The Marginal Utility of Choice-of-Law Clauses

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I spend a lot of time researching and writing and thinking about choice-of-law clauses. So much so that I sometimes worry that I’ve fallen victim to a cognitive bias known as the law of the instrument or (more colorfully) Maslow’s Hammer. This bias arises when a person acquires a specific skill and thereafter looks for opportunities to use that skill everywhere. When one is a hammer, it is tempting to treat everything like a nail. And when one knows a lot about choice-of-law clauses, it is tempting to view them as really important even when they are not.

This post serves as a corrective. It argues that while choice-of-law clauses have the potential to be extremely important in dispute resolution, their marginal utility in most disputes is low. A number of conditions must be met for a choice-of-law clause to be relevant. Contract drafters know this and rationally devote relatively little time to drafting and negotiating the clause. While this lack of attention sometimes proves costly, the simple fact of the matter is that choice-of-law clauses rarely play a decisive role in dispute resolution.

The Dispute Pyramid

At some point during their first year in law school, most law students are taught that only a small fraction of contract disputes wind up in litigation. When parties disagree about an issue relating to a contract, this disagreement will typically be resolved by informal negotiations. When these negotiations are unsuccessful, the matter may be escalated to higher-ranking individuals within an organization. If these conversations fail to generate a solution, the parties may turn to mediation. As a rule, parties are reluctant to initiate formal litigation proceedings because litigation frequently leads to the end of the business relationship.

The choice-of-law clause is essentially irrelevant until very late in the process of dispute resolution. While the clause may provide guidance to parties seeking to ascertain the strength of their claims, it is a truth generally acknowledged that only lawyers read choice-of-law clauses. Vanishingly few non-lawyers will ever research the law of a particular jurisdiction to determine whether a claim is likely to succeed or fail. This means that, realistically, the choice-of-law clause will not play a meaningful role in the dispute resolution process until informal attempts to resolve the dispute have failed, formal litigation is contemplated, and the lawyers have entered the picture.

The Choice-of-Law Clause

Once the decision is made to litigate, a number of contractual provisions immediately become relevant. If the contract contains an exclusive forum selection clause, for example, the suit must be brought in the forum named in the clause. If the contract contains an arbitration clause, then the parties must resolve their dispute in arbitration. The choice-of-law clause is initially relevant only to the extent it identifies the law that should be used to interpret the forum selection clause or the arbitration clause. After the court has determined that jurisdiction and venue are proper and turns to the merits, the choice-of-law clause may play a larger role. Even then, however, there is no guarantee that the clause will make a difference. There are three conditions that must be met.

Condition #1: A Material Conflict of Laws

When the laws of State A and the laws of State B are identical, it does not matter which state’s law is applied to resolve the dispute. The outcome will be the same either way. A choice-of-law clause is therefore relevant only when the laws of the two states are different. The laws of these states must also be different in a way that is material to the dispute. If one contracting party is suing the other for breach of contract, for example, the fact that the tort law of State A is different from the tort law of State B is neither here nor there.

Although there are some differences between the laws of various U.S. states, there are many more similarities. Every state except Louisiana has, for example, enacted Article 2 of the Uniform Commercial Code. Every state except Louisiana also applies rules derived from English common law to resolve tort and contract and property disputes. These similarities mean that, in most cases, there will be no conflict between the laws of the interested states, which means that a choice-of-law clause will play no role in resolving the dispute.

The differences between the laws of U.S. states and the laws of foreign countries are obviously more extensive than those between U.S. states. These differences help to explain why many commentators recommend that choice-of-law clauses be written into international agreements. Even in the international context, however, the utility of the clause is limited by the costs of researching foreign law, as discussed below.

Condition #2: Manageable Research Costs

It is not always easy to ascertain the content of the law of a foreign country. The sources detailing the content of that law may be hard to locate. The costs of translating that law into English may be prohibitive. Experts in the law of the relevant country may be expensive. In light of these challenges, a U.S. lawyer may conclude that the costs of researching the law of the foreign jurisdiction named in a choice-of-law clause exceed the potential benefits. To quote a prior blog post:

Imagine a scenario where the two jurisdictions with an interest in the litigation are New York and Brazil. The suit is brought in New York. A U.S. lawyer might devote a significant amount of time to translating and researching the law of Brazil only to discover that there is no material difference between that law and the law of New York. Alternatively, the lawyer might discover that Brazilian law is less favorable to her client’s position than New York law. When the outcome of the inquiry is unknown, and where there is no guarantee that spending time and money on research will improve the client’s position in litigation, it is easy to see why some attorneys might simply ignore the issue and argue the case under New York law.

This happens all the time. The Federal Reporter is replete with cases in which the litigants ignored a foreign choice-of-law clause and briefed the court on the law of the forum. In such cases, the court is generally happy to follow the lead of the parties and apply the law of a familiar jurisdiction.

When vast sums of money are at stake, and when the parties are willing to pay their lawyers top dollar to explore every possible legal avenue, in summary, there is a possibility that the costs of researching foreign law will be borne. When smaller sums of money are at stake, however, or when clients are reluctant to pay their attorneys tens of thousands of dollars to research foreign laws that may or may not prove helpful, it is more likely that the choice-of-law clause will be ignored and the parties will tacitly agree to apply forum law to resolve the dispute.

Condition #3: A Sufficiently Broad Clause

There are many variations in how choice-of-law clauses are drafted in the United States. Some of them are written broadly enough to select a law to govern tort and statutory claims as well as contract claims. Others are not. Some of them are drafted so as to select the statutes of limitations of the chosen jurisdiction. Others are not.

These variations present the possibility that even if a conflict exists, and even if that conflict is material, and even if the parties are willing to incur the necessary research costs, the clause may ultimately not be applied because it does not, by its terms, govern the issue at hand. Unlike the first two conditions, this one is entirely within the parties’ control. It is not difficult to draft a broad choice-of-law clause that selects all of the relevant laws in the chosen jurisdiction. In a striking number of cases, however, the text of the choice-of-law clause is entirely silent on the issues of scope and statutes of limitations. In such cases, the clause will play no role in the resolution of the parties’ dispute with respect to these issues even if there is a material conflict of laws.

Summing Up

In order for a choice-of-law clause to play a decisive role in dispute resolution, all of the following things must be true:

1. The dispute must be so intractable that informal attempts at resolution fail;
2. There must be a conflict between the laws of the interested jurisdictions;
3. The conflict must relate to an issue that is material to the litigation;
4. The costs of ascertaining the foreign law must be low enough—or the amount of money at stake in the litigation must be high enough—to make it rational for the attorneys to devote resources to researching that law;
5. The clause must be drafted broadly enough to cover the relevant issue.

There are many cases where all of these conditions are met. I’ve blogged about them here at TLB.  The choice-of-law clause undoubtedly has the potential to affect the outcome in litigation. However, the list of conditions identified above is sufficiently daunting that it is the unusual case where the choice-of-law clause will play a decisive role.