'; Choice of law clause not something that should be taken for granted

Choice of law clause not something that should be taken for granted

February 15, 2017 Chicago Daily Law Bulletin

When was the last time you thought about choice of law and forum clauses when drafting or reviewing a contract? In practice, many lawyers have developed a preferred set of so-called “miscellaneous provisions,” including an integration clause, choice of law and choice of forum clauses, that they routinely copy and paste after those provisions detailing the purpose of the agreement and the obligations of the parties. Conversely, when reviewing contracts prepared by others, primary consideration is often given to selecting the law of the state where the parties to the contract reside, or to aligning the choice of law clause to the choice of forum. But is something lost or overlooked by doing this?

In most instances, I suspect not. For example, with respect to contracts for the sales of goods, most states have adopted a version of the Uniform Commercial Code, so the laws of commerce between states are relatively uniform, and selection of a particular state’s laws in a sales contract is unlikely to result in a different outcome if there is a dispute.

However, in those instances where state laws vary, such as with respect to non-compete and employment provisions, the choice of applicable law can have significant consequences, as can the choice of forum for resolving disputes under the agreement. One real world example, discovered while investigating a choice of law question in connection with a settlement agreement, will drive this point home, and is a cautionary tale.

Prior to drafting and negotiating the settlement agreement, all contracts entered between the parties required that the contracts be construed under Delaware law, without regard to a state’s choice of law provisions. Nevertheless, counsel for one party insisted that Oklahoma law apply to the construction of the settlement agreement, and that all disputes be heard by courts sitting in Oklahoma, ostensibly because her client was a resident of Oklahoma. Indeed, that counsel continued to change the choice of law provision to Oklahoma law in every draft, even after the principals in face-to-face negotiations agreed that Delaware law would apply, suggested there was more involved than an attorney’s emphatic obstinance.

Research revealed that the choice of law provision could be nullified by courts in those states (like Delaware and Illinois) that apply the Restatement’s “most significant relationship” test. Thus, if the chosen state has no substantial relationship to the parties or the transaction, and there is no other reasonable basis for the choice of the parties, a court can decline to apply the law of the chosen state. In our example, one of the parties was incorporated in Delaware, so there was a relationship between Delaware law and at least one of the parties to meet the “substantial relationship” test.

Research also revealed that the choice of law clause can be nullified if application of the law of the chosen state would be contrary to the fundamental policy of a state which has a materially greater interest in the determination of a particular issue, and which would be the state of the applicable law in the absence of an effective choice of law clause. Because a noncompetition clause constituted the centerpiece of the agreement between the parties, whether Delaware and Oklahoma laws are aligned on the handling of restraints of trade was therefore significant and relevant.

Delaware law permits covenants not to compete that are reasonable in time, area and line of business. Oklahoma law, on the other hand, voids all restraints of trade except those made pursuant to the sale of goodwill or dissolution of a partnership, and as to those exceptions, the scope of the non-compete is geographically limited to a specified county, and those counties contiguous thereto.

The choice of Oklahoma law would therefore have arguably eviscerated a central feature of the agreement. Choosing Oklahoma as the forum for resolving disputes under the agreement would have made the application of Oklahoma law effectively indisputable. Similar issues arose in an opinion by the United States District Court for the Northern District of Oklahoma in Southwest Stainless, L.P. v. Sappington, 2008WL918706 (April 1, 2008). There, with respect to a contract governed by Florida law which had a broad non-compete, the court blue penciled the non-compete provision, substantially narrowing its reach, so that it conformed to Oklahoma law.

The court in Southwest Stainless wrote that “Oklahoma law governs the interpretation of the Noncompete Provisions because the parties’ choice of law ‘violate[s] the provisions of Oklahoma law with respect to contracts in restraint of trade.’” The court specifically held that the non-compete provisions are invalid and unenforceable insofar as they are inconsistent with Oklahoma law. On this basis, the court determined that enforcement of the seven-state geographic restriction in the non-compete provisions must be limited to Tulsa and surrounding counties.

The lesson here is to be mindful of the choices made in drafting and negotiationg choice of law and forum clauses, particularly in the context of noncompetition and employment agreements. Surprises can be avoided by understanding whether there is a conflict between the laws of those states under consideration in choice of law and forum clauses, and then ensuring that there is a reasonable basis for the parties’ choice, and that the chosen state has more than an insubstantial relationship to the parties.