A Primer on Choice-of-Law Clauses

A choice-of-law clause is a contract provision that selects the law to govern the contract and claims relating to the contract.

Purpose

The purpose of a choice-of-law clause is to reduce legal uncertainty by prospectively selecting a law to govern the agreement between the parties. Choice-of-law clauses facilitate settlement because they identify the law that will be applied to resolve any potential dispute. They also reduce the cost of dispute resolution by making it unnecessary for the court to conduct a choice-of-law analysis should a dispute wind up in litigation.

History

The first modern choice-of-law clauses in the United States date to roughly 1869. These provisions were incorporated into life insurance contracts, mortgage agreements, and transportation agreements by companies doing business across state lines in the late nineteenth century. By the early twentieth century, these provisions had found their way into a range of other types of agreements, including sales agreements, employment agreements, and license agreements. While choice-of-law clauses were widely known in the first half of the twentieth century, they were not widely used prior to 1960. Beginning in the early 1960s, however, the percentage of U.S. contracts that contain choice-of-law clauses has steadily increased. One recent study found that 75% of material contracts filed by public companies with the Securities and Exchange Commission now contain such a clause. A detailed history of the choice-of-law clause can be found here.

Interpretation and Drafting

Virtually every word in the choice-of-law clause has a hidden meaning. There are, broadly speaking, seven distinct interpretive issues that are litigated with respect to these provisions: (1) choice of law, (2) scope (contract law), (3) scope (tort and statutory law), (4) substantive and procedural law, (5) conflict of laws, (6) federal law, and (7) temporality.

Choice of Law. The courts should always apply the law of the jurisdiction selected in the choice-of-law clause to interpret the language in the choice-of-law clause. This conclusion follows logically from the fact that the parties to the agreement could have rewritten their choice-of-law clause to state their intentions more clearly. If the parties may obtain a particular result by redrafting their agreement, there is no reason why they should not be able to obtain this same result by selecting the interpretive rules of the chosen jurisdiction.

Scope Issues – Contract Law. Some choice-of-law clauses state that the agreement shall be “interpreted” or “construed” in accordance with the law of the chosen jurisdiction. Others state that the agreement shall be “governed” by the law of the chosen jurisdiction. While most courts have held that it makes no difference whether the clause uses the word “interpreted,” “construed,” or “governed,” a few courts have held otherwise. This smattering of contrary interpretive holdings brings us to the first interpretive issue that sometimes arises in the context of a choice-of-law clause—the scope of the clause with respect to contract law.

The contract law of a particular jurisdiction addresses many different topics. In Ohio, for example, the law of contracts covers (1) contract interpretation, (2) contract defenses, and (3) contract damages. When a choice-of-law clause states that it is to be “interpreted” or “construed” in accordance with the laws of Ohio, then there can be no question that the clause selects the interpretive law of Ohio. This is an easy question. The harder question is whether this choice-of-law clause selects the rest of Ohio contract law. Does it choose that state’s law of contract defenses? Contract damages? If one reads the clause literally, the answer may well be no. The clause merely states that the contract is to be “interpreted” or “construed” in accordance with the laws of Ohio. It does not say anything about the rest of that state’s contract law.

As a practical matter, such a narrow reading of the clause is probably not what most parties intend. Accordingly, most courts have held that a choice-of-law clause stating that the contract shall be “interpreted” or “construed” in accordance with the laws of a given state operates to select the contract law of the chosen jurisdiction in its entirety. However, a few courts have read these clauses literally and held that they only select that portion of the chosen jurisdiction’s law that deals with contract interpretation.

The easiest way to draft around this problem is to add the word “governed” to the clause. All courts agree that this word signals the intent of the parties to select all of the contract law of the chosen jurisdiction, not just the portion of that law relating to contract interpretation. A more detailed discussion of cases addressing this issue can be found here.

Scope Issues – Tort and Statutory Law. Another interpretive issue is whether a choice-of-law clause selects the tort and statutory law of the chosen jurisdiction. Imagine a scenario where the choice-of-law clause in the contract states that it shall be “governed by the laws of the State of New York.” One party to the agreement sues the other for (1) breach of contract, (2) fraud, and (3) unfair and deceptive trade practices. While the choice-of-law clause clearly applies to the breach of the contract issue, it is less clear whether it applies to the claim for fraud (a tort) or the the claim for unfair and deceptive trade practices (a statutory claim).

To resolve this ambiguity, the courts will first look to see if the clause contains any language suggesting that the parties intended for it to apply to tort and statutory claims. Most courts have held, for example, that a clause stating that it shall apply to claims “relating to” the agreement or claims arising “in connection with” the agreement suggests the parties wanted the clause to apply to tort and statutory claims related to the agreement. Similarly, most courts agree that clauses stating that they shall apply only to “claims for breach of contract” do not sweep broadly enough to cover non-contract claims. When a clause contains such express language, the interpretive task is straightforward.

Unfortunately, many clauses do not contain such express language. These generic clauses sometimes state that the agreement shall be “interpreted” or “construed” or “governed” in accordance with the chosen law. In other cases, the clause may by its terms apply to clauses “arising out of” the contract. In these situations, the courts must fashion an interpretive default rule to determine whether the clause applies to tort and statutory claims.

The courts in some states (Florida, New York, Texas) have held that generic clauses do not apply to non-contract claims. In these states, the parties are deemed not to have selected any law to govern these claims and the courts must perform a choice-of-law analysis with respect to the non-contract claims. The courts in other states (California, Minnesota, Virginia) have held that generic clauses do generally apply to non-contract claims. In these states, the parties are deemed to have selected the tort and statutory law of the chosen jurisdiction to govern these claims and there is no need for the court to perform a choice-of-law analysis. This split in authorities means that the same choice-of-law clause may be assigned one scope under the law of New York and a different scope under the law of California. A more detailed discussion of this split in authority can be found here.

Substantive vs. Procedural Law. Courts in the United States have long distinguished between procedural and substantive law. The standard formulation provides that the substantive law of a jurisdiction relates to the right and the procedural law of a jurisdiction relates to the enforcement of the right. Tort and contract law are typically classified as substantive law. The law of evidence is typically classified as procedural law. There are, however, several issues that straddle the line between substantive and procedural law. One such issue is statutes of limitations. Roughly half of all states view statutes of limitations as procedural. The other half view statutes of limitations as substantive.

The courts have generally held that choice-of-law clauses only operate to select the substantive law of the chosen jurisdiction. It would be exceedingly difficult, for example, for the courts of Utah to apply the evidentiary rules of Colorado. Accordingly, the Utah courts will not apply the evidentiary rules of Colorado even if the contract in question contains a Colorado choice-of-law clause.

When a particular issue straddles the line between substance and procedure, however, the question becomes more difficult. When a clause selects the “laws” of a state, for example, does that clause select the statute of limitations of that state or not? Most courts have answered that question by looking to how the chosen jurisdiction classifies statutes of limitation. Florida, for example, has held that statutes of limitations are substantive. When a choice-of-law clause selects the law of Florida, it should therefore be interpreted to select that state’s statutes of limitation. New York, by comparison, has held that statutes of limitations are procedural. When a choice-of-law clause selects the law of New York, it should therefore be interpreted not to select that state’s statutes of limitation. The same general approach is applied to other issues that straddle the substantive/procedural divide.

A few choice-of-law clauses expressly address this issue, thereby making it unnecessary for courts to interpret the clause. These clauses typically state that they choose the “substantive and procedural law” of the chosen jurisdiction or that any actions to “enforce” the agreement shall be brought in accordance with the law of the chosen jurisdiction. There are obviously limits on this practice. Even if the parties purport to select the procedural law of Colorado in their choice-of-law clause, it is unlikely that the Utah court will apply that state’s law of evidence. Clauses that expressly address the issue can, however, provide some clarity with respect to issues like statutes of limitations that lie in the shadowlands between substance and procedure. A more detailed discussion of cases addressing this issue can be found here.

Conflict of Laws. Many choice-of-law clauses provide that the contract is to be governed by the laws of a particular state “without regard to its conflict of laws rules.” This was not always the case. Such language only began appearing in choice-of-law clauses around 1970. As this language has become more common, however, it has created questions. What exactly does it mean? And is it strictly necessary for a clause to include this language?

To answer these questions, it is necessary to draw a distinction between the “internal” law of the chosen jurisdiction and the “whole law” of the chosen jurisdiction. The internal law of the chosen jurisdiction does not include that jurisdiction’s choice-of-law rules. The whole law of the chosen jurisdiction includes its choice-of-law rules. Choice-of-law rules, it will be recalled, are the rules that allow a court to determine which jurisdiction’s law to apply when the transaction or the parties have a connection to more than one place. The parties who write a choice-of-law clause into their agreement typically don’t want to select the choice-of-law rules of the chosen jurisdiction because the application of those rules could result in the application of the rules of yet another jurisdiction. If the parties choose Pennsylvania law to govern their agreement, for example, and if the choice-of-law rules of Pennsylvania direct the court to apply Alabama law, the parties don’t want the court to apply the whole law of Pennsylvania and the contract law of Alabama. They want the court to apply the internal law of Pennsylvania and the contract law of Pennsylvania. When the parties select the “laws” of a state in their choice-of-law clause, therefore, they generally intend to select the internal law of that state rather than its whole law.

Adding the phrase “without regard to its conflict of laws rules” to a choice-of-law clause makes this implicit preference explicit. It should be emphasized, however, there are virtually no cases where the courts have interpreted a choice-of-law clause to select the whole law of the chosen jurisdiction. Most courts recognize that such an approach would defeat the certainty and predictability that choice-of-law clauses aspire to provide. There is no harm in adding this language to one’s choice-of-law clause. Most courts will, however, read it into the clause even if it is absent.

Federal Law. When a choice-of-law clause selects the “laws” of a particular state, one question that naturally arises is whether the parties to the contract also intended to select any relevant provisions of federal law. In many cases, party preferences with respect to this issue will be irrelevant; mandatory rules of federal law apply regardless of party intent. In cases where the relevant provisions of federal law are mere default rules, however, then an interpretive question arises. Did the parties intend to select state law to the exclusion of the federal default rule? Or did they intend to select the federal default rule as an alternative to state law?

This question arises most frequently with respect to two bodies of federal law. The first is the Federal Arbitration Act (FAA). The second is the United Nations Convention on Contracts for the International Sale of Goods (CISG). The FAA overlaps to a significant extent with the Uniform Arbitration Act that is in force in many states. The CISG overlaps to a significant extent with Article 2 of the Uniform Commercial Code (UCC). When the parties choose to have their international sales contract governed by the “laws” of Illinois, did they intend to select Article 2 of the UCC? Or did they intend to select the CISG? Either outcome is permissible because the parties are free to exclude the CISG if they so desire. The question is what the parties intended.

To date, most courts have invoked the Supremacy Clause to hold that parties generally intend to select federal law to the exclusion of state law when they select the “laws” of a particular state in their choice-of-law clause. These courts have reasoned that federal law is a part of state law and that while the parties have the ability to exclude federal law, they must clearly state their intent if this is what they want to do. If an international sales contract states that “the CISG shall not apply,” for example, this constitutes clear evidence of party intent to exclude the treaty. A mere statement that “this contract shall be governed by the laws of the State of Ohio” is not enough. Similarly, a contract must clearly state that the “Federal Arbitration Act shall not apply” in order to avoid that Act. Absent such a clear statement of party intent, most courts have held that the default federal rule preempts any inconsistent state rules even if the contract contains a choice-of-law clause selecting the laws of a specific state.

Temporality. The last interpretive issue presented by choice-of-law clauses has to do with timing. Are the parties choosing the law of the chosen jurisdiction as it existed at the time when the contract was signed? Or are the parties choosing the law of that jurisdiction as it exists at the time of litigation? Some scholars argue that most parties want to select the law as it existed at the time the contract was signed on the theory that the courts should protect the parties’ expectations. The better position is that most parties want to select the law as it exists at the time of litigation. Since most parties do not conduct extensive research into the law of the chosen jurisdiction at the time of contracting, there are rarely any expectations to protect. The purpose of a choice-of-law clause is, moreover, to reduce litigation costs and promote litigation efficiency. These efficiency gains are substantially reduced if the parties must seek to “reconstruct” the law as it existed years before at the time the contract was signed in order to brief and argue their case.

Drafting Tips. The foregoing discussion of interpretive rules naturally leads to a single question: How do I draft my choice-of-law clause to get what I want? The answer to this question depends on what exactly you’re looking for. If you are in a strong negotiating position and want to lock in the law of your home jurisdiction to give you an advantage in any litigation, you will want to draft one type of clause. If you are in a weak negotiating position and want to limit the scope of the choice-of-law clause selecting a jurisdiction whose law is unfavorable to you, you will want to draft a very different type of clause.

If the goal is to narrow the scope of the choice-of-law clause as much as possible, the following clause represents one possible approach:

This Agreement shall be interpreted in accordance with the laws of the State of ________.

This bare-bones clause leaves considerable room for maneuvering with respect to choice-of-law issues after the dispute arises. On the other hand, if the goal is to draft a clause that maximizes the likelihood that the law of the chosen jurisdiction will be applied to all aspects of the dispute, the following language may be preferred:

This Agreement and all claims relating thereto shall be governed by the substantive and procedural laws of the State of ________, as they presently exist or may hereafter be amended, without regard to principles of conflict of laws. The United Nations Convention on Contracts for the International Sale of Goods shall not apply to this Agreement.

This clause covers contract claims (“governed by”), tort and statutory claims with some connection to the contract (“related thereto”), and procedural issues that straddle the substantive/procedural divide (“procedural”). It selects the laws of the chosen jurisdiction as they exist at the time of litigation (“may hereafter be amended”). It excludes the choice-of-law rules of the chosen jurisdiction (“without regard to principles of conflict of laws”). If the agreement is an international sales contract, the addition of the final sentence serves to exclude the CISG and ensure that a court will instead apply the chosen state’s version of UCC Article 2 in its place.

Enforceability

As used herein, the term “enforceability” refers to any special rules that address the question of whether a choice-of-law clause should be given effect for reasons having nothing to do with whether the clause is valid as a matter of contract law.

Choice of Law. The prevailing view among courts is that the enforceability of a choice-of-law clause must be determined by the law of the forum. This outcome follows logically from the fact that clause enforceability is part of the broader doctrine of conflict of laws. The courts always apply the conflicts rules of the forum.

Invalidating Statutes. A choice-of-law clause will not be enforced if the forum state has enacted a statute directing its courts to ignore it. All fifty states have passed laws providing that outbound choice-of-law clauses will not be enforced when they appear in certain types of contracts. The State of Illinois, for example, has adopted a law that invalidates clauses that select the law of another state to govern building and construction contracts:

A provision contained in or executed in connection with a building and construction contract to be performed in Illinois that makes the contract subject to the laws of another state or that requires any litigation, arbitration, or dispute resolution to take place in another state is against public policy. Such a provision is void and unenforceable. 815 Ill. Comp. Stat. Ann. 665/10

When the forum state has enacted an invalidating statute, the state and federal courts in that state are obliged to apply it to the exclusion of the common-law test laid down in Section 187. A partial list of invalidating state statutes can be found here.

Validating Statutes. A choice-of-law clause will be enforced if the forum state has enacted a statute directing its courts to apply it. A number of states have enacted statutes which call for the enforcement of inbound choice-of-law clauses when they appear in certain types of contracts. The North Carolina legislature, for example, recently passed a law which provides that:

The parties to a business contract may agree in the business contract that North Carolina law shall govern their rights and duties in whole or in part, whether or not any of the following statements are true: (1) The parties, the business contract, or the transaction that is the subject of the business contract bear a reasonable relation to this State. (2) A provision of the business contract is contrary to the fundamental policy of the jurisdiction whose law would apply in the absence of the parties’ choice of North Carolina law.

When a state has enacted such a statute, the state and federal courts in that state are obliged to apply it to the exclusion of the common-law test laid down in Section 187. A partial list of validating state statutes can be found here.

Restatement 187. When a court in the United States is asked to determine whether a choice-of-law clause is enforceable, it must first inquire as to whether there is any conflict between the internal laws of the interested jurisdictions. If there is no conflict, then there is no need to assess the enforceability of the clause. If there is a conflict, the court should next inquire as to whether the conflict relates to a default rule or a mandatory rule. If the conflict relates to a default rule—a rule that the parties could have changed by revising their agreement—then the clause should be given effect. If the conflict relates to a mandatory rule—a rule the parties could not have changed by revising their agreement—then the court must look embark on a more searching inquiry to determine whether the clause may be given effect.

First, the court will seek to ascertain whether the chosen jurisdiction has a reasonable connection to the parties or the transaction or there is a reasonable basis for the parties’ choice. The chosen jurisdiction will generally be deemed to have a reasonable connection to the parties or the transaction if one of the parties is domiciled, incorporated, or headquartered in that jurisdiction, if the contract was to be performed in that jurisdiction, or if the contract was made in that jurisdiction. Even if there is no connection between the contract and the chosen jurisdiction, however, the clause will be given effect if there was a reasonable basis for the parties’ choice. The courts have held that there is a reasonable basis for the parties’ choice if the chosen jurisdiction is a state with a well-developed body of law in a given area. A clause selecting New York, for example, is likely to be enforced because that state has wealth of precedents in the area of commercial law. The same is true for Delaware in the area of corporate law. So long as there is either a reasonable connection to or a reasonable basis for choosing the law of the state named, the clause will survive step one of the enforceability inquiry set forth in Section 187.

Second, the court will consider whether the clause is contrary to a fundamental policy of the state whose law would have governed absent the clause. As part of this inquiry, the court must first consider whether there is a state that has a materially greater interest in the determination of the issue than the state named in the choice-of-law clause. If such a state exists, then the court must consider whether that state’s law would be applied if the choice-of-law clause didn’t exist. If that state’s law would be applied in the absence of the clause, the court must then inquire whether application of the law of the state named in the clause would be contrary to a “fundamental policy” of the state whose law would otherwise apply. If a clause would be contrary to a fundamental policy, then it is unenforceable. Conversely, if there is no state with a materially greater interest, or if that state’s law would not apply absent the clause, or if enforcement would not offend any fundamental policy of this other state, then the choice-of-law clause is enforceable.

Uniform Commercial Code. When a contract falls within the ambit of the Uniform Commercial Code, the enforceability of any choice-of-law clause is evaluated by looking to the text of UCC Section 1-301:

Except as otherwise provided in this section, when a transaction bears a reasonable relation to this state and also to another state or nation the parties may agree that the law either of this state or of such other state or nation shall govern their rights and duties.

The notes to Section 1-301 indicate that a transaction has a “reasonable relation” to a state only when “a significant enough portion of the making or performance of the contract is to occur or occurs” in that state. This test thus parallels the substantial relationship requirement set forth in Section 187. In contrast to the Restatement, however, the UCC does not state that a choice-of-law clause is enforceable when there is a “reasonable basis” for the parties’ choice. In light of this omission, it would appear that a clause selecting the law of a well-developed commercial jurisdiction like New York or Delaware may go unenforced if the transaction lacks any meaningful connection to that jurisdiction.