A letter of credit sometimes allows the financial institution to make advances to the beneficiary. The beneficiary uses these funds to find merchandise to prepare the merchandise for shipment. A clause that authorizes your bank to advance these funds was apparently written in red to warn banks and applicants inherent risks.
The perils are that the lending company and the beneficiary are in cahoots with each other to fleece the applicant. In Leonard A. Feinberg, Inc. v. Central Asia Capital Corp (974 F. Supp. 822 (ED Pa. 1997) the applicant contended that the funds advanced by the nominated bank to the beneficiary were not used to prepare the shipment, but to pay off the beneficiary's indebtedness towards the bank.
Even without collusion, the beneficiary can simply take the funds and run off. In these cases the applicant fails to avail him or herself of the safeguard offered by a letter of credit, namely, documentation evidencing suitable performance of the underlying contract.
Advancing funds before shipment is an invitation to be defrauded. The most secure way for the applicant to shield him or herself against deceit is to ask the beneficiary to have its bank issue a "letter of indemnity". This letter of indemnity, issued by the beneficiary's bank, serves to indemnify the applicant in case of fraud. However, a beneficiary who requests a red clause credit generally will lack the funds to satisfy collateral requirements a bank will impose before issuing this type of document.
A better option, and the manner typically used, is to at least be notified of the beneficiary's intent to draw on the red clause letter of credit. This notification cannot be agreed upon straight between applicant and beneficiary, but needs to be part of the letter of credit in order that it shapes the relationship between the bank and the beneficiary. The nominated bank won't have a contract with the applicant but only with the issuing bank. Hence, it cannot defend itself against a demand to advance funds by referencing the contract between applicant and named beneficiary . The correct way is for the applicant to include the notification requirement when opening the letter of credit with the issuing bank.
A notification of an intent to draw (typically 30 days advance notice) will be a first step to protect the seller; other more meaningful options for protection are to require documentation from the beneficiary of the beneficiary's promise to draw upon these funds only within 30 days, declarations of intent how the funds are going to be used, invoices etc.
To further help a seller without funds, the seller might agree with the nominated bank to issue a back-to-back letter of credit. A back-to-back letter of credit allows the beneficiary to utilize the letter of credit as collateral to obtain further financing. The beneficiary who needs to issue a letter of credit to his supplier may pledge the letter of credit to his bank as collateral for the issuance of a second LC.
In this case, the nominated bank, and not the buyer, as would be the case in a red clause credit, trusts the beneficiary of the first letter of credit and believes that he or she will comply with the obligations of the first letter credit. However, a bank issuing a back to back letter of credit might find itself in the uninviting position that it is obligated to pay the beneficiary of the back to back letter of credit (i.e. the credit to the benefit of the first beneficiary's supplier), but not be able to recover from the first beneficiary, since the first beneficiary did not comply with the requirements of the original letter of credit.
A better alternative for the cash-stripped beneficiary may be to partially assign the proceeds of the letter of credit to his supplier. However, in this case the supplier bears the risk, that the beneficiary will comply with all requirements under the LC.
Red letter clauses are hazardous in letter of credits and defeat the the objective of securing the buyer's position. Alternatives exist, but a cash-stripped seller has to convince either his bank, his supplier, or the buyer to share the risk of the beneficiary's non-compliance.