What is a Green Clause Letter of Credit?

A green clause Letter of Credit (LC) is an LC that includes a specific clause, which primarily lets buyers provide advance payments to sellers as a part of an international trade agreement. With red clause LCs, the advance payments are deducted from the original credit amount on the LC that covers the cost of the goods.

Green clause and red clause LCs share several common attributes, including the presence of an issuing bank and a beneficiary bank— also known as the seller’s bank. The seller uses these advance payments to cover their manufacturing, packaging, transportation, and other expenses. In addition to advance payments, the green clause covers pre-shipment warehousing costs at the point of origin and insurance expenses. The green clause LC features data written or printed in green ink.

The advance payments made to the beneficiary through the green clause LC are considered to be a secured, collateral-based loan.

Features of a green clause LC

  • A green clause LC is a secured loan that the consignee extends to the consigner as per an international trade agreement between the two parties.
  • A green clause LC is an extension of a red clause LC, with the additional coverage of pre-shipment warehousing and insurance costs.
  • Green clause LCs offer a more significant percentage of the original credit amount in the form of advance payments (75 to 80% as compared to the 20 to 25% provided by red clause LCs) to the LC beneficiaries.
  • Green clause LCs boost the working capital of sellers and manufacturers.
  • Green clause LCs are more expensive than standard LCs for the buyer (the party that extends the LC to the seller).
  • Green clause LCs always involve collateral. So, if the seller defaults on the repayments of these credit amounts, the items or receivables enlisted as collateral can be seized by the banking authorities.
  • Green clause LCs enable buyers to get discounts and better offers from sellers. Additionally, both red clause and green clause LCs help build long-term trade relationships between international traders.
  • Green clause LC's main distinction with red clause LC is in terms of the financial security provided to the seller, documentation, advance payment percentages, and the status of credit (secured, as compared to unsecured loan in the case of red clause LCs).

The documents involved in the green clause LC filing and liquidation process

Generally, LCs involve the transaction of documents such as transport documents (the airway bill, bill of lading, railway or lorry receipts, amongst others), also known as the documents of title which the holder can use to take delivery of the goods. Apart from those, bills of exchange drawn by the seller on the buyer are also required. Bills of exchange include commercial invoices, packing list, quality certificates (if any), the certificate of origin, and others. Other documents include works test certificates and pre-shipment inspection certificates.

How does the green clause LC work?

This document is a payment guarantee to the seller for maintaining their working capital. The buyer approves advance payments to the seller to cover their logistics operations such as packaging, shipping, and manufacturing. Additionally, the green clause entered into an LC also acts as a documented form of secured credit wherein the consigner can obtain pre-shipment warehousing in the port they select in their country for executing the shipment of the goods.

The working mechanism of the green clause LC begins with the consigner demanding advance payments from the consignee while the two parties decide on various details in their trade deal. Accordingly, after zeroing in on a percentage of the total credit (from the credit amount on a standard LC) that will be approved as advance payments, the buyer approaches their bank to add a green clause to a standard LC for the seller, who becomes the beneficiary of the LC. The green clause, written or typed in green ink on the LC to differentiate it from a standard one, will reflect the terms and conditions agreed upon in the trade agreement between the two entities.

The working of the green clause LC includes the coverage of pre-shipment warehousing and insurance costs incurred by the seller. Therefore, all the documentation confirming that goods will be stored in a selected warehouse needs to be provided to the issuing bank of the LC. This prompts the bank to release advance payments to the seller from the credit based on the percentage decided beforehand.

Later when the seller goes to their bank to receive the payment for the successful delivery of their goods, the LC is liquidated and the seller receives what they are owed after the bank subtracts the advance and interest amounts (if any).

An example of the green clause LC

  • Mr. A from India is purchasing leather shoes worth US$ 25,000 from Mr. C from the US.
  • While they discuss their trade agreement for this transaction, Mr. C asks Mr. A to include a green clause in their LC. According to this clause, US$ 20,000 (80% of the total credit amount of the LC) will be provided to Mr. C as advance payments to sustain their logistics operations. Mr. A obliges and applies for a green clause LC with his bank, ABC Ltd.
  • In this scenario, the importer/consignee/buyer is Mr. A from India, while the exporter/consigner/seller is Mr. C from the US. The green clause LC issuing bank is ABC Ltd in India, while the advising bank is the CBZ Ltd in the US.
  • Once the sale transaction is agreed upon across the board, the India-based bank issues a green clause LC of US$20,000 in the name of the beneficiary Mr. C.
  • Mr. C's US-based bank advises the green clause LC received from the Indian bank to Mr. C.
  • Mr. C submits the advance payment documents (written undertaking, title documents, payment receipts, and other important documents to CBZ Ltd.
  • After verification, the US-based bank sends the documents to the India-based bank. Authorities from the Indian bank notify Mr. A about the arrival of the papers.
  • In return, Mr. A drafts an undertaking with help from the India-based bank, which specifies that they would pay 80% advance (US$20,000) to them in the future.
  • ABC Ltd pays this amount to Mr. C through CBZ Ltd. The US-based bank notifies Mr. C about the same.
  • After receiving the notification, Mr. C prepares for the shipment procedure and ships the leather shoes to Mr. A. Mr. C submits documents such as the bill of lading, commercial invoice, and packing list to CBZ Ltd. As per the green clause LC, the pre-shipment cost of warehousing and insurance will also be covered by the advance payments.
  • CBZ Ltd closely verifies the documents and forwards them to ABC Ltd.
  • The Indian bank informs Mr. A about receiving the documents, and the buyer pays the bank US$25,000, the total amount of the purchase, and the interest amount on the advance payment of US$20,000 that the bank had paid to Mr. C.
  • ABC Ltd pays the amount of US$5,000 to Mr. C through the CBZ Ltd.
  • Mr. A clears the goods from the shipping line by showing the documents received from Mr. C. The buyer can now collect their batch of leather shoes.

Advantages & Disadvantages of Green Clause LC

Advantages of green clause LCs

  • A green clause LC offers steady working capital to sellers/manufacturers that helps them avoid downtime due to a lack of finances or raw materials used for manufacturing.
  • The coverage of on-port warehousing further alleviates headaches related to pre-shipment goods storage for sellers.
  • Green clause LCs, like red clause LCs, facilitate long-term relationships between importers and exporters and help the former get attractive trade deals.
  • Collateral involvement makes green clause LCs safer than red clause LCs, especially for international trade deals.

Disadvantages of green clause LCs

  • Green clause LCs are far costlier than regular LCs for buyers.
  • For new trade deals involving the green clause LC, the consignee will need to spend time hiring a collateral manager.
  • Both green clause and red clause LCs lack flexibility, meaning that the advance amounts, once approved, won’t change even when the seller needs more funds.

Red Clause Letter of Credit vs. Green Clause Letter of Credit

The green clause LC is just an extension of its red clause counterpart. As a result, the green and red clause LCs are nearly identical, except for a few differences. One of the obvious ones is using red or green ink on the documents. Some other differences are:-

  • The percentage of credit provided to sellers as advance payments from the total value of the purchase in the LC is vastly different in green clause LCs (75-80%) compared to a red clause LC (usually 20-25%).

  • Green clause LCs provide collateral-based loans to sellers. The amount forwarded to sellers in the red clause LCs is ordinarily unsecured.

  • The advance payments in red clause LCs reach the seller before they commence production of goods, while in green clause LCs, the advances are issued only once the product arrives at the warehousing phase.