Choice of law clause

What Is a Choice of Law Clause?

A choice of law clause is a contractual provision that allows parties to an agreement to specify which jurisdiction's laws will govern the interpretation and enforcement of the contract, regardless of where the contract is executed or where a dispute might arise. This critical component of contract law falls under the broader umbrella of commercial transactions, providing a framework for legal certainty in complex dealings. The presence of a choice of law clause helps to avoid potential conflicts between different legal systems that might otherwise apply, particularly in international trade or interstate commerce. It is a fundamental tool for risk management by establishing predictable legal outcomes.

History and Origin

The concept of parties choosing the law to govern their contracts, known as "party autonomy," has roots in legal systems for centuries. However, the widespread adoption and judicial enforcement of the choice of law clause in its modern form gained significant traction in the late 19th and early 20th centuries, particularly in the United States. Early use cases emerged among companies conducting extensive business across state lines, such as life insurance companies, transportation companies, and mortgage lenders¹⁵.

A pivotal moment in the popularization of the choice of law clause was the development and eventual enactment of the Uniform Commercial Code (UCC) in the U.S. in the early 1960s. The draft UCC included provisions that specifically directed courts to enforce choice of law clauses in commercial contracts, provided certain conditions, such as a "reasonable relation" to the chosen state, were met¹³, ¹⁴. This legislative recognition helped standardize and legitimize the use of such clauses, contributing to their current omnipresence in contracts.

Key Takeaways

• A choice of law clause allows contracting parties to pre-select the governing law for their agreement.
• It enhances predictability and reduces the complexity of dispute resolution in multi-jurisdictional transactions.
• The clause operates based on the principle of party autonomy, where parties have the freedom to agree on applicable legal rules.
• While generally enforceable, choice of law clauses can be subject to limitations such as public policy concerns or lack of a "reasonable relation" to the chosen jurisdiction.
• Its effective drafting is crucial to prevent ambiguity and costly litigation.

Interpreting the Choice of Law Clause

Interpreting a choice of law clause involves understanding its scope and how courts apply it to various types of claims. Generally, such clauses clearly state that the chosen law will govern the "validity, construction, and enforcement" of the contract. This means that the selected jurisdiction's statutes and precedents will be used to determine if the contract is legally binding, how its terms are understood, and what remedies are available if a party defaults.

However, ambiguity can arise regarding whether a generic choice of law clause applies only to contractual claims or also to non-contractual claims, such as torts or statutory claims, that might emerge from the relationship between the parties¹². Some courts interpret these clauses narrowly, limiting them to contractual disputes, while others may apply them more broadly to all disputes between the parties¹¹. Therefore, precise drafting is essential to ensure the clause achieves the parties' intended breadth of application, covering all relevant aspects of their legal framework.

Hypothetical Example

Consider two companies: AlphaTech, based in Delaware, and BetaManufacturing, based in California. AlphaTech wishes to purchase specialized components from BetaManufacturing for a new product. Given their different locations, they want to ensure clarity on which state's laws will govern their supply contract.

They include the following choice of law clause in their agreement:

"This Agreement and all transactions contemplated hereunder shall be governed by, construed under, and enforced in accordance with the internal laws of the State of Delaware, without giving effect to any choice of law or conflict of laws principles thereof."

In this scenario, if a dispute arises regarding product quality or payment terms, both parties know that the laws of Delaware, and not California, will be applied by a court or arbitrator to resolve the matter. This clause helps prevent arguments over which jurisdiction's rules apply, streamlining any potential dispute resolution process.

Practical Applications

Choice of law clauses are widely used across various financial and commercial agreements to provide clarity and predictability. They are commonplace in:

• International Contracts: In cross-border business dealings, where parties from different countries are involved, a choice of law clause is crucial to avoid conflicts between national legal systems. It allows parties to select a neutral or preferred legal system, fostering trust and efficiency in international trade. Such clauses are considered vital for international business contracts⁹, ¹⁰.
• Loan Agreements: Banks and financial institutions often include these clauses in lending agreements to ensure that the laws of their home state or a state with a well-developed commercial legal system (like New York) govern the terms, particularly for large syndicated loans or complex financial instruments. For instance, BNY Mellon, like many financial institutions, includes provisions that ensure compliance with applicable laws, often specifying the governing law for their agreements⁸.
• Mergers and Acquisitions (M&A) Contracts: These clauses determine which state's corporate laws will apply to the complex transactions, indemnities, and representations involved.
• Service Agreements: Businesses providing services across state lines often specify the law of their primary operating state to ensure consistent legal interpretation across all their client agreements.
• Standard Form Contracts: For businesses dealing with a high volume of similar agreements (e.g., software licenses, online terms of service), a choice of law clause allows for uniform application of legal principles. An example of a robust choice of law clause might state: "This Agreement shall be governed by and construed in accordance with the laws of the State of New York (regardless of the laws that might otherwise govern under applicable principles of conflicts of laws thereof) as to all matters, including, but not limited to, matters of validity, construction, effect, performance and remedies."⁷

These clauses are a cornerstone of modern contract drafting, reflecting the parties' negotiation and agreement on a predictable legal framework.

Limitations and Criticisms

Despite their widespread use, choice of law clauses are not without limitations or criticisms. One primary limitation is that courts may not always enforce a choice of law clause if the chosen law has no "reasonable relation" to the parties or the transaction, or if its application would violate the fundamental public policy of the forum state where the dispute is heard⁵, ⁶. For example, a court might refuse to apply a chosen law if it allows for an outcome that is deemed unconscionable under the forum's law⁴.

Another critique revolves around the potential for "boilerplate" or generic choice of law clauses to create new problems. Poorly drafted clauses can lead to costly and time-consuming litigation over the preliminary issue of which law should apply, effectively defeating the clause's purpose of providing certainty³. This can particularly affect consumers who may unwittingly agree to unfavorable terms in standard form contracts without understanding the implications of the choice of law clause². Some academic research highlights that parties are often unaware of the gaps and ambiguities in generic choice of law clauses, underscoring the need for careful due diligence in drafting¹.

Choice of Law Clause vs. Forum Selection Clause

While both a choice of law clause and a forum selection clause are found in contracts and pertain to dispute resolution, they serve distinct purposes.

Confusion often arises because parties might assume that by choosing a forum, the law of that forum automatically applies, which is not necessarily true. An effective contract usually includes both clauses to establish both the applicable law and the location for dispute resolution.

FAQs

Q: Why is a choice of law clause important?

A: A choice of law clause is important because it provides predictability and legal certainty to contracting parties, especially in transactions spanning multiple jurisdictions. It clarifies which set of rules will govern the contract's interpretation and enforcement, thereby reducing potential conflicts and litigation costs.

Q: Can parties choose any law they want?

A: Generally, parties have significant freedom to choose the governing law. However, there are limitations. The chosen law must typically have a "reasonable relation" to the parties or the transaction. Additionally, courts may refuse to enforce a choice of law clause if applying that law would violate a strong public policy of the state where the lawsuit is filed.

Q: What happens if there is no choice of law clause in a contract?

A: If a contract lacks a choice of law clause, a court will apply its own conflict of laws rules to determine which jurisdiction's laws apply. This process can be complex, unpredictable, and lead to additional litigation over preliminary legal questions. This uncertainty can significantly increase the cost and duration of resolving a dispute resolution.