So far a description has been provided of the basic types of letters of credit used to cover the shipment of goods. In addition to these basic types, there are various specialized formats which meet particular sets of circumstances.
Red Clause Letter of Credit
A red clause letter of credit incorporates a clause, traditionally written in red, which authorizes the bank acting as the negotiating or paying bank to pay the beneficiary in advance of shipment. This enables the purchase and accumulation of goods from a number of different suppliers, and the arrangement of shipment in accordance with the letter of credit terms. Such advances will be deducted from the amount due to be paid when the documents called for are presented under the letter of credit. If the beneficiary fails to ship the goods or cannot do so before the expiry of the letter of credit, the issuing bank is bound to reimburse the negotiating or paying bank, recovering its payment from the applicant.
Variations of such credits may also require that any advances be secured by temporary warehouse receipts until shipment is effected. Beneficiaries of red clause letters of credit are invariably brokers/agents of buyers in a particular field.
Transferable Letter of Credit
A transferable letter of credit allows the beneficiary to act as a middleman and transfer his rights under a letter of credit to another party or parties who may be suppliers of the goods. Depending on whether the letter of credit permits partial shipments, fractional amounts may be transferred to more than one beneficiary. The letter of credit however, can be transferred only once: the secondary beneficiaries cannot transfer their rights to a third party. Transfer of a letter of credit can be made on specific application by the original beneficiary to the authorized transferring bank
To be transferable, a letter of credit must be so marked by the issuing bank which can only do so on the applicant’s specific instructions. The applicant should be aware that any second beneficiary, the probable supplier, is usually a party not likely known to the applicant.
The terms and conditions of the transferred letter of credit must be identical to those of the original letter of credit with the following exceptions:
• The original beneficiary may be shown as the applicant on the transferred credit.
• The amount of the letter of credit, and unit prices if any, may be less than in the original letter of credit (the difference being the original beneficiary’s profit margin).
• The latest shipment date, if any, and expiry date as shown on the original letter of credit should be shortened.
• The percentage of insurance coverage, if any, should be increased to satisfy the requirements of the original letter of credit.
• When a drawing takes place, the original beneficiary normally substitutes his invoices for those of the second beneficiary for up to the amount and unit prices available under the original letter of credit, and draws the difference as profit.
Back-to-Back Letter of Credit
Although not recorded on a letter of credit, “back-to-back” is a term used in transactions involving two irrevocable letters of credit.
Such transactions originate when a seller receives a letter of credit covering goods which must be obtained from a third party who in turn requires a letter of credit. The “second” issuing bank looks to the first issuing bank for reimbursement after paying under the second letter of credit.
The difference between back-to-back letters of credit and transferable letters of credit, is such that in a transferable letter of credit, the rights under the existing letter of credit are transferred. In a back-to-back transaction, different letters of credit are actually issued. Because technical problems can arise in back-to-back transactions, banks tend to discourage their use.
Deferred Payment Letter of Credit
Under a deferred payment letter of credit, the applicant does not pay until a future date determined in accordance with the terms of the letter of credit. No drafts are called for, which avoids “stamp duties” charged by some countries on bills of exchange (drafts). One reason an exporter might extend credit terms to an importer could be the competitiveness of the market and the need for the exporter to finance the importer if the exporter is to make the sale.
