In a standard Letter of Credit (“LC”), the applicant requests their bank to issue a conditional promise of payment to the LC beneficiary. Typically, the LC applicant is the party seeking to purchase goods while the LC beneficiary is the seller of those goods. When the LC beneficiary is able to borrow funds by using the LC instrument as collateral, this is called a “Red Clause Letter of Credit”.
Letters of Credits assist the buyer and seller to any transaction increase cash flow and mitigate risk. The buyer can often issue an LC in lieu of leaving cash deposits with their suppliers. The buyer’s risk is lower because their promise to pay is limited since payment under an LC depends solely on whether the seller complies with the specifications and instructions of the buyer. If the seller does not comply, payment is not guaranteed.
On the other hand, the seller’s risk is reduced because payment is assured and guaranteed by a multinational bank rather than relying solely on the buyer’s promise to pay. In addition to securing a guarantee of payment from a bank, the LC also gives the seller a secured financial obligation which they can use as collateral to obtain cash advances from their own bank. As mentioned above, when the letter of credit allows the seller to take a cash advances “against” the credit, the instrument is called a red clause letter of credit.
The red clause refers to language inserted into the LC by the issuing bank which permits the bank that receives and accepts the LC on behalf of the beneficiary (i.e. the “nominated bank”) to pay a percentage of the value of the credit to the beneficiary. Traditionally, since this clause appeared in bold red type the credit was named ‘red clause’ credit.
By using a red clause LC, the LC beneficiary can request an advance for an agreed amount from the nominated bank. Such advances are most often intended and used to finance the manufacture or purchase of the goods to be delivered to the LC applicant who issued the credit. Advances given against red clause letters of credit are often referred to as “packing credit”. Thus, one can think of the red clause letter of credit as a financial instrument in which a buyer extends an unsecured loan to a seller even though it is really the seller’s bank that provides the actual cash by using the instrument as collateral to secure the loan.
For more information on how to obtain a red clause letter of credit, please fill out our application or contact us at CONTACT. You can also learn more about letters of credit and other financial instruments relevant to trade here.