What is a Choice of Law Clause?
A choice of law clause is essentially a contract provision that expressly states that the law of a particular state will govern the legal proceedings that arise under the agreement. From a contract perspective, a choice of law clause specifies which body of law will be used to resolve any disputes made under the contract. For instance, if the parties to the agreement were located in both for example New York and Connecticut , a choice of law clause stating "The parties hereby agree that all questions concerning the enforcement of this agreement shall be determined by the laws of the state of New York." would legally obligate the parties to the contract to follow New York law in determining any dispute made under the contract.
The most important reason as to why a contracting party decides to include a choice of law clause revolves around the fact that there may be a more favorable outcome in the event of a dispute arising under the agreement. In addition, a choice of law clause provides certainty as to the governing body of law to be applied in the event of a dispute arising out of the agreement.
Why Select a Choice of Law Clause?
The benefits of using a choice of law clause are to reduce uncertainty, avoid conflicts and have the law that applies to the contract or dispute clear and known by all parties.
If the contract contains a choice of law clause, you can focus on determining what the chosen law is because the parties have already determined which state’s law applies. While it may be difficult to find a case that is exactly the same as the facts of your dispute, you will know that the case does not involve California law (if you are trying to avoid California law) when it is decided by the Illinois Supreme Court, for example. Knowing what law will govern a contract or dispute also provides certainty to the parties of which legal obligations and rights apply to the transaction. The court will not need to spend time deciding which state’s law applies; the law that is chosen in the contract will control. The parties save money and time in quickly determining how the law affects their dispute. And the parties usually include a choice of law clause because it can be effective to avoid conflicts and frustrating disputes. For example, while several states may have a version of the UCC, each state can have their own non-uniform UCC provisions. Absent a choice of law clause, the courts of more than one state can apply their own non-uniform UCC, rather than a single version of a uniform UCC that was agreed to by the parties. This can increase the costs of resolving a dispute because the parties will need to consider the law of two or more states that may differ, and it can increase the uncertainty of the outcome of the dispute. In the end, if the parties cannot come to an agreement on which state’s version of a non-uniform UCC should apply, the court can look to federal court precedent for guidance when no other binding legal authority applies to that particular dispute. The same certainty applies when alternative dispute resolution (ADR) is included in the contract. Absent a choice of law clause that includes the state where the dispute will be settled by arbitration, if an arbitration occurs in a different state, there could also be a disagreement regarding what law should apply to the arbitration. The parties can avoid this conflict before arbitration and the arbitration process will move much faster.
Key Components of a Choice of Law Clause
The elements of a choice-of-law provision can vary from contract to contract. However, certain key elements are often present in a judicially enforceable choice-of-law clause.
Specificity: First of all, a choice-of-law clause should specify which laws should apply. In Nikken, Inc. v. Superior Court for example, the California Supreme Court held that Article 21 of the Netta dispute settlement provision of the parties’ private-label manufacturing agreement was an unambiguous choice-of-law clause that expressly indicated a choice of law, namely Japanese law. The court found that the provision stated "the Parties shall have the rights and obligations provided for under Japanese law." A choice-of-law provision in a sales agreement to be performed in Japan, specifying the applicability of Japanese law is another clear example of specificity in a choice-of-law provision. Numerous determinations involving the applicability of state law have been made by California courts even in the absence of a clear or express choice-of-law clause. In Asael v. State of California for example, the California Court of Appeal found that the parties’ intent to apply California law was made abundantly clear in a licensing agreement and incorporated license agreement in a subsequent settlement agreement. For further examples please see Berger v. Home Depot USA, Inc. (finding waiver of right to contest California law); Shen Chandrasekhar LLP v. Last Call Operating Co., LLC (finding argument that Minnesota law applied for breach of contract to be precluded later through waiver doctrine); Samsung Technology America, Inc. v. Fujikura Ltd. (noting that the parties’ agreement signified they intended to apply California law); DeLa Torre v. Merril Lynch, Pierce, Fenner & Smith, Inc. (finding California law to apply through a series of agreements).
Applicability: Next, most courts find that choice-of-law provisions must contain language indicating the choice of law is meant to apply to the entire agreement or at least describes specifically the areas of law that should be controlled by the chosen state’s laws. In Berkla v. Dillard Department Stores, Inc., the United States Court of Appeals for the Ninth Circuit interpreted that the phrase "enforceability of the merchandise certificate shall be determined in accordance with the law of the state where the certificate was issued" was not sufficiently specific to satisfy the parties’ stated intention to govern their contractual relationship in accordance with California law. See also Bank Melli Iran v. Pahlavi.
Naming of Laws: Finally, choice-of-law provisions may also specifically name a jurisdiction’s laws by their number or other designation, i.e., 100. The Nikken Court found an unambiguous choice-of-law clause found in Article 21 of the Netta dispute settlement provision and parties’ licensing agreements named the laws of Japan, specifically "the United Nations Convention on Contracts for the International Sale of Goods" (CISG) Article 21. Article 21 of the CISG states, "The parties may exclude the application of this Convention or, subject to the provisions of article 12, derogate from or vary the effect of any of its provisions." A court’s interpretation of the parties’ agreement as a whole persuaded the Nikken Court to find that parties did indeed choose Japanese laws to govern their contracts.
Choice of Law Clause in the Real World
Our final installment will show how these concepts are used in the real-world. In the winning party’s appellate brief, for example, the Elevators could rely on the following choice of law clause from its FTT:
This Agreement, and the rights and obligations of the parties hereto, are governed by and shall be construed in accordance with United States Federal law and the laws of the State of Washington, except for any provisions with reference to the appointment of and fees for legal counsel.
This clause is interesting because it purports to select federal law (along with Washington law) as the governing law. The fact that the clause only applies to the "rights and obligations of the parties" is also important. Among other things, it leaves open the possibility that another choice of law clause applies to non-parties. It should also be noted that the clause above says that the parties’ agreement will be "construed" under federal law and Washington law. As has been pointed out in some cases, the Federal Rules of Evidence, for example, do not actually specify which state’s law controls questions of privilege when the parties’ contract does not provide that it is controlling and vice versa. Other companies might simply use a clause like this one, which can be created without reference to other sources of law: The substantive law and the laws of construction of the State of New York shall govern the validity, performance, execution and interpretation of this agreement. Companies in the same industry may use similar clauses that differ in only minor respects. For example, it is possible that one company would provide for the "laws of the state of Tennessee" to govern its contracts, while another company uses a clause that refers to the "laws of the State of Tennesee." There are potentially dozens of ways to word your choice of law provision. While you should give priority to using terms already used by courts in their decisions, you might also use a phrase you could define yourself in your contract. You do not necessarily have to choose a state’s law. You might even choose to say that no state’s law will govern your contract. A clause similar to the following would suffice: The undersigned agree that there is no governing law applicable to this agreement. No governing law is necessary in order to interpret this agreement.
Pitfalls and Solutions When Drafting a Choice of Law Clause
A common mistake is to refer to the governing law as "the law of the State of [X]." For instance, "The laws of the State of New York." Using generic terms like these provides no guidance regarding the particular version of the laws that are intended to apply. It is highly recommended that the law not be referenced in this shorthand manner. This will force a court to effectively rewrite the contract to explain which version of the state’s laws are intended. The result may be an outcome that the parties neither expected nor desired .
Another common drafting mistake is too vague of a choice of forum provision. For example, a choice of forum provision that specifies that all lawsuits are required to be brought in New York is insufficient. It does not specify whether the parties are required to bring the lawsuit in state or federal court in New York.
It is important for contracts to be clear and concise in their request for the governing law and proper venue for disputes. Clarifying the governing law and proper venue in contracts can minimize disputes down the line.
Choice of Law Clauses: Enforcing and Adjudicating Disputes
Courts of competent jurisdiction will enforce choice of law clauses. The particular municipal, state, or federal law will be applied to the matter and may also be the law that governs in a dispute resolution proceeding (if a dispute arises). When deciding the governing law to apply to the matter, the court will look to see if there is a choice of law clause (and if so, which one), and if the parties have expressly stated what they intend to apply in the language of the contract and/or whether the language of the agreement can be fairly interpreted to safeguard their intention. The law that governs the Contract of the Parties in a dispute does not need to be exclusively the law in the state where an action is filed, only a substantial relationship to the matter.
Disputes related to the contract or other agreements between the two parties will, in most instances, be enforceable in the courts of a competent jurisdiction. This could mean enforcement in any state court or federal district court, and somewhat through arbitration. Subject matter jurisdiction and personal jurisdiction will be determined by the connection of the party with the relevant state, and jurisdictional issues can be waived if not raised timely, or even settled in the agreement executed by the parties.
The court of competent jurisdiction will enforce the choice of law clause if none was included in the agreement between the parties, or interpret it fairly to effectuate its intention. Thus, courts will not actually strictly enforce the law or statutes of the applicable jurisdiction as they appear; rather, the court will enforce the language of the contract to interpret the intention and/or enforce the law as it applies to the circumstances of the parties. The court will seek to protect the rights of the parties and create a remedy, if one is not expressly mentioned.
Relationship Between Choice of Law and Jurisdiction Clauses
For many, choice of law and jurisdiction clauses are one in the same. That is not correct. There is nothing unique about a choice of law clause. It simply directs the parties to use the law of a particular jurisdiction in determining contract rights and obligations. This is often confused with agreement to use the law and courts of a particular jurisdiction which is what a jurisdiction actually means. But a choice of law clause can exist without any agreement about where any dispute must be brought. And frequently they do.
Parties might include a choice of law clause without a jurisdiction clause simply because they know the law of their jurisdiction is more favorable than that of their counter-party. Think of the difference in the cost of litigation in the United States and China. Alternatively, parties may include both types of clauses because their laws might be similar on an issue, but they are much more favorite to one of the parties. Still other times, the parties may include both because one buys their goods from Country Z and sells them in Country A. Again, for example, if the manufacturer is in the United States and the seller is in China , the seller might want to have China law apply to its dealings with consumers in China and United States law apply to its dealings with the manufacturer.
As for whether any of this really makes sense, it all depends. The fact is the strongest reason to have a clear choice of law and jurisdiction clauses in an international contract is that they force the parties to think about things they often do not otherwise think about. For example, the Chinese import company seeking to save costs would do itself and its United States supplier a lot of good by having United States law apply to their United States transactions. Even if United States litigation is going to be more expensive, the extra expense is well worth it if the contract will be controlled by United States law. The parties may also want the contract to be controlled by the law of a third country, such as Singapore, Switzerland or the European Union, which has closely aligned laws. In fact, the choice of Switzerland as governing law has become hugely popular for sophisticated transnational companies because it essentially requires neutral choice of law and jurisdiction provisions.