The provisions of a contract must be interpreted and enforced in accordance with the laws of a particular country and/or state. Application of different national and state laws can have significant effects on enforceability of the contract.
For example, in the state of California, employee non-compete agreements are generally void. In the state of New York, on the other hand, employee non-compete agreements can be enforced – in limited circumstances – but are highly dependent on the facts. Thus, whether a non-compete clause is enforceable may ultimately depend on what law is used to interpret the underlying contract.
In the event of a breach of contract, ambiguity over applicable law and jurisdiction can lead to an extensive preliminary legal dispute that requires additional time, effort, and expense to litigate. To put it in simpler terms: parties generally want to litigate their contract disputes in accordance with the law that gives them the greatest advantage. An employer attempting to enforce a non-compete agreement might prefer to apply New York law over California law. A Florida-headquartered, U.S.-based company receiving shipments from a Chinese company might prefer to apply Florida law in interpreting the shipping contract.
The reality is that many contracting parties will fight tooth-and-nail to secure the legal framework and courts that are most advantageous to their arguments. If it is in the best interest of a contracting party to invalidate the contract, then it should be assumed that they will make an attempt to apply the laws of a particular state or country that would invalidate the contract.
Fortunately, when drafting a contractual agreement, the preferred law can be chosen by the contracting parties through the insertion of a choice-of-law clause (otherwise known as a governing law clause), thus minimizing the uncertainty and costs associated with choice-of-law disputes. Most reasonable parties seeking to draft effective contracts therefore negotiate the governing law before later disputes arise.
Choosing an Unambiguous Governing Law
If you are interested in selecting a U.S. state law to serve as the governing law of your contract, it pays to be aware of the limitations. Primarily, U.S. courts cannot enforce a governing law clause unless there is some reasonable nexus (connection) between the subject matter of the contract and the state law selected to govern the contract. Whether the court determining the enforceability of your governing law clause will find that there is a reasonable nexus is dependent on the circumstances, and as such is not completely predictable. The presence of certain factors does improve the possibility that a court will find your governing law provision enforceable, however.
The following factors are likely to favor the enforceability of your governing law clause. This is a non-exhaustive list.
- The physical residence or presence of one of the parties in the state.
- The manufacture, distribution, or sale of goods takes place in the state.
- Services are rendered, fully or partially, in the state.
- One of the parties does significant other business in the state.
- The state of incorporation of a corporate entity involved in the contract matches the governing state law.
- The contract was signed in the state.
Let’s run through a simplified example to highlight the issue without too much legalese.
Suppose that two parties enter into a contract for services. One party is offering building renovation services – we’ll call them RenovateCorp – and the other party is a landlord purchasing those renovation services for one of their buildings. We’ll call him Landlord. The Landlord is located in California. RenovateCorp has its physical headquarters in Texas. The building to be renovated is located in Colorado.
If the contract is governed by either California, Texas, or Colorado law, it is likely to be enforceable. Each of these states has an obvious and significant connection to one of the parties, or a significant connection to the content of the agreement itself (i.e. the renovation of the building).
What if the contract is governed by some other state law, however? Finding a reasonable connection between the governing law and one of the parties (or the content of the agreement) becomes more difficult, but is not necessarily impossible. If RenovateCorp has a regional office in New York, for example, that might serve as a reasonable connection to the application of New York governing law. This connection might be strengthened if it could be shown that some of the design-work for the building’s renovation was conducted at the New York regional office. If RenovateCorp was incorporated in New York, that would further strengthen the governing law claim.
We finally arrive at a general rule: you should choose a governing law that is directly related to the parties or the content of the agreement itself. If you do not, make sure that there are substantial enough connections between the governing law and one of the parties (or the content of the agreement). Otherwise, you may find that the governing law clause is unenforceable.
Selecting the Applicable Jurisdiction
When drafting a governing law clause into your contract, do not ignore the jurisdiction clause.
A governing law clause indicates what state and/or national law you would like to apply to your contract.
A jurisdiction clause indicates which courts you would like to apply the governing law. It controls the venue in which your legal dispute will be heard.
This difference may seem confusing at first. Many laypeople assume that a state or federal court can only apply its own law. In reality, however, state courts can apply the laws of other states. A California court can interpret and apply Texas law, for example. A New York court can interpret and apply Florida law. In certain circumstances, courts can even interpret and apply the laws of other countries.
Ambiguity over jurisdiction can lead to additional disputes and litigation, so – just like governing law – it is best negotiated while drafting the contract. Jurisdictional choice might seem minor at first, but there are several reasons for negotiating jurisdiction: convenience, familiarity, bias (it is generally accepted that a party in its home state will enjoy a minor advantage against an out-of-state party), and cost.
Exclusive vs. Non-Exclusive Jurisdiction
When drafting your jurisdiction clause, you can make jurisdiction exclusive or non-exclusive. Exclusive jurisdiction limits litigation to the specified venue. Non-exclusive jurisdiction does not limit litigation, but simply allows for litigation at a particular venue.
Let’s compare.
Suppose that a contract is drafted to indicate New York governing law, and non-exclusive jurisdiction. The parties are from California and New York. As jurisdiction is non-exclusive, a lawsuit can be filed in both California and New York courts. If jurisdiction were exclusive to New York, however, then a lawsuit could not be filed in California or any other state besides New York.
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Governing law and jurisdictional ambiguity in your contract can lead to extensive, costly litigation. Knowledgeable parties draft governing law and jurisdiction clauses to avoid issues down the line.