What Is a Red Clause Letter Of Credit?

A red clause letter of credit is a specific type of letter of credit in which a buyer extends an unsecured loan to a seller. Red Clause Letters of Credit permit documentary credit beneficiaries to receive funds for any merchandise outlined in the letter of credit. These letters are commonly used by beneficiaries who act as purchasing agents for buyers in another country.

Key Takeaways

  • A red clause letter of credit is an unsecured loan that a buyer extends to the seller, considered an advance. 
  • These letters of credit are often used to facilitate international exports and trade. 
  • Red clause letters of credit are a way for sellers to boost their working capital. 
  • These letters of credit can be more expensive than regular letters of credit, however.

How a Red Clause Letter Of Credit Works

The funds provided in a red clause letter of credit are known as advances. These advances are then deducted from the face amount of the credit when it is presented for payment. Red Clause Letters are usually employed to facilitate international exports and trade. These letters of credit were originally written in red ink. 

A red clause letter of credit allows for an exporter to obtain pre-shipment finance, although available credit is usually only part of the estimated value. It could even be the entire sales value. A buyer can expand their supply sources with a red clause letter of credit. Most buyers shy away from becoming involved in financing goods that have not yet been shipped, but exporter and buyer may be linked together through a normal contract with the trade bank establishing the red clause letter of credit against a registered contract with an approved buyer.

Interestingly, when using this specialized form of credit, the clause is printed or typed in red ink. In contrast, under a Green Clause Letter of Credit, in addition to pre-shipment finance, storage facilities are allowed at the port of shipment to the exporter. The clause is typed or printed in green ink.

Special Considerations 

In order to secure a red clause letter of credit, a buyer may make a seller sign a letter of indemnity. This letter notes that if the seller doesn’t meet the necessary obligations that the buyer bears no financial loss. In some cases, a red clause letter of credit will require a declaration of intent, which lays out the purpose of the said payment. 

The red clause letter of credit is a form of financing working capital. It boosts the seller’s working capital by unsecured financing facilities. In return, the seller may offer a discount to the buyer for offering such a line of credit. 

The downside to the red clause letter of credit is if the seller doesn’t use it for necessary working capital needs. The buyer extends these letters of credit in hopes of ensuring the products will be manufactured on time. If the seller doesn’t use the credit to pay for necessary expenses the letter of credit is for naught. Red clause letters of credit can be expensive, however. They carry a fixed fee that tends to be higher than regular letters of credit.