What Is Governing Law?
Governing law, also known as the proper law of the contract, is the legal framework that dictates how a contract or other legal agreement is interpreted and enforced. It is a fundamental concept within legal and financial contracts that provides predictability and clarity to parties entering into agreements, particularly in cross-border transactions. The chosen governing law determines which country's or jurisdiction's statutes, regulations, and judicial precedents will apply in the event of a dispute resolution. Without a clearly defined governing law, parties risk prolonged litigation and uncertainty regarding their rights and obligations.
History and Origin
The concept of governing law has evolved significantly with the increase in international trade and commerce. Historically, conflicts of laws arose when contracts spanned multiple sovereign territories, each with its own distinct legal system. Early attempts to resolve these conflicts often involved courts applying their own domestic law or attempting to infer the parties' unstated intentions.
A significant development in harmonizing international commercial contract law came with the adoption of the Hague Principles on Choice of Law in International Commercial Contracts. Approved in March 2015 by the Hague Conference on Private International Law (HCCH), these non-binding principles affirm the concept of party autonomy, allowing parties to choose the law applicable to their international commercial contracts. They aim to enhance predictability and reduce legal uncertainty in cross-border agreements.5
Key Takeaways
- Governing law specifies the set of legal rules that will interpret and enforce a contract.
- It is crucial for providing legal certainty and predictability in agreements, especially those with international elements.
- Parties typically have the freedom to choose the governing law for their contracts, a principle known as party autonomy.
- The absence of a clear governing law clause can lead to complex and costly legal disputes.
- Various international principles and national laws exist to guide the determination of governing law where it is not expressly chosen.
Interpreting the Governing Law
When a contract specifies a governing law, courts or arbitrators will apply the substantive laws of that chosen jurisdiction to interpret the terms of the agreement and resolve any disputes that arise. This means that if a contract states it is governed by the laws of New York, for example, a court would look to New York's commercial law, contract statutes, and relevant case precedents to decide the matter.
However, the choice of governing law does not always mean that every aspect of the dispute will be handled under that law. Procedural rules of the forum where the dispute is heard (e.g., rules of evidence or court procedures) generally still apply. Furthermore, certain overriding mandatory rules or matters of public policy in the forum state might supersede the chosen governing law in specific, limited circumstances.
Hypothetical Example
Consider two companies: Alpha Corp, based in Germany, and Beta Ltd, based in the United Kingdom. They enter into a supply contract for specialized manufacturing equipment. To avoid potential conflicts arising from different national laws, they include a clause stating: "This contract shall be governed by and construed in accordance with the laws of the Republic of Ireland."
If a disagreement arises over the quality of the delivered equipment, and Alpha Corp decides to sue Beta Ltd, a court or arbitration tribunal tasked with resolving the dispute would apply Irish contract law to determine if Beta Ltd breached its obligations and what remedies might be available to Alpha Corp. This clear statement of governing law provides both parties with a known legal framework for their agreement from the outset.
Practical Applications
Governing law clauses are ubiquitous across various financial and commercial agreements, serving as a critical component of risk management and legal certainty.
- International Transactions: In large-scale investment agreements and cross-border mergers and acquisitions, the selection of governing law helps standardize the legal treatment of the deal.
- Debt Instruments: Loan agreements, bonds, and other financial instruments often specify a governing law, typically that of a major financial center, to ensure consistent interpretation and enforcement of repayment terms and covenants.
- Online Agreements: Terms of service for digital platforms and financial technology applications frequently include governing law clauses, often pointing to the jurisdiction where the company is based.
- Regulatory Compliance: For financial institutions, adhering to the governing law of their operational jurisdictions is essential for regulatory compliance and avoiding enforcement actions. For example, the Federal Reserve Board has statutory authority to take formal enforcement actions against various entities for violations of laws, rules, or regulations.4
- Securities Contracts: In the securities industry, specific rules may dictate how disputes are handled, such as FINRA Rule 12204, which states that class action claims generally cannot be arbitrated under its Code, preserving access to courts for such matters.3
The choice of governing law can also influence the attractiveness of a jurisdiction for international business. For instance, despite Brexit, London has maintained its position as a leading center for dispute resolution, partly due to its well-established legal system and widespread use of English law as governing law in international contracts.2
Limitations and Criticisms
While establishing a governing law provides considerable benefits, there are limitations and potential criticisms. One major limitation is that the chosen law may not always be applied universally or exclusively. Courts in different countries might still apply their own overriding mandatory rules, especially if there is a strong public policy interest or an imbalance of power between the parties. For example, consumer protection laws often cannot be overridden by a chosen governing law if the consumer resides in a different jurisdiction.
Furthermore, a governing law clause does not dictate the forum for dispute resolution. A contract may specify Irish law as the governing law but designate New York as the exclusive jurisdiction for any litigation. This separation can sometimes lead to complex legal arguments if the forum's procedural rules conflict with the substantive governing law. Additionally, ambiguities or vagueness in the drafting of a governing law clause can themselves become a source of dispute, undermining the very certainty it aims to provide.
Governing Law vs. Choice of Law
The terms "governing law" and "choice of law" are often used interchangeably, but there's a subtle distinction. "Governing law" refers to the specific body of law (e.g., "the laws of the State of Delaware") that will be applied to interpret and enforce a contract. It is the substantive legal system chosen by the parties.
"Choice of law," on the other hand, refers to the act or principle by which parties select that governing law. It is the contractual provision itself that states which law will govern. In essence, the "choice of law" clause within a legal framework leads to the determination of the "governing law" for the agreement. The broader field of private international law includes "choice of law" rules that courts apply to determine the applicable law in the absence of a contractual designation.
FAQs
What happens if a contract does not specify a governing law?
If a contract does not specify a governing law, a court or arbitration tribunal will determine the applicable law based on its own "choice of law" rules. These rules typically consider factors such as the place where the contract was formed, the place of performance, the domicile of the parties, and the subject matter of the contract. This can lead to uncertainty and potentially unfavorable outcomes for one or both parties.
Can parties choose any governing law for their contract?
Generally, parties have significant freedom to choose the governing law for their contracts, a principle known as party autonomy. However, this freedom is not absolute. Certain mandatory laws, such as consumer protection laws or competition laws, may still apply regardless of the chosen governing law. Additionally, the chosen law must typically be a recognized legal system, not an arbitrary set of rules. For example, the Hague Principles on Choice of Law in International Commercial Contracts affirm party autonomy with limited exceptions.1
Does governing law determine where a dispute will be heard?
No, governing law does not automatically determine the jurisdiction where a dispute will be heard. The location for resolving disputes is determined by a separate clause, often called a "forum selection clause" or "exclusive jurisdiction clause," or by an arbitration agreement. It is common for a contract to specify one country's law as the governing law and another country's courts or a specific arbitration body as the forum for dispute resolution.