Key Takeaways

  • “Applicable law” refers to the legal rules and principles a court or arbitral tribunal will apply to resolve a contract dispute.
  • Courts typically honor choice of law clauses unless they conflict with public policy or are irrationally chosen.
  • The significant relationship test guides courts in absence of a choice of law clause, evaluating contacts like contract formation and performance location.
  • False conflicts occur when different jurisdictions' laws lead to the same outcome; in these cases, the court uses local law.
  • In cross-border agreements, parties can designate national, state, or even non-national laws (e.g., transnational principles).
  • The applicable law is generally fixed at the time the contract is signed but may change due to mandatory transitional legislation.
  • Additional principles like public policy exceptions, mandatory rules, and procedural distinctions further influence applicable law decisions.
  • Parties can find skilled attorneys on UpCounsel to help navigate these complex legal determinations.

The applicable law in a contract dispute is an issue termed by the legal community as “conflict of laws.” In a conflict of laws case, a court must determine which jurisdiction’s law applies to the particular contract dispute. This element of law is one of the most confusing. A court must determine whether the location of the 1) making of the contract, 2) performance of the contract, or 3) another place related to the contract is most important/substantial in determining the jurisdiction’s law that should apply.

False Conflict

In determining what jurisdiction’s law should apply, courts should recognize that there may be a “false conflict.” In order to answer a conflict of law question, a court must first determine whether there is a difference, or “true conflict,” in the outcomes between the application of two jurisdiction’s laws. If the laws of two applicable jurisdictions would lead to the same result on an issue present in the case, then there is a “false conflict” and the court must apply the local law (aka it doesn’t matter which law they apply).

If a “true conflict” of laws exists, because it would result in different outcomes depending on which law was applied, a court must determine which state (or state v. federal) has the greater interest in applying its law. Under traditional conflict-of-law rules, the construction and validity of a contract is governed by the law of the jurisdiction in which the contract was formed.

Significant Relationship Test

Courts have moved past the traditional rules and instead adopted the significant relationship rule. This rule requires that the jurisdiction with the most significant relationship or substantial contacts with both the transaction and the parties should govern what law shall be applied.

This rule has other names as well:

  1. Choice influencing theory
  2. Center of gravity theory
  3. Substantial contacts theory
  4. Grouping of contacts theory
  5. Interest weighing theory

Under the most significant relationship test, courts look to the following factors to determine which state’s law applies:

  1. Location of contract formation
  2. Where the relationship of the parties is/was centered
  3. Location of contract negotiations
  4. Location of performance of either or both parties
  5. Subject matter (location if applicable)
  6. Incorporation state
  7. Location of parties (business)

Solution

These issues only arise in the absence of a valid choice of law provision. If your contract includes this provision, then the courts will apply that law, if possible, to a contract dispute. A court will honor the law negotiated and contracted by the parties. Parties to a contract have the right to negotiate and contract as to what state’s law will govern the contract as a whole.

There is no reason to prevent parties from deciding which laws they would like to govern the performance, validity, formation, execution, etc. of the parties, as long as the reasons for choosing said law are not against public policy.

Mandatory Rules and Public Policy Exceptions

Even when parties have selected a governing law, courts may refuse to apply that law if doing so would contravene the forum state's mandatory rules or public policy. Mandatory rules are legal provisions that cannot be derogated by agreement because they serve public interests—such as rules related to competition law, labor law, or consumer protection.

A public policy exception allows a court to disregard the chosen applicable law if applying it would lead to a result fundamentally at odds with the values and principles of the forum state. For example, a court might refuse to enforce a contract governed by a foreign law that permits forms of discrimination that are illegal domestically.

Cross-Border

In a transaction across state or country lines, laws from several jurisdictions could logically apply. Parties entering into an international transaction should decide on the law that shall be applied to the contract and include that decision in a provision within the written agreement in order to avoid court decision on that matter. Arbitral tribunals and international courts will respect the parties’ autonomy to make this decision.

Parties may choose a national or state law to govern the contract, but they may also choose other sets of rules such as transnational law, public international law, general principles of law or equitable principles to apply. The parties may also agree if they so choose that different parts of the contract will be governed by different sets of laws or principles if they would like. And this decision can be made any time, even if not made at the time of contract formation.

Non-State and Hybrid Legal Frameworks

In addition to selecting national laws, contracting parties—especially in international commerce—can opt for non-state legal frameworks. These include the UNIDROIT Principles of International Commercial Contracts, the Principles of European Contract Law, and general principles recognized in international trade.

Such transnational norms may offer a neutral and flexible approach, particularly suitable when parties are from different legal traditions. These frameworks can be applied as either the applicable law by agreement or as interpretive tools that supplement a national law.

In arbitral proceedings, parties often enjoy even greater freedom in selecting these non-state norms, and tribunals are typically more inclined to apply them when justified by the context of the dispute.

Applicable Law in Time

Once a court has determined which jurisdiction’s law it should apply, it must determine what law was applicable at the time of contract formation. The applicable law to a contract throughout its duration should be the one in force at the time of its signature.

However, there are situations where a new law may apply to an ongoing contract. The newly enacted law may provide for its immediate application through transitional legal provisions.

Renvoi and Dépeçage in Conflict of Laws

Two advanced principles in conflict of laws further complicate the determination of applicable law:

  • Renvoi occurs when the law of a foreign jurisdiction refers the matter back to the law of the forum or to another legal system. Some courts accept renvoi, especially in civil law jurisdictions, while common law jurisdictions typically reject it to avoid circular references.
  • Dépeçage allows different aspects of a single contract to be governed by different legal systems. For example, the performance terms might be governed by German law, while dispute resolution clauses fall under New York law. This technique is often used in complex cross-border agreements where different jurisdictions have particular expertise or benefits.

Procedural vs. Substantive Law

When determining the applicable law, it is also critical to distinguish between substantive and procedural law:

  • Substantive law governs the actual rights and duties of the parties—such as contract formation, obligations, breach, and remedies.
  • Procedural law relates to how the case is conducted in court, including evidence rules, jurisdiction, and limitation periods.

The forum court’s procedural law generally applies, even when it uses a foreign law for substantive matters. This distinction is essential because procedural rules might affect outcomes (e.g., statute of limitations may differ by jurisdiction).

Frequently Asked Questions

1. What does “applicable law” mean in a contract? Applicable law refers to the body of legal rules a court or tribunal applies to interpret and enforce a contract.

2. Can parties choose any applicable law for their contract? Yes, but the chosen law must have a reasonable connection to the contract and must not violate public policy or mandatory rules of the forum.

3. What happens if the contract does not specify an applicable law? Courts use conflict-of-law rules, such as the significant relationship test, to determine which jurisdiction's law should govern the contract.

4. Is procedural law ever subject to the choice of law clause? Generally, no. Procedural law is governed by the forum court, even when a different substantive law is applied.

5. Can different parts of a contract be governed by different laws? Yes. This is known as “dépeçage” and is permissible when explicitly stated in the contract.

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