Please clarify the risk factors in a RED CLAUSE LC .

1. Any amount of advance payment under the red clause credit is a clean exposure on the client until the beneficiary presents the documents evidencing shipment of goods.
    
2. There is no guarantee that the amount that is advanced under the credit would be utilised by the exporter for the purpose intended.
    
3. The recovery of the money from the beneficiary due to non-shipment is outside the scope of the LC and hence issuing bank has no control. Banks are apprehensive in issuing red clause LC for down payment exceeding 20 percent
    
4. The negotiating bank would not advance any money to the extent of advance payment. They would claim from the issuing bank or reimbursing bank and upon receipt of payment they would pay to the beneficiary

Disadvantages to the applicant:

1. Difficulty in getting back the amount once availed by the beneficiary, if he fails to make shipment.
    
2. Banks do not issue such letters of credit exceeding more than 20 percent as advance payment. Even if they do so, they would recover the money immediately upon payment to the presenter. The applicant does not get any facility for this portion of the money - Loan against Imports of TR (Trust Receipt) is not given. Hence cash flow is affected.  
    
3. Even where the beneficiary agrees to pay the money back - this would be without interest. No interest would be paid by the beneficiary from the date of receipt of advance amount to the date of refund.
    
4. In some countries - exchange regulations may prevent refund of money in foreign currency.
    
5. The applicant pays for the difference in two rates - buying and selling and then further takes the risk in exchange rate fluctuations - the selling rate is charged by his bank when the bank pays out the money under the credit. In the event if the money is paid back by the beneficiary, then the applicant gets the money in home currency and the bank applies the buying rate. This rate can be avoided if the applicant has a foreign currency account as that of the LC currency, but the still the applicant may be called upon to pay a small charge known as exchange compensation.

However there are few strict measures to be adopted to deter the beneficiary in misusing the funds and to compel them to make shipment.

While applying for a Red clause credit please request for :

• A receipt for the advance duly signed by the beneficiary
   
• An undertaking from the beneficiary to utilise the funds to purchase and pack the merchandise
   
• The undertaking of the beneficiary to present the full set of documents as stipulated in the credit to the nominated bank within the expiry date

Regards

Zahoor N Dattu

Regards,

Don Smith

Dattu has made a nice summary of almost all risks relating to Red Clause credits.

Like Don, just to add a little -

• I have done Red Clause credits of up to 100% advance payment for import of 'basmati rice'
   
• the suppliers enjoy high demand, some times monopoly, for their goods
   
• These suppliers have exclusive arrangements with the buyer/applicant and / or some times, agents or subsidiaries of the applicant company.
   
• This is basically assessed as a pure credit risk of the Applicant, who is usually a first rate client.
   
• Advance payment against Red Clause credits replace clean TR / Import Loans and is in the nature of 'pre cum post shipment advance''
• 
  Some kind of arrangement with the beneficiary's Bank to monitor beneficiary's production cycle will help in risk mitigation, apart from documentation suggested by Dattu.