Flyover 2: Contracts

Hello, everyone. In this lesson, we're going to be talking about how to handle choice-of-law questions in contracts cases. In other words, how do we figure out which substantive law governs a contractual dispute? There are three main topics that I want to think about.

First, we're going to discuss a couple of the traditional rules for resolving choice-of-law questions in the contracts realm. Second, we're going to talk about a variation on some of those traditional rules. The Second Restatement is going to give us several factors to consider when figuring out the substantive law that should govern a dispute.

And finally, we're going to discuss how to handle a situation in which a contract contains a choice-of-law clause. This is probably the most difficult of the topics, but we're going to break it down step by step. So you might think about it as a checklist or a flowchart.

Before we start digging into these topics, I want to start with a hypothetical that we'll use at several points, and that's probably going to seem familiar in other conflict of laws lessons when we talk about these contracts questions.

Hypo

Okay, the hypo is this: two New Yorkers negotiate and sign a contract in Rhode Island, and the contract is to be performed in New York. Something goes wrong and there's a lawsuit. This is a pretty straightforward choice-of-law problem, and again, specifically, we're trying to figure out which state's substantive law of contract is going to govern the dispute: New York's or Rhode Island's.

First Topic: Traditional Rules (First Restatement)

Let's take just a few minutes to think about the first topic, the traditional rules that governed choice of law in contracts cases. These rules are often associated with the First Restatement. Now, back in the bad old days, courts took a rigidly territorial approach to these choice-of-law questions. So in the contracts realm, that meant that you were looking at only a couple of considerations.

In most instances, courts focused on where the contract was formed. Metaphorically, we might think about this as the place where the contract sprang into being. In my hypothetical, the parties signed the contract in Rhode Island, so Rhode Island would govern nearly every aspect of the contract: whether it was valid, how it should be interpreted, and things of that nature.

So the place of contracting was the state that governed almost all of those contracts questions. The major exception to this was with respect to questions about performance of the contract. For example, what counts as substantial performance? What counts as a breach of the contract? Those are the questions that are going to be governed by place of performance.

So again, in my hypothetical, even though the contract was signed in Rhode Island, it was to be performed in New York, so New York law is going to govern those performance questions. For purposes of the bar exam, this traditional approach is as easy as it sounds.

Now, very concretely, why does it matter to you? Well, the bar examiners might tell you that the lawsuit is taking place in a forum that adheres to the First Restatement or these traditional rules, but the bar examiners tend not to do that. It's possible, though.

The other main reason that I mentioned these rules is because they're a good backstop. If you see a choice-of-law issue in a contracts question, and then you absolutely blank on everything else that we are about to discuss, you can pick up some points by articulating these two easy rules and applying them. The law of the place of contracting governs most contracts questions, but the law of the place of performance governs performance questions.

Second Topic: Second Restatement

Okay, let's move on now to talk about our second main topic in this lesson: the Second Restatement's approach to choice-of-law questions in contracts cases. This, in fact, has become the dominant approach in most states. It's a bit more nuanced than the old approach. It's trying to capture a wider array of factors that go into identifying the state that has the most significant relationship to the parties and the contract. And that's the touchstone of the Second Restatement, the most significant relationship.

Now, here's a tip for the bar exam. Most of the time, you are not going to be told which choice-of-law methodology a state follows. Now, that's never going to happen in the real world, but on the bar, the safest approach is to apply the Second Restatement. And in fact, that's usually what the bar examiners expect you to do.

So, this is the analysis that you're going to use when there's a contractual dispute, and we're trying to figure out which substantive law governs that contract. Several years ago on the bar exam, for example, this came up in the context of a question about the law that would apply to a premarital agreement, a prenup, in other words.

Our approach is going to be pretty straightforward. First, you are going to begin by noting that you're trying to identify, again, the state with the most significant relationship to the parties and the contract. And then in a contracts case, you're going to point to five factors that help identify the state that has that most significant relationship.

These factors are coming from Section 188. You don't necessarily need to worry about remembering the specific section number. What you want to remember are these five factors: (1) the place of contracting; (2) the place of negotiation; (3) the place of performance; (4) the location of the subject matter of the lawsuit; and (5) the domicile residence or place of incorporation of the parties.

Okay, let's return to my hypothetical and see how that plays out here. Remember, we've got two New Yorkers who negotiate and sign a contract in Rhode Island, and the contract is to be performed in New York. Something goes wrong, and then there's that inevitable lawsuit.

Five Factors (Most Significant Relationship)

All right, first factor: place of contracting. Well, that's Rhode Island. Number two, the place of negotiation is also Rhode Island. Number three, the place of performance is specified to be New York. Number four, the location of the subject matter of the lawsuit. Now, in my short hypothetical, that wasn't really specified. On the bar exam, if you need to fill in some gaps, just make sure that you are making reasonable assumptions.

So, here, if the place of performance is New York, it seems pretty likely that the contract is centered around events in New York. So I think it's a decent assumption that this fourth factor is also going to point to New York. And then number five, we're told that the two parties are New Yorkers. So this final factor is also going to point to New York. Now, this is a bit of a close call. Three of the five factors seem to point to New York.

It's important to remember, though, that you're not simply adding up which state has more factors. But these factors are designed to guide the analysis, again, of which state has the most significant relationship to the contract and to the parties. And here, it really does seem that the contract is centered in New York.

All right, let's recap the Second Restatement approach. Remember that we're going to apply the most significant relationship test, and then remember that you're just going to articulate and apply those five factors that we discussed. You don't have to be perfect, but simply laying out the law is going to get you the lion's share of those points.

Third Topic: Choice-of-Law Clauses

And now we get to the third and probably the most challenging topic in this lesson: how to deal with choice-of-law clauses. Up until now, we've been asking how courts will deal with contractual disputes when the contracts themselves are silent about the law that's going to apply. But imagine that in our hypothetical, the New Yorkers who negotiated and signed the contract in Rhode Island included a forum selection clause, and that forum selection clause chooses Delaware law.

We'll get to why that might be in just a minute, but it's useful for this hypothetical. A pretty typical example of a choice-of-law clause would say something like, "This agreement shall be governed by and construed in accordance with the laws of Delaware." It's usually going to be that straightforward.

Sometimes the bar examiners like to ask whether these forum selection clauses are valid, and this can get a little bit tricky if the parties are arguing about a contractual term that they could not have negotiated directly, that they could not have written directly into the contract. An easy example of that kind of issue is going to be something that goes to the contract's validity. So, in this vein, think about a non-compete clause. And in fact, that's something that has come up on the bar exam fairly recently.

Let's return to our hypothetical to see how this plays out. Assume that the New Yorkers include a non-compete clause in their agreement. That is to say, if one of the parties leaves the company, then that party isn't allowed to set up a competing business for a certain amount of time. Let's also imagine that this particular clause is going to be valid under Delaware law, but invalid under both Rhode Island and New York law.

All right, to figure out whether the courts are going to enforce the non-compete clause, we've got to know whether the choice-of-law clause is valid. In other words, we have to know whether the parties have validly chosen Delaware law to govern their agreement.

Now, here, you're going to be applying the Second Restatement's rules, specifically Section 187. And again, if those numbers don't stick in your brain, don't worry about it. Let's try to keep this pretty mechanical. We're going to work through it step by step.

There's going to be a presumption that choice-of-law clauses are valid. In other words, we now have a presumption that the parties are allowed to choose the law that is going to govern their dispute. A party that's trying to invalidate the clause is going to have to show one of two things.

First, the party could try to show that the chosen law, again, Delaware in our hypothetical, has no substantial relationship to the parties or the transaction, or that there's no other reasonable basis for choosing the particular state's law. All right, so our magic words here are "substantial relationship to the parties or transaction" or some other reasonable basis. All right, that's the first way that a party could try to invalidate the choice-of-law clause.

Now, the second way that a party trying to invalidate the choice-of-law clause could do so is to show that the chosen state's law would be contrary to the fundamental public policy of the state that has the most significant relationship to the parties and the transaction.

All right, that's a bit of a mouthful. This is essentially looking at the public policy exception. That's what should really be sticking in your brain here. Let's see how this plays out in our hypothetical. Does the choice of Delaware law have a substantial relationship to the parties or the transaction?

Well, not really. The parties are from New York, which is also where the contract was to be performed, and it was negotiated and signed in Rhode Island. So there's no substantial relationship with Delaware. All right, but there's still a chance that there might be a reasonable basis for choosing Delaware's law. How's that possible?

Well, the choice of Delaware law might make sense if this is a contract that is about corporate law. After all, Delaware is known for having developed a really robust body of corporate law. So perhaps the parties have chosen the expertise that Delaware offers in this particular area. That very well could be a reasonable basis for having chosen Delaware law, in other words, for having Delaware law within the choice-of-law clause.

Now, the second way that someone could try to invalidate the choice-of-law clause is by showing that it violates the fundamental public policy of the state with the most significant relationship to the parties and the transaction. Now, a couple of minutes ago, we said that New York is probably the state that indeed has that most significant relationship. That's where both of the parties are from, that's where the contract was to be performed, that seems to be where the contract is centered.

All right, so what we are asking concretely here is whether Delaware law is violating some fundamental public policy of New York. Now, we know that Delaware and New York would view this non-compete clause differently. Delaware would validate it; New York would not. But that difference is not going to be enough to show that Delaware law would somehow run afoul of a fundamental New York policy.

For this public policy exception to come into play, we are usually looking for some deeper moral concern, for instance, a public policy against child marriages or something like that. In other words, we need to see more than just the fact that New York takes a different approach than Delaware does. We need to identify something in the question that points to New York's deep moral aversion to Delaware's approach. And we're probably just not going to see that.

All right, so let's do a quick recap of choice-of-law clauses and the extent to which they are going to be validated. There is going to be a presumption that a choice-of-law clause is valid, and then a party that's challenging the validity of that choice-of-law clause is going to have to show that the chosen state's law has no substantial relationship to the parties or the transaction, or that there's no other reasonable basis for the choice, or else the party is going to have to show that the chosen state's law violates the fundamental public policy of the state that otherwise has the most significant relationship to this contract.

All right, that's going to do it for today, and I think that that's about as difficult as it's going to get when we are thinking about these choice-of-law issues. Thanks very much.