Red Clause Letter of Credit: Definition, How It Works & Examples
That large export order you just received is a big win. But before your client sends the payment, you need to source raw materials, pay your workers, and get the shipment ready. Many exporters use their own savings to pay for this. But there is a smarter way: a Red Clause Letter of Credit.
It is a special type of LC that allows the exporter to receive a cash advance from the bank before the goods are shipped, giving you the working capital to fulfill the order without dipping into your own funds.
In this blog, you’ll learn what a Red Clause LC is, how it works, the documents you need, its pros and cons, and how it stacks up against a Green Clause Letter of Credit.
TL;DR - Summary
- What it is: - A Red Clause LC provides advance payment from the bank before you ship any goods.
- Best for: - Exporters needing working capital to cover raw materials, labour, and production costs upfront.
- When it makes sense: - When you have an established relationship with your buyer and a large order to fulfil.
- Key risk: - If you cannot ship, your buyer is liable to their bank for the advance.
What is a red clause letter of credit
A Red Clause Letter of Credit (LC) is a payment arrangement providing a cash advance even before you ship any goods. Your buyer opens it through their bank, called the issuing bank. That bank then sends the LC to your bank in India, known as the advising or nominated bank. Your bank releases the money to you, the beneficiary.
To access the money, you only need to submit a signed receipt and a Letter of Indemnity, a written commitment that you’ll ship the goods as agreed or return the advance.
How is a Red Clause Letter of Credit different from an Export Packing Credit?
Export Packing Credit (EPC) is a loan provided by your bank against an export order. You must apply for it separately and meet the eligibility criteria too.
A Red Clause LC is an advance created by the buyer (your client). The buyer’s bank sends the money to your bank through the international banking system.
What are the types of red clause letters of credit
There are two types of red clause LC depending on how much documentation your buyer requires before releasing the advance
1. Unsecured or “Clean” Red Clause LC
This is a more common version when the buyer has a high level of trust in the exporter.
- No proof needed: No warehouse receipts or proof of purchase are required to access the advance.
- Simple paperwork: Only a signed receipt and a Letter of Indemnity.
- A promise to deliver: The letter of indemnity is your formal commitment to ship the goods or return the money if you can’t.
- Highest buyer risk: With no collateral involved, the buyer bears the full risk if the order isn’t fulfilled.
- Use case: A seasonal crop exporter receiving an advance from their long-term international buyer to secure the crop from farmers.
2. Secured or “Documentary” Red Clause LC
This type offers your buyer more protection and is well-suited for newer trade relationships.
- Early proof required: You must submit documents such as warehouse receipts before your buyer releases the money.
- Proof of progress: All the documents that prove production fall into this category. The list includes invoices sent by your suppliers, inspection certificates, and testing reports.
- Controlled risk: This is a popular choice with first-time buyers as the risk is comparatively lower and there is enough documentary evidence.
How a red clause letter of credit works
A Red Clause LC follows a sequential pattern from start to end. Here’s how the process works step-by-step:
1. Buyer applies for the Red Clause LC
You and your buyer agree on the advance amount. The buyer then instructs their bank (the issuing bank) to open a red clause LC specifying how much you can draw before shipment.
2. Issuing bank sends the LC to the advising bank
The issuing bank sends the LC to your bank in India (the advising bank). Your bank reviews it and notifies you that the credit is ready to use.
3. You receive the advance
You submit a signed receipt and a letter of indemnity to your bank. They release the money so you can begin production.
4. You produce and ship the goods
You use the advance to buy raw materials, pay for labour, and fulfil the order. Once ready, you ship the goods as per the agreed schedule.
5. You submit the shipment documents
After shipment, you present the required documents, including the bill of lading and commercial invoice to your bank for final settlement.
6. Final settlement
Your bank deducts the advance and any applicable interest from the total LC value and transfers the remaining balance to you. The documents are then forwarded to the issuing bank.
Key Takeaways
The LC value and your invoice value are the same. Both reflect the total amount your buyer owes you for the shipment.
Red clause letter of credit example
Suppose a Surat-based textile exporter receives an order from the US worth $50,000. The buyer agrees to open a Red Clause LC with a 30% advance, i.e. $15,000, to help them get started.
Here’s how the process looks:
- Buyer opens the Red Clause LC: The buyer asks their bank to issue a red clause LC worth $50,000 and allows a $15,000 advance before shipment based on the payment terms.
- The exporter receives the advance: The exporter’s bank notifies that the LC is active. The bank releases ₹13.5 lakh (approximate INR conversion) after the exporter submits a signed receipt and a letter of indemnity.
- Procurement and production: The exporter uses the advance to purchase yarn, pay weavers, and complete the order over the next six weeks.
- Goods shipped: Once the fabric is ready, the exporter dispatches the shipment and receives the Bill of Lading.
- The exporter submits the documents: The exporter presents the Bill of Lading, Commercial Invoice, Packing List, and Certificate of Origin to their bank.
- Final settlement: The exporter’s bank deducts the $15,000 advance plus applicable interest from the $50,000 LC value and transfers the remaining balance to you.
What are the documents required for a red clause LC?
Not all documents are required at the advance stage of a red clause LC. Here is an infographic that shows what documents are required at each stage:
Your LC process is a lot smoother when you have the right set of documents with you. Here's a list that you can save to ensure you miss nothing:
- Letter of Indemnity (LOI): Your formal promise to ship the goods as agreed or return the advance if you can't.
- Simple Receipt: A signed acknowledgement for the advance amount you're drawing.
- Declaration of Intent: A written note explaining how you'll use the advance. This may be only applicable when the buyer asks for it.
- Commercial Invoice: Your itemised bill covering goods, quantities, and prices. Make sure that the details match the LC terms exactly.
- Bill of Lading or Airway Bill: Proof that the goods have been shipped
- Packing List: This document mentions the number of boxes, weights, and dimensions of the packed goods
- Certificate of Origin: This confirms the goods were manufactured in India. An essential document required for customs and duties.
- Insurance Certificate: Proves that your shipment is covered against damage or loss in transit.
- Inspection Certificate: A third-party quality check certificate; only required if your buyer specifically asks for it.
- Advance Payment Guarantee: A bank-issued guarantee securing the refund of the advance
- RBI Purpose Code: Mandatory for every export invoice to stay compliant with Indian regulations.
What are the advantages of red clause letters of credit
A red clause letter of credit provides the much-needed liquidity, but it’s also a highly effective way to build stronger relationships with international buyers. Here are more advantages:
Reduced seller risk
As a seller, you know that the money is coming from the buyer’s bank and not solely based on the buyer’s promise.
Stronger buyer-seller relationships
When a buyer opens a Red Clause LC for you, it shows they’re confident in your ability to deliver. This creates the foundation for a strong and long-term buyer-seller relationship.
Flexible financing terms
Red clause LC provides you the room to negotiate the advance percentage amount based on your production needs. You can also request the advance in INR to pay local vendors quickly.
What are the risks and disadvantages of red clause LCs
Despite its advantages, a red clause LC could be risky. Here's what to watch out for.
Buyer exposure if seller fails to deliver
If the seller doesn’t export the goods, the buyer is liable to pay their bank. It’s a tremendous risk for the buyer, and therefore, the red clause LC is only offered to exporters with a strong, proven track record.
Higher bank fees and charges
Banks charge higher fees to compensate for the early release of funds. They also start charging interest from the day the amount enters your account, which is deducted from the final settlement. Taking a sizable cut from the entire amount.
Complex documentation requirements
Red clause LCs involve paperwork at two separate points: first, when you claim advance and then again at final settlement. Any discrepancy in the documentation can cause a delay in the final settlement.
Limited bank availability
Red Clause LCs are high-risk instruments. Banks offer this facility to selected exporters who have an established relationship with them and a clean export history. This can be a demerit if you’re working with a new banking partner.
Difference between red clause and green clause letters of credit
You might have come across a green clause letter of credit, this is not the same as the red clause letter of credit. Here’s a quick red clause vs. green clause LC comparison table:
How Skydo helps after shipment
A Red Clause LC solves your pre-shipment cash flow problem. But you still need your final payment to reach you quickly, at the best conversion rate, and with the right compliance documentation.
That's where Skydo comes in. Skydo is a payment platform for Indian exporters to solve cross-border payment challenges. With Skydo, you receive foreign remittance in your savings bank account quickly and without delays, hidden fees, or compliance headaches.
Here’s what Skydo offers:
- Transparent forex rates: Skydo uses live mid-market exchange rates to convert foreign currency into INR. There are no conversion charges, so you always know the exact amount credited to your account.
- Predictable flat fees: You pay a flat fee of $19 for an amount less than $2000, $29 for $2000 - $10000, and 0.3% for $10,000+. No hidden charges.
- Instant FIRA: Every time you receive an international payment, Skydo auto-generates Foreign Inward Remittance Advice (FIRA), essential for RBI compliance and closing your export records.
- Faster payment realisation: Payments are typically settled to your Indian bank account within one working day.
- Local virtual accounts: Set up local bank accounts in key geographies like the US, UK, and Singapore, so your buyers can pay via local transfers instead of costly SWIFT transfers.
- Automated compliance: Skydo saves the purpose code once you use it in your invoice and auto-fills it the next time you invoice the same client. This way your bank always receives compliant data from you that also matches the EDPMS records.
Clean record-keeping: As Skydo saves all payment information with a proper paper trail, you always have access to thorough documentation to apply for future loans and surprise audits.
Are red clause letters of credit still commonly used today?
Yes, they are most actively used in industries like textiles, agri-exports, gems and jewellery. Also, in bulk commodities where the buyer has a high level of trust in the exporter and wants to support their production cycle.
What percentage of the LC value can be advanced under a red clause?
What happens if the exporter does not ship goods after receiving a red clause advance?
Can any bank issue a red clause letter of credit?
Does the seller’s bank issue a red clause letter of credit?
Is the red clause letter of credit and pre-shipment credit the same?
