What is a Red Clause Letter of Credit?

A red clause letter of credit is a particular type of document that is often used in situations where purchase agents conduct business on behalf of buyers. This document allows a seller to receive an unsecured loan or an advance from a buyer prior to the buyer actually receiving the goods that have been purchased. An arrangement of this type of loan or advance is not uncommon when an importer purchases items from dealers that are located at various international locations.

The benefit of a red clause letter of credit is that sellers receive a portion of the total purchase price of the order up front. In some cases, this advance payment serves as a means to arrange for the shipping of the buyer’s order, using delivery methods that were agreed upon between the two parties when the purchase was executed. Once the goods have been delivered, the amount of the loan or advance is deducted from the invoice prepared by the seller. Typically, the structure of the invoice will reflect the original total of the invoice and note the amount of the unsecured loan as a line item. The amount of the loan is deducted from the original total, leaving the remaining amount due for the order. After reviewing and approving the invoice, the buyer remits payment in whatever method that was previously arranged with the seller.

A buyer can also benefit from this payment method. Since the buyer is essentially paying for a percentage of an order in advance, there is no need to delay the shipment while a payment clears. Once the seller has the letter of credit in hand, the order can be prepared and shipped as quickly as possible. This often means the buyer receives the goods in a shorter period of time than would be possible using other payment methods.

While the use of a red clause letter of credit is most often associated with the import/export industry, this type of financial instrument can be used in just about any business transaction where there is a need to provide an advance or unsecured loan to the seller. Since sellers often use the proceeds from this type of loan to manage the expenses associated with shipping an order according to the instructions provided by the buyer, the letter ensures that the seller does not have to temporarily absorb those expenses while waiting for the buyer to remit the full payment for an order.