Red Clause Letter of Credit (LC): Definition, How It Works, and Its Risks

In international trade, exporters often need capital to prepare goods before they are shipped. They have to buy raw materials, pay workers, package products, and arrange transportation. The challenge is that payment from the importer is usually only received after the goods have been shipped and the required documents have been submitted.

One instrument that can help meet this funding need is a Red Clause Letter of Credit (LC). This facility allows exporters to receive an advance from a bank before the goods are shipped, subject to the terms set out in the Letter of Credit.

So how does it work? Who bears the risk, and how does it differ from a regular LC?

What Is a Red Clause Letter of Credit?

Red Clause Letter of Credit is a type of Letter of Credit that authorizes a bank to pay an advance to an exporter before the goods are shipped. The advance is made based on instructions or a special clause included in the LC by the importer.

The name “red clause” comes from the historical practice of writing advance payment terms in LC documents in red ink so they would be easy to spot.

In this transaction, exporters can use the advance to cover production costs or prepare the goods for shipment. After the goods are shipped, exporters still have to submit documents that meet the LC requirements to receive the remaining payment.

As a result, a Red Clause LC provides working capital for exporters who need funds before fulfilling an order.

How Does a Red Clause LC Work?

A Red Clause LC involves the importer, the exporter, and the banks that issue the LC and handle payments under it.

Here are the general steps:

1. Agreeing on the transaction: The importer and exporter agree to purchase goods and use a Red Clause LC as the payment method.
2. Issuance of the LC: The importer asks the issuing bank to issue an LC with a clause authorizing an advance payment to the exporter.
3. Verification of requirements: The nominated bank checks the documents or requirements for releasing the advance in accordance with the LC terms.
4. Advance payment: Once the requirements are met, the bank pays the exporter a sum of money before shipment.
5. Preparing and shipping the goods: The exporter uses the funds to prepare the order and ship it to the importer.
6. Submission of documents: The exporter submits the shipping documents required under the LC.
7. Settlement of payment: The bank processes the payment in accordance with the LC terms. The advance already paid is taken into account in the final settlement.

The process may vary depending on the LC terms, the required documents, and the agreement between the banks.

Types of Red Clause LC

In international trade, two common forms of Red Clause LC are used.

#Clean Red Clause

Under this arrangement, the exporter can receive an advance without having to submit proof of ownership or storage of the goods as security. The funds are released according to the requirements set out in the LC, such as a receipt and a written statement that the shipping documents will be submitted later.

Because it does not require proof of the goods as security, this arrangement carries a higher risk for the party providing the advance.

#Documentary Red Clause

Under this form, the advance can be released only upon submission of supporting documents, such as a warehouse receipt or similar document. The exporter must also commit to submitting the shipping documents after the goods have been shipped.

These requirements provide an additional layer of security compared with a clean red clause. However, the importer and bank still need to assess the exporter’s ability to meet its obligations.

The main difference between the two is the documents that must be submitted before the advance is released.

Example of a Red Clause Letter of Credit

For example, a company in Indonesia buys manufactured products from an overseas exporter in a transaction worth US$100,000.

The exporter needs funds to buy raw materials and start production. The two parties then agree to use a Red Clause LC with an advance payment facility of 30% of the transaction value.

The transaction can be outlined as follows:

The exporter receives US$30,000 before the goods are shipped. The funds are used to prepare the order. Once production is complete and the goods have been shipped, the exporter presents the documents required under the LC.

If the documents comply with the requirements, the bank processes the remaining payment. The US$30,000 advance is credited toward the total, so the total payment for the transaction remains US$100,000, before any applicable fees or interest.

Note: The 30% figure is for illustration only; it is not a limit or standard requirement for a Red Clause LC. The advance amount and disbursement requirements must be agreed upon and clearly stated in the LC.

Advantages and Disadvantages of a Red Clause LC

Using this facility benefits the exporter but creates additional risks for the importer.

One point importers should consider is the advance payment position. Once the funds have been released, if the exporter fails to produce or ship the goods, the importer may incur a loss. That’s why it’s important to review the choice of trading partner, release conditions, and advance payment refund arrangements from the outset.

Difference Between a Red Clause LC and a Green Clause LC

Red Clause LCs are often compared with Green Clause LCs because both allow exporters to receive funds before shipping the goods.

The difference lies in the security requirements for the advance payment.

Thus, a Green Clause LC provides additional security by using stored goods as collateral for the advance payment. A Red Clause LC, meanwhile, can provide access to funds under simpler requirements.

When Should a Red Clause LC Be Used?

A Red Clause LC may be considered when the exporter needs working capital before shipment and the importer is willing to provide an advance payment facility to support order fulfillment.

This arrangement is relevant, for example, for transactions involving:

• Bulk purchases of raw materials.
• Production of custom-ordered goods.
• Collecting goods from multiple suppliers before export.
• Financing packaging and shipping preparation costs.

However, this facility should be considered carefully if the exporter has no established track record or the advance is too large relative to their financial capacity.

For exporters, this facility helps meet working capital needs. For importers, its use should be accompanied by checks on the supplier’s credibility, disbursement requirements, and refund terms in the event of a failed delivery.

With clear arrangements in place, a Red Clause LC can be an alternative financing option to support smooth export-import transactions.