The English Commercial Court has reaffirmed the principles to be applied when examining the effect of a failure to establish a letter of credit required under a sale of goods contract subject to English law.

In Vitol S.A. v Conoil PLC [2009] EWHC 1144 (Comm) Vitol were the sellers under four separate contracts of quantities of gasoil to Conoil. The contracts, entered into between July and September 2008, were on a part fixed and part variable price mechanism and each provided as follows in relation to payment:

"Payment Secured by L/C

Payment to be secured by a fully operative and workable irrevocable documentary letter of credit...

Without prejudice to time being of the essence and seller's other rights generally, seller shall not be required to discharge the mother vessel prior to receipt of such a letter of credit...

In case the letter of credit has not been made operational to sellers satisfaction on or before 8 August 2008 at sellers' option seller has the right to (1) terminate the contract and claim damages..."

The price of Gasoil dropped producing a substantial market differential on the fixed price portions of the contracts. Conoil part-performed one of the contracts but then announced that it had been unable to sell previous cargos and sought to avoid their obligation under the contracts, asking Vitol to "cancel" them. Conoil refused to open the outstanding letter of credit and were held in default by Vitol.

It has long been established under English law that where a contract provides for payment by letter of credit, then failure by the buyer to establish the credit within the time specified in the contract or, if no such time is specified, then at the latest by the first day upon which the seller could be required to deliver the goods, the seller will be entitled to hold the buyer in terminal breach of its obligations.

As a novel twist, in the Vitol v Conoil case, Conoil as purchaser sought to argue in proceedings brought by it against Vitol in Nigeria (in breach of an anti-suit injunction in the English court) that Conoil's own failure to establish the required letters of credit actually meant that the relevant contracts had not yet become enforceable at all and it was no longer required to perform. It argued that the letter of credit was "the final binding document" between the parties which was required to breathe life into the contracts.

In raising this argument it had spliced together, somewhat imaginatively, the well known principle as to termination of a contract for failure to establish a letter of credit referred to above and a lesser known legal principle - that where payment under an English law contract is to be made by letter of credit then, unless the parties agree otherwise, any variation from the original terms of the contract contained in the letter of credit which is accepted by the seller will have the effect of changing the terms of the underlying contract. In the landmark case of W J Alan v El Nasr in 1972, parties to a contract had agreed after the date of the contract that a letter of credit could be issued for payment in Sterling rather than in Kenyan Shillings, the original contractual currency. Sterling, infamously, was then devalued before the date for payment under the credit arose. The seller was deemed to have consented to a variation in the contractual terms to permit payment of the contract price in Sterling and lost out heavily.

That case gave rise to the belief often repeated by traders (though not lawyers) that until the letter of credit is established in accordance with the contract terms the final terms of the contract are not yet known. However, the El Nasr decision has never meant that no contract existed at all until the letter of credit is established – merely that the establishing of the credit gives rise to an unwelcome opportunity for the unwary seller to find that the contract terms have changed to his prejudice.

Although Conoil failed to appear at trial in London, the court considered their arguments in their absence. The judge had no hesitation in finding in favour of Vitol. The true effect of the clause in the contract was that the seller would not be obliged to discharge goods from the carrying vessel until the establishment of the LC and then to terminate the contract if the LC was not established by a particular date. However neither of the contractual provisions referred to supported the suggestion that there was no binding contract until a letter of credit had been issued.

In practice Conoil was found to have part performed one of the contracts and the letter of credit provision in the contract made matters clear. The judge found in favour of Vitol awarding substantial damages against Conoil.