MCLE Article and Self-Assessment Test #86
By Gary L. Dickson and David O. Blood
Gary L. Dickson is a retired finance partner who is now of counsel in the Los Angeles office of Latham & Watkins. David O. Blood is an associate with the firm. They would like to acknowledge Sandra R. Sexton for her research and editorial contributions.
It is common for parties to enter into agreements in which the laws of more than one jurisdiction could apply. In the United States—where each of the 50 states and additional territories has its own set of laws, regulations, and court interpretations—it is not surprising that parties to all types of agreements will perceive their chances of prevailing in one jurisdiction as more promising than in another. For tactical advantage and to ensure certainty regarding how a contract will be enforced or interpreted, most agreements contain a choice of law provision that specifically designates which jurisdiction's laws, regulations, and rulings are applicable.
California lawyers, in the course of advising their clients, are often called upon to draft agreements or provide written opinions involving the enforceability of clauses choosing the law of some state other than California in transactions in which one or more of the parties are located in California. Despite the fact that the California Supreme Court addressed these types of clauses in 1992 in Nedlloyd Lines B.V. v. Superior Court,1 two exceptions to the clauses' enforceability that are delineated in the decision require further interpretation and clarification—and this limits contracting parties from being able to fully rely on a choice of law stipulation favoring a jurisdiction other than California.
When the supreme court decided Nedlloyd in 1992, the court ended its long silence on the enforcement of freely negotiated choice of law provisions. It did so by adopting a relatively simple test that follows the Restatement (Second) of Conflict of Laws.2 The court stated plainly that "California courts shall apply the principles set forth in Restatement section 187, which reflects a strong policy favoring the enforcement of [freely negotiated choice of law clauses]."3 This "strong policy," however, is subject to the two exceptions.
Restatement Section 187(2) sets forth the following standards:
The law of the state chosen by the parties to govern their contractual rights and duties will be applied, even if the particular issue is one which the parties could not have resolved by an explicit provision in their agreement directed to that issue, unless either
(a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties choice, or
(b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue and which, under the rule of section 188,4 would be the state of the applicable law in the absence of an effective choice of law by the parties.5
The "substantial relationship/reasonable basis" exception in Restatement Section 187(2)(a) and the "fundamental policy" exception in Section 187(2)(b) create significant uncertainty regarding the enforceability of choice of law provisions.
Substantial Relationship/Reasonable Basis
Only a relatively small showing is required to establish a substantial relationship or a reasonable basis, so it is generally a simple matter to avoid the application of Restatement Section 187(2)(a). According to the court of appeal in Application Group, Inc. v. Hunter Group, Inc., a 1998 decision citing Nedlloyd, "[T]he mere fact that one of the parties to the contract is incorporated in the chosen state is sufficient to support a finding of 'substantial relationship,' and the mere fact that one of the parties resides in the chosen state provides a 'reasonable basis' for the parties' choice of law."6
Moreover, if the chosen state has a substantial relationship to the parties, there is necessarily a reasonable basis for their choice.7 There may be a rare occasion, however, in which there is no substantial relationship between the parties and the chosen state and yet there is still a reasonable basis for the parties' choice of law. This could occur if the parties choose a state where neither party resides or is domiciled but where there exists some other connection to the contract. New York, for example, might be a reasonable choice to govern stock option agreements in which the stock at issue is nationally traded on the New York Stock Exchange.8
The importance of this aspect of California's choice of law rules can be observed in the context of lending agreements. Since California law generally is protective of borrowers' interests, most nonexempt lenders seek to apply another jurisdiction's laws to their agreements.9 For example, lenders may attempt to escape California's strict usury requirements by choosing to apply New York law, which emphasizes the protection of parties' invested expectations by enforcing their agreement—even if it is less favorable to the underdog.10 The narrow application of the substantial relationship/reasonable basis exception provides the means by which a California lender can choose a jurisdiction where it neither resides nor is domiciled but where the contract has some inherent connection—such as where the contract is to be executed or performed.11
It is the rare case in which the parties do not have a reasonable basis for their choice of law agreement. The comments to the Restatement suggest that a reasonable basis would be lacking if "a foreign law…has been chosen by the parties in the spirit of adventure or to provide mental exercise for the judge."12 Indeed, "[c]ontracts are entered into for serious purposes and rarely, if ever, will the parties choose a law without good reason for doing so."13
Despite the ease of establishing reasonable basis, counsel must be watchful for the rare case in which it does not exist. In Hall v. Superior Court, for example, a contract for the private sale of securities contained a forum selection clause—which is "closely related" to a choice of law provision14—in favor of Nevada even though all parties were California residents.15 The only apparent connection between the contract and Nevada was that the parties met in the Nevada airport to execute it and the contract contained a provision stating that the contract (including the offer to sell securities) was negotiated and created in Nevada. Despite these representations in the contract and the location of ultimate execution, the court concluded that the transaction in fact took place in California. The court agreed that some factors pointed toward finding a reasonable basis for the Nevada choice of forum provision, declaring that after "balancing only the factors of inconvenience and expense against 'the parties' free and voluntary choice of a different forum…,' the agreement to bring all litigation in Nevada is not unreasonable in our view, especially since the agreement was executed in that state."16 Nevertheless, the court determined that the "forum selection clause [was] unreasonable"17 because it violated California Corporations Code Section 25701 and the public policy of California.
As demonstrated by Hall, even though a reasonable basis for choosing a particular state's laws to govern an agreement is relatively easy to establish in most cases, an evasion of the protections provided by California to its public, by itself—no matter how it is cloaked—will probably not be deemed a reasonable basis. In this type of case, most courts will void the choice of law provision as being contrary to fundamental policy rather than merely lacking a reasonable basis.
Under Restatement Section 187(2)(b), the parties' choice of law will not be applied if doing so "would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue."18 The Restatement, however, fails to describe which issues implicate the fundamental policy of a given state.
Even the comments to the Restatement acknowledge that "[n]o detailed statement can be made of the situations where a 'fundamental' policy of the state of the otherwise applicable law will be found to exist."19 Nevertheless, a review of the cases applying this exception reveals some guidelines for practitioners seeking not only to draft choice of law provisions but also to provide reasoned opinions on the enforceability of a freely negotiated choice of law stipulation.
The most obvious trend in these cases is that if one of the parties is prohibited from waiving the benefit of a particular statutory right, and the application of the negotiated choice of law clause would act as such a waiver, then it is more likely that the courts will conclude that the issue is one of fundamental policy. In Guardian Savings and Loan Association v. MD Associates, for example, the appellate court concluded that California's "bar to deficiency judgments set forth in [Code of Civil Procedure] section 580b reflects a fundamental policy that is in conflict with the choice-of-law provision contained in the [parties'] agreements."20 The court found that its conclusion "is supported by California precedents dealing with the waiver or evasion of section 580b."21
Similarly, in Ribbens International, S.A. v. Transport International Pool, Inc., the parties' agreement contained a nonreciprocal attorney's fees provision contrary to Civil Code Section 1717(a), which "imposes an obligation of mutuality on such one-way attorney fees provisions."22 The court held that "section 1717(a) represents the strongly held public policy of California." The primary support for this conclusion was found in the text of Section 1717(a): "Attorney's fees provided for by this section shall not be subject to waiver by the parties to any contract.…"23
This same reasoning guided the Hall court's conclusion that a choice of law agreement violated a strong California public policy expressed in Corporations Code Section 25701, which provides: "Any condition, stipulation or provision purporting to bind any person acquiring any security to waive compliance with any provision of this law…is void."24 In light of this clear statutory language, the court held that it would be an abuse of discretion to enforce the disputed choice of forum provision.
The counterpart to this reasoning is that absent a prohibition of waiver of an issue of California law, the courts are more likely to enforce a freely negotiated choice of law provision. In CQL Original Products, Inc. v. National Hockey League, the parties' choice of law clause resulted in a potential conflict regarding the treatment of forfeiture clauses.25 The court concluded that this issue "does not amount to a conflict involving fundamental policy in California…given the absence of any statute prohibiting the parties from choosing [another] forum and therefore waiving California law."26
Similar to those cases citing prohibition of waiver to support a finding of fundamental policy are cases that cite clear or emphatic statutory language (albeit without an express waiver prohibition) to reach the same conclusion. For example, there are several cases that conclude that California's prohibition of covenants not to compete implicates fundamental policy. These cases cite the "explicit" language of Business and Professions Code Section 16600: "[E]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void."27 These cases are related to the "no waiver" cases, because implicit in this clear legislative directive is a prohibition against any waiver of the protections of Business and Professions Code Section 16600.28
For instance, in Scott v. Snelling and Snelling, Inc., the court concluded that Section 16600 represents "a strong public policy which would override the choice of law provision in the contract at least with regard to the restrictive covenant."29 Key to the court's analysis in Snelling is that a "simple reading of [Section 16600], giving the words their ordinary meaning, demonstrates that the California state legislature intended [S]ection 16600 to apply to any sort of contract which contains a covenant restraining competition."30
Another factor that appears important to the courts' determination of the impact on fundamental policy of a freely negotiated choice of law stipulation is the sufficiency of the relationship with the chosen state. Comment g of Restatement Section 187 suggests that the issue of fundamental policy may depend on the same considerations required in making a reasonable basis determination:
The more closely [the chosen] state is related to the contract and to the parties, the more likely it is that the choice-of-law provision will be given effect. The more closely the state of the chosen law is related to the contract and the parties, the more fundamental must be the policy of the state of the otherwise applicable law to justify denying effect to the choice-of-law provision.31
At least one case appears to have applied this principle to a choice of law provision to determine whether it offends California policy. In Gamer v. duPont Glore Forgan, Inc., the court stated, "Some of the reasons for holding [that] California policy…is not offended by the contract under discussion bear upon the sufficiency of the relationship between the [chosen state] and the contract, its subject matter, and its performance."32
Courts also tend to rely upon several public policy considerations in making a determination of fundamental policy. This line of reasoning is consistent with Civil Code Section 3513: "Anyone may waive the advantage of a law intended solely for [his or her] benefit. But a law established for a public reason cannot be contravened by a private agreement."
In Guardian Savings,33 the court's analysis was "guided by the purposes attributed to the antideficiency legislation." In determining that the conflict resulting from California's antideficiency statute implicated fundamental policy, the court examined several public policy justifications for the statute at issue:
- "[E]conomic stabilization—preventing overvaluation of real property."
- "[A]voiding the aggravation of an economic downturn in a depression."
- "Equitable allocation of risk."
- "[E]ncouraging homeownership by limiting risks of financial loss in acquiring a home."34
Likewise, the Hall court refused to enforce a choice of forum clause in a private California securities agreement.35 The court first acknowledged the general rule that "choice of law provisions are usually respected by California courts."36 Then, the court stated that "'an agreement designating [a foreign] law will not be given effect if it would violate a strong California public policy…[or] 'result in an evasion of…a statute of the forum protecting its citizens.'"37 Thus the Hall court concluded that "California's policy to protect securities investors, without more, would probably justify denial of enforcement of the choice of forum provision."38
There are other possible factors that a court may consider in determining the issue of fundamental policy. A court may decide that an issue implicates fundamental policy if the issue is subject to a "comprehensive regulatory scheme" in the relevant jurisdiction.39 In a case involving the application of a statute of limitations, the court determined that "in the absence of a choice-of-law provision, California's conflict of laws principles recognize that it may be appropriate to apply a foreign state's [law]."40 Thus the conflict did not involve an issue of fundamental policy. Presumably there are numerous other possible considerations that may come to a court's attention as relevant factors in determining the application of the fundamental policy exception.
Even if a court determines that the application of the parties' choice of law agreement is contrary to fundamental policy, the Restatement 187(2)(b) exception adds an additional level of complexity by requiring a balancing of interests. Specifically, the court must determine if the state "has a materially greater interest than the chosen state in the determination of the particular issue." In Guardian Savings, the court concluded that fundamental policy was implicated by the conflicting issue but nevertheless held that the choice of law provision was enforceable because California's interest in the particular issue of fundamental policy was "not materially greater than Texas's policy of assuring the justified expectations of the parties."41
As a practical matter, this means that even if an attorney can wade through the multitude of considerations to predict whether or not an issue implicates the fundamental policy of a particular state, the attorney still must consider an additional balancing of interests. This balancing test may involve so many variables that practitioners could be completely inhibited from rendering any legal opinion regarding the enforceability of choice of law stipulations without a series of disclaimers.42 Indeed, even if practitioners can boast a detailed knowledge of the exceptions that govern the enforceability of choice of law provisions, the tradition of offering clients reasoned, discursive choice of law opinions is likely to continue.
1 Nedlloyd Lines B.V. v. Superior Court, 3 Cal. 4th 459 (1992).
3 Id. at 464-65.
4 Restatement (Second) of Conflict of Laws §188, "Law Governing in Absence of Effective Choice by the Parties."
5 Restatement (Second) of Conflict of Laws §187(2) (emphasis added).
6 Application Group, Inc. v. Hunter Group, Inc., 61 Cal. App. 4th 881, 899 (1998) (citing Nedlloyd, 3 Cal. 4th at 467-68).
7 Restatement (Second) of Conflict of Laws §187, cmt. f. See also Mencor Enters., Inc. v. HETS Equities Corp., 190 Cal. App. 3d 432, 440 (1987) ("When the state of the chosen law has some substantial relationship to the parties or their contract, the parties have a reasonable basis for the choice.").
8 See International Business Machines Corp. v. Bajorek, 191 F. 3d 1033, 1038 (9th Cir. 1999).
9 See, e.g., Nev. Rev. Stat. Ann. §99.050; Idaho Code §28-42-201. Nevada and Idaho have very liberal usury laws.
10 But even New York has certain usury maximums. See Joshua Stein, Confusion Unraveled: A Road Map of New York's Usury Law, N.Y. St. B. A. Real Prop. Sec. Newsl., Fall 1993, at 17.
11 Restatement (Second) of Conflict of Laws §187, cmt. f (stating that the place of contracting may be a reasonable choice, "except, perhaps, in the unusual situation where this place is wholly fortuitous and bears no real relation either to the contract or to the parties."). But see Industrial Indem. Ins. Co. v. United States, 757 F. 2d 982, 987-88 (9th Cir. 1985)("that it was the place of contracting is not enough when there was no other relationship to the transaction").
12 Restatement (Second) of Conflict of Laws §187, cmt. f.
14 California courts have acknowledged that for purposes of determining enforceability, forum selection clauses are "closely related" to choice of law provisions. See Nedlloyd Lines B.V. v. Superior Court, 3 Cal. 4th 459, 464-65 (1992); Cal-State Business Prods. & Servs., Inc. v. Ricoh, 12 Cal. App. 4th 1666, 1676 (1993).
15 Hall v. Superior Court, 150 Cal. App. 3d 411 (1983).
16 Id. at 416.
17 Id. at 418.
18 Restatement (Second) of Conflict of Laws §187.
19 Id., cmt. g.
20 Guardian Sav. & Loan Ass'n v. MD Assocs., 64 Cal. App. 4th 309, 317 (1998).
21 Id. at 321.
22 Ribbens Int'l, S.A. v. Transport Int'l Pool, Inc., 47 F. Supp. 2d 1117, 1119 (C.D. Cal. 1999).
23 Id. at 1122.
24 Hall v. Superior Court, 150 Cal. App. 3d 411, 417 (1983).
25 CQL Original Prods., Inc. v. National Hockey League, 39 Cal. App. 4th 1347, 1357 (1995).
27 Bus. & Prof. Code §16600. See Application Group, Inc. v. Hunter Group, Inc., 61 Cal. App. 4th 881, 900 (1998) ("[Bus. & Prof. Code §]16600 reflects a 'strong public policy' of the State of California."); Frame v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 20 Cal. App. 3d 668 (1971) ("[Bus. & Prof. Code §]16600 does represent a 'strong public policy' of this state.").
28 But see International Business Machines Corp. v. Bajorek, 191 F. 3d 1033 (9th Cir. 1999) (holding that restrictions on stock options in exchange for a commitment not to work for any competitor for six months does not violate Bus. & Prof. Code §16600 and thus does not implicate fundamental policy).
29 Scott v. Snelling and Snelling, Inc., 732 F. Supp. 1034, 1039-40 (N.D. Cal. 1990).
30 Id. at 1040.
31 Restatement (Second) of Conflict of Laws §187, cmt. g.
32 Gamer v. duPont Glore Forgan, Inc., 65 Cal. App. 3d 280, 287 (1976).
33 Guardian Sav. & Loan Ass'n v. MD Assocs., 64 Cal. App. 4th 309, 317 (1998).
34 Id. at 318-20.
35 Hall v. Superior Court, 150 Cal. App. 3d 411 (1983).
36 Id. at 417 (quoting Smith, Valentino & Smith, Inc. v. Superior Court, 17 Cal. 3d 491, 494 (1976)).
37 Id. (quoting Frame v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 20 Cal. App. 3d 668, 673 (1971)).
38 Id. at 418.
39 Foreman v. George Foreman Assocs., Ltd, 517 F. 2d 354, 356 ("The comprehensive regulatory scheme which California imposes on boxing reflects a public policy which is 'unusually strong.'").
40 Hambrecht & Quist Venture Partners v. American Medical Int'l, Inc., 38 Cal. App. 4th 1532 (1995).
41 Guardian Sav. & Loan Ass'n v. MD Assocs., 64 Cal. App. 4th 309, 323 (1998).
42 See Gary L. Dickson, Working around California's Stringent Usury Law, Los Angeles Lawyer, Mar. 1999, at 23.
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