentary requirements for green clause letter of credit are more than the red clause LC like in addition to written undertaking and receipts, the issuing bank also requires documents of title to transfer advance under green clause LC.
The document of title is just proof of the goods that are to be shipped have already been warehoused.
Both red and green clause LCs can be differentiated on the basis of the following.
- As discussed in the aforementioned paragraphs that the major difference between both of the LCs is in their documentation. In the red clause letter of credit, the advance can be transferred by presenting written undertaking and receipts while an additional document of title is required in green clause LC for transfer of advance.
- In the green clause LC, the percentage of advance is 75% to 80% of the face value of the letter of credit while it is 20% to 25% the red clause LC.
- The buyer is always worried about his safety as he is paying advance money to the seller while dealing in international transactions. In the green clause letter of credit, the buyer (the importer) is more secured than the red clause LC since in green clause LC, he is extending the advance against the document of title which means he knows that the goods in question are already warehoused and the only thing remaining is the shipment procedure while on the other hand, in the red clause LC, the advance is extended even before the production initiates which makes it riskier for the buyer.
Let’s understand the process of the green clause letter of credit process with an example.
Mr. Tim from the USA is buying wheat worth USD 10,000 from Mr. Ohio in India. Mr. Ohio requests Mr. Tim to issue a green clause letter of credit with an advance payment of USD 5,000 (50%). Mr. Tim agrees and applies for green clause letter of credit with his bank – Bank of USA.
Bank of USA on the requests of Mr. Tim issues Green Clause Letter of Credit of USD 10,000 in the name of Mr. Ohio. Bank of India informs about the Green Clause LC received from Bank of USA to Mr. Ohio of India who scrutinizes these documents and sends it to Bank of USA.
Bank of USA examines the advance payment documents and communicates Mr. Tim that the documents have arrived.
Mr. Tim undertakes to pay the 50% advance i.e. USD 5,000 to the Bank of USA in future.
Bank of USA pays USD 5,000 to Mr. Ohio through Bank of India which means that the Bank of India receives the payment from the Bank of USA and notifies Mr. Ohio.
Mr. Ohio starts the shipment procedure and ships the goods to Mr. Tim upon receiving the advance payment.
Mr. Ohio submits to the Bank of India the shipping documents (invoice, packing list, bill of lading, etc).
The Bank of India examines the shipping documents and forwards it to the Bank of USA who then informs Mr. Tim that they have received the shipping documents.
Mr. Tim makes the payment of USD 10,000 to the Bank of India (100%) along with the interest for the 50% advance payment that has been paid by the Bank of USA earlier.
The Bank of USA remits the unpaid portion of USD 5000 (50%) to Mr. Ohio through the Bank of India which further remits this amount to Mr. Ohio’s account.
Mr. Tim clears the goods from the shipping line by using the shipping documents.