Prof. Dr.

Patrick Ostendorf
The choice of the governing
Iaw in internationaI
commerciaI contracts
nternational Business Days 2009
Rotterdam
The governing Iaw of a contract - why do
we need it in the first pIace?
Every (national or international contract) must have a governing law!
The governing law sets forth the necessary rules on contract
formation: When (and under which prerequisites) will a contract
come into existence ?
The governing law of the contract stipulates the fundamental
principle of contract law: Valid contracts are binding and must be
enforced (,pacta sunt servanda")!
The governing law fills gaps and restricts the freedom of the parties
to deviate from (mandatory) statutory provisions!
Governing Iaw and internationaI
commerciaI contracts
The choice of the governing law of a contract becomes in particular
relevant on the international level: Whenever a contract has links to
more than one legal order, courts in charge of resolving a
contractual dispute must determine which law will govern the
contract.
Example: A German company concludes a commercial contract with a Dutch
company. n the event of a contractual dispute, courts must decide whether German
or Dutch substantive laws apply.
A purely domestic contract, on the other hand, is governed by the
respective national law a choice of another law is not permitted!
Private internationaI Iaw
National courts must apply the Private International laws of their state to
determine the applicable (substantive) law of the contract in case of an
international dispute.
From 18 December 2009 onwards, Private nternational law will be
harmonized on the European level also in relation to (international)
contractuaI reIationships: Every court residing within the EU must apply
the Rome Regulation.
Parties of an international commercial contract can in principle freely
choose the governing law including the choice of a law that is not linked
the contract!
Example: The contract concluded between the Dutch and the German company contains a
,choice of law" clause pursuant to which Swiss law shall govern the contract.
ROME I ReguIation
Art 1 (1) Rom I ReguIation:
Material scope
This Regulation shall apply, in situations involving a conflict
of laws, to contractual obligations in civil and commercial
matters. [.].
Art 3 (1) Rome I ReguIation:
Freedom of choice
A contract shall be governed by the law chosen by the parties.
[.].
Private InternationaI Iaw
(cont.)
n the absence of a choice of law provision in the contract, courts will
(depending on the applicable Private nternational law) regularly
apply the law of the country with which the contract is most closely
connected.
f the parties do not agree on a choice of law clause in an
international commercial contract, they may accordingly face legal
uncertainty: t is not always clear which laws are most closely
connected to a contract!
ROME I ReguIation
Art 4 (1) Rom I ReguIation:
Applicable law in the absence of choice
To the extent the law applicable to the contract has not been
chosen in accordance with Art 3, [.], the law governing the
contract shall be chosen as follows:"
Art 4 (4) Rome I ReguIation:
Where the law applicable cannot be determined pursuant to
paragraphs 1 and 2, the contract shall be governed by the law
of the country with which it is most closely connected
The impact of the governing
Iaw in more detaiI
Starting point: Assume two companies,
that are domiciled in different countries,
conclude an international sales contract
TypicaI provisions in an internationaI
saIes contract
Description of the contractuaI goods
Contract price
Delivery terms
Payment terms
Warranty periods
Available remedies in case of breach
Limitation of Liability (e.g., liability for delay in delivery and exclusion of
,consequential" damages in case of any breach)
Governing law of the contract (Choice of Law) /Jurisdiction Agreement or
Arbitration Agreement
What is Ieft for the governing Iaw once the
contract is concIuded ?
The governing Iaw operates as a ,gap fiIIer": Legal issues arising
out of a contractual relationship that are not addressed by the
contract must be resolved by the governing law!
As a consequence, the governing law becomes less important once
the parties have extensively dealt with duties, rights and possible
legal consequences in case of any breach.
CommerciaI reaIity however: Business parties never manage to
cover all relevant legal issues in the contract. Gap filling function of
the governing law is almost always required!
Governing Iaw as the ,gap
fiIIer"
Governing law will in the absence of contractual
provisions) determine i.a.
- the scope of contractual obligations
- the applicable remedies in case of a contract breach
(and their preconditions)
- the extent and duration of liability of the parties in
case of breach.
The result may be an uncomfortable surprise for at least
one party!
Case Study I
The English company E orders certain production machinery from
the German manufacturing company D. The order submitted to D
indicates the type of the equipment, the contract price, the
requested delivery dates and contains also a choice of law provision
as follows: ,This order and the sales contract concluded hereunder
shall be governed by English law".
D confirms the order towards E without any further reservation.
However, due to problems with the sourcing of necessary raw
materials, D fails to deliver the contractual goods on time.
As a consequence, E terminates the contract without granting a
grace period and claims damages incurred due to a cover
transaction.
SoIution
English law does in principle permit the termination of a
(sales) contract in case of any (even a short) delay in delivery.
Contrary to Dutch or German law, the buyer is accordingly (in
the absence of a contract provision stipulating otherwise) not
required to set a grace period as a condition precedent for a
withdrawal from the contract!
A breach of contract governed by English law does (contrary
to other legal systems in Europe) not require fault on part of
the party in breach!
Case Study II
The Dutch distributor D buys certain products from the US
manufacturer E. The contract contains only a description of the
contract goods and the agreed contract price.
The contractual goods delivered by D are defective. D demands the
delivery of substutite products or the repair of the delivered
products.
E refuses to make good the defect.
Can D enforce perfomance claims in front of a court that has
jurisdiction for the case?
SoIution
f the sales contract is governed by English law, D cannot
claim performance (by means of repair or delivery of
substitute goods) given that common law does not
acknowledge a right of ,specific performance".
f the contract would be governed by Dutch (respectively
another ,continental" legal order), D would be entitled to
enforce a claim for specific performance.
Another exampIe for risks of
gap fiIIing - Iimitation periods
Remedies for a breach of contract cannot be enforced
forever: f not stipulated in the contract, the governing
law of the contract determines when contractual claims
are time barred.
Domestic laws (also in Europe) deviate greatly with
regard to the length (and commencement) of limitation
periods, in particular with regard to warranty periods!
Business people often forget to fix the applicable
limitation period in the contract: Governing law must fill
the gap!
AppIicabIe Iimitation periods for warranty
cIaims under a saIes contract in different
IegaI systems
Swiss law: 1 year (Art 210 Swiss Code of Obligations)
German and French law: 2 years (438 (2) BGB; Art
1648 Code Civil)
Russian law: 3 years (Art 196 Russian Civil Code)
US- and Chinese law: 4 years (2- 725 UCC; Art 129
Chinese Contract Law 1999)
English law: 6 years (Sec 5 Limitation Act 1980)
How to avoid detrimentaI gap-
fiIIing
Draft a contract that contains the applicable
rights and duties of the parties as well as
potential remedies in case of their breach.
Try to agree on a governing law in an
international commercial contract that you are
familiar (and happy) with!
The second issue - Mandatory
Iaws
Besides ,gap filling" in case of omitted
contractual terms, the governing law has one
other essential impact on the contract and the
legal position of the contract parties:
Mandatory laws of the governing law limit the
parties' freedom to deviate from statutory
provisions!
The principIe of freedom of
contract
Generally speaking, parties (of a commercial
contract) may determine their obligations, rights
and remedies resulting out of a contract at their
own discretion.
Accordingly, they can deviate from the
provisions of the governing law as far as these
are not of a mandatory (but derogatory)
character.
Mandatory ruIes of the
governing Iaw
Laws of almost all jurisdictions contain however
mandatory laws that apply if the respective law
is the governing law of the contract!
Mandatory provisions of the governing law
prevail over the stipulations of the parties in the
contract!
Mandatory Iaws
Domestic laws deviate greatly with regard to the amount
of freedom of contract and the existence of mandatory
laws!
See, for instance, German law and the ,strict scrutiny" of
general terms and conditions: Only minor deviations
from statutory law are permitted in general terms and
conditions (i.e. standardized contracts that have not
been individually negotiated) governed by German law
(even in Business to Business transactions!)
Case Study I
Assume you represent an export company that wants to use a
standard sales contract.
n order to reasonably limit your liability in case of delay in delivery
or delivery of defective contractual goods, you put a ,limitation of
liability clause" in the contract. Pursuant to this clause, liability for
,indirect and consequential damages" is excluded.
s the clause enforcable? How will it be interpreted by a court?
ResuIt
The outcome depends on the governing law of the
contract! Governing law is decisive as regards
interpretation and validity of this clause!
Under German law, the clause would be ineffective
if used in a standardized contract!
Under English law, the clause would be narrowly
interpreted and cover only damages that did not
arise ,naturally from the harmful event"!
Case Study II
Suppose you represent a manufacturing
company. n order to distribute your products to
end-customers, you appoint dealers/distributors
for different territories.
After a couple of years, you decide to terminate
one or more of the dealership agreements.
The dealers demand compensation to make
them whole for the loss of their customer base.
ResuIt
f the dealership agreement is (for instance) governed by
German, Swiss, Austrian or Belgium law, the dealer is under
statutory law entitled to claim compensation.
The compensation claim cannot be excluded in the contract
given that it is of mandatory character!
f you have (in an international dealership contract) agreed on
another governing law (e.g., English or Dutch law), no
compensation claim exists!
Case Study III
Assume you represent a Dutch company (D) that intends to
cooperate with a U.S. firm (U) regarding the development of a new
product.
Before the conclusion of the cooperation agreement, you demand
from U to enter into a Non-Disclosure Agreement (confidentiality
agreement) in order to protect your secret know-how that may be
submitted to U in the course of the cooperation.
n order to prevent a breach of confidentiality by U in the first place,
you put a penalty clause in the contract: Pursuant to the clause, U
must pay a contractual penalty amounting to USD 50.000 in every
case of breach. Enforceable?
ResuIt
The solution depends on the governing law:
f U.S. law is the governing law of the contract, the
penalty clause is not enforceable: U.S. law does not
permit the use of penalty clauses in contracts
n case, e.g., Dutch law applies, the clause would in
principle be enforceable
How to deaI with the probIem?
Business parties notoriously underestimate
the importance and impact of the (chosen)
governing law on their legal position!
The choice of the governing law in an
international contract should be handled with
care!
Which Iaw shouId be chosen ?
n the first place, business parties insist
regularly on the application of their own
domestic laws.
n order to overcome a stalemate in contractual
negotiations, a compromise must be found.
Which Iaw shouId be chosen?
(cont.)
On a regular basis a bad compromise:
Parties agree on a governing law of a third
country they are both not familiar with for more
or less irrational reasons!
A better compromise: The application of
international (substantive) law respectively
domestic law that provides for a reliable legal
framework and sufficient contractual freedom!
InternationaI Iaw
Private law is still domestic law: A global civil
code does (for the time being) not exist!
However, sales law has been harmonized on the
international level: The United Nations
Convention on Contracts for the nternational
Sales of Goods (CSG) has been ratified by
some 74 states!
InternationaI Iaw - the CISG
The CSG applies in particular if the
parties of a sales contract are domiciled in
different countries and both countries are
member states of the CSG (Art. 1 lit. a
CSG)
n commercial reality, however, business
parties regularly exclude the CSG!
Advantages of the CISG
A true compromise: The CSG is a blend of
different legal systems (in particular common
and civil law) and hence a truly ,neutral law"
74 member states, almost all leading industrial
countries
Easy access to case law and literature regarding
its interpretation and construction
Shortcomings of internationaI
Iaw
Besides the CSG (international sales
law), international substantive law does
merely exist!
The CSG does not provide a
comprehensive legal system: A variety of
legal issues must still be resolved by
domestic laws!
Some ruIes for the choice of
Iaw
Use a choice of law clause: Only the explicit choice of law in the
contract can offer sufficient legal certainty as to the governing law!
n case of an international sales contract: Reconsider whether an
exclusion of the CSG is reasonable in the individual case!
n the absence of international instruments: f possible, choose a
governing law that you are familiar with!
Make use of the contractual freedom existing on the international
level: Choose a law that permits sufficient contractual freedom!
Some ruIes for the choice of
Iaw (cont.)
Agree on a reasonable compromise as to the governing
law instead of opting for the law of a ,neutral" state
without any further consideration.
Finally: The less you know about the governing law, the
more specific should you be with regard to the
stipulations in the contract!
Prof. Dr. Patrick Ostendorf
Thank you for your
attention!