These clauses, which usually appear at the end of contracts, tend to be the most difficult to grasp for non-lawyers (and even for some lawyers).
What is governing law?
Governing law refers to the set of rules applied to determine whether the contract is valid, and to interpret its wording and the parties’ rights and obligations.
There are two “gold standards” for governing law in international business transactions: New York law and English law. This is largely due to the breadth and depth of case law in these jurisdictions: any given legal issue is much more likely to have been litigated in New York or England than to have been litigated in, say, Wyoming or the Marshall Islands.
It’s usually a bad idea to choose the governing law of a non-English-speaking country unless you are extremely familiar with it. Most English-speaking countries operate based on common law inherited from England, and their laws of contracts tend to be very similar; most importantly, they tend to respect whatever is written in the contract. Most non-English-speaking countries operate based on a civil code of some kind, and civil codes often apply unexpected rules to contracts. For example, under Japanese law, it is often difficult to terminate a long-term contract with a party perceived to be in a position economically reliant upon the other, despite whatever termination provisions are written in the contract.
What is jurisdiction?
Jurisdiction refers to where the parties go in order to resolve disputes. This clause is sometimes called "venue" or "dispute resolution."
There are three basic kinds of jurisdiction clauses. One is non-exclusive jurisdiction or submission to jurisdiction, which means that the parties agree that either party can be sued somewhere, but retain the option to bring a lawsuit elsewhere. This is useful for contracts like guarantees and non-disclosure agreements, which might need to be promptly enforced through different courts in different locations.
The second is exclusive jurisdiction, which means that the parties agree to only bring disputes in a certain court. This makes the outcome of disputes more predictable, but also removes each party’s flexibility in choosing a venue.
The third is alternative dispute resolution, which means that the parties agree to use an alternative method of resolving disputes outside of court. Arbitration, where the parties agree to a private third-party “referee” of some kind instead of going to court, is a popular option in international contracts, since it allows disputes to be resolved almost anywhere under almost any governing law and in almost any language, and there are a variety of arbitration institutions and rules to choose from.
How do they line up?
Governing law and jurisdiction clauses typically match (e.g. New York law and litigation in New York courts), but this is not a requirement. For example, you can have a contract governed by New York law, but have disputes settled by arbitration in Tokyo.
That said, it’s often a bad idea to mix governing law in one state/country with exclusive jurisdiction in another state/country’s courts. If you choose arbitration in Tokyo, you can appoint arbitrators who are familiar with New York law and have the case tried by New York qualified lawyers. If you choose courts in Tokyo, you will be stuck with Japanese judges who may not even understand English that well, and who will have to rely upon opinions from New York lawyers in order to interpret New York law, which makes everything much less predictable.
How do you choose the optimal combination?
Approaches to governing law and jurisdiction clauses vary from lawyer to lawyer. Most lawyers simply insist upon whichever law and jurisdiction they personally understand (which is usually their home country law).
My first concern is always how the contract can be enforced if there is a problem. If another party is in a country with a weak, slow or unpredictable court system, it’s often a good idea to avoid that court system by choosing arbitration. However, arbitration is not a “silver bullet,” and in some cases it makes more sense to have the option (or the obligation) to go to court.
If court is the way to go for dispute resolution, then it typically makes sense to align the governing law with the court’s home law. Otherwise, it typically makes sense to choose a governing law that is internationally recognized and likely to be acceptable to all of the parties.
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