It is a type of Letter of Credit that includes a special clause of facilitating the seller with advance payment. Historically, the special clause remained part of the full trade agreement, and the clause used to be inked in red, hence the name.
The sellers or exporters require cash to procure raw materials and inventory. One way of securing the cash is to obtain an advance from the buyers requiring the products.
For sellers, the Red Clause LC works as a form of unsecured loan from the buyer instead of the bank. The facilitating bank may charge a higher processing fee for the Red clause LC.
How the Red Clause Letter of Credit Works?
The Red clause LC is one form of advance to the sellers. It works well for regular suppliers and consistent purchases. The full LC amount is decided between the buyer and the seller first.
The buyer adds the “red clause” allowing the bank to issue advance or credit to the seller. The amount of advance is, however, deductible from the face value of the letter of credit.
The availability of the advance depends on the approval of the buyer. The buyer approves for a certain portion or percentage of the total face value of the Letter of Credit as an advance.
The seller uses the advance to meet the working capital requirements such as raw material purchases.
The facilitating bank issuing advance to the seller receives the interest and the principal amount before the final payment is settled.
Like other LC contracts, if the seller fails to make the shipment deadline or the trade deal is canceled, the bank recovers the advance amount from the buyer.
Conditions under the Red Clause Letter of Credit:
As the buyers are the main facilitators of the advance loan to the sellers, they add certain clauses or conditions with the facility.
- The most prominent clause being the condition of funds utilization only for the purchase of raw materials and goods shipment costs
- The advance payments to be settled from the face value of the LC
- The documentary proofs to the facilitating bank before the shipment proceeds
For sellers, the Red clause facility offers advanced cash or loan from the bank. The sellers need to repay or settle the amount with the full LC value and pay interest to the bank.
Many businesses struggle to avail of the debt facilities from the banks and require cash, the buyers in this scenario become their cash facilitators.
The default risk with the Red clause LC remains with the buyers. If the trade deal gets canceled or the buyers wish to revoke the LC facility, they will have to cover the advance issued with interest to the bank.
The Red Clause LC facility often attracts the middleman trading agents that work with both buyers and sellers.
They fulfill their advance payment needs to place orders with sellers, and upon order completion repay the amount to the buyers.
Advantages of Red Clause Letter of Credit:
The Red Clause LC facility offers certain benefits to both buyers and sellers. In fact, the facilitating banks charge higher interests to the buyers as it is one form of unsecured loan.
- The Sellers can meet the working capital requirements for raw material purchases
- The buyers in return get the discount of total trade contract value or on the prices of the goods
- The buyer may add certain clauses to facilitate the seller such as the condition of default with the deal cancellation
- The buyer may also adjust the advance payments on intervals and up to the maturity of the LC period
The Red Clause LC facility works smoothly often when the buyers add certain clauses such as the Indemnity or declaration of Intent. Both these conditions secure the buyers, if the sellers fail to meet the goods shipments deadlines the buyers may cancel the deal in full.
Limitations of Red Clause Letter of Credit:
There are certain downsides with the Red Clause Letter of Credit for both buyers and sellers:
- The buyers bear the risk of default, they have to repay the advance and interest if the seller fails to repay
- The buyers may also face the currency translation losses if the sellers are in a foreign country
- The banks charge higher interest and Fixed Fees to issue the Red Clause Letter of Credit Facility
- The Sellers may have to offer lucrative discounts to the buyers to acquire the advance payments, which may prove costly in the long run
- The sellers need to repay or adjust the advances in full with interest to the bank