Red Clause, Letter Of Credit, Beneficiary, Draft, Applicant
RED CLAUSE RESULTED IN $70,000 SAVINGS ANNUALLY
A US company importing mosaic ceramic tile sent an annual payment on January 1st to their Italian supplier for the entire year’s purchases. The supplier always performed and presented no obvious risk of nonperformance.
When the US company learned of the red clause letter of credit, they realized it could save them money. Issuing a red clause letter of credit to the supplier would enable them to borrow money from their own bank and pay interest instead of using the importer’s money interest free. After issuing a letter of credit with the red clause, they estimated that they saved $70,000 the first year.
WHY IS IT CALLED "RED CLAUSE?"
A red clause letter of credit, originally so called because of a clause printed in red ink on the face of the letter of credit, permits the beneficiary to obtain advance funds from the letter of credit with the intent to repay the funds at the time he presents documents for payment. The red clause typically restricts the advance to a certain percentage of the letter of credit, say 30%. When the beneficiary presents documents for payment, the bank uses 30% to repay the loan and the beneficiary receives the remaining 70%.
ORIGINS OF THE RED CLAUSE
Several versions of the history of the red clause letter of credit have circulated. Jim Harrington believed it began in the Philippine Islands. The Philippines established home-based businesses to produce lace tablecloths. Eager buyers filled a demand of a ready market in the United States. Buying agents would call on home-based businesses throughout the Philippine Islands agreeing with each to order a certain quantity of tablecloths.
The agents discovered they could get better prices by paying for a portion of the goods in advance because the households needed money for living expenses and also to purchase needles and thread to make the tablecloths. The red clause allowed the agent to borrow from the Philippine bank, pay the households and then store the tablecloths until he had enough to make a shipment and draw a draft against the LC. The proceeds of the draft paid off the borrowed money.
The applicant of the letter of credit should understand the risk: The beneficiary could get the advance and disappear with the money. In that case, the bank which made the advance has recourse to the applicant. As in any other transaction, a high level of trust reduces the risk.
Because of the risk, buyers rarely use red clause letters of credit. However, buyers such as the mosaic tile importer, who have to pay cash up-front, may consider the red clause letter of credit as a viable alternative.
In one of his workshops, Jim Harrington stated that he wanted to put to rest a myth. With a twinkle in his eye, he explained that the red clause has nothing to do with lobsters whose claws turn red when placed in boiling water.