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Choice-of-Law Agreements and Public Policy Enforceability Exception

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February 11, 2015
By: P. Clarkson Collins, Jr.
Delaware Business Court Insider

By statute, Delaware has affirmed the ability of parties to agree to have their rights, remedies, liabilities, powers and duties governed by the law of Delaware. Title 6, Section 2708 of the Delaware Code recognizes that the parties' contractual choice-of-law provision is itself a "significant material and reasonable relationship with this state and shall be enforced whether or not there are other relationships with this state." A recent decision of the Delaware Court of Chancery reveals that important limitations remain, however, on the ability of parties to enforce Delaware choice-of-law provisions.

In Ascension Insurance Holdings LLC v. Underwood, C.A. No. 9897 VCG (Del. Ch. filed Jan. 28, 2015), Vice Chancellor Sam Glasscock III denied a preliminary injunction application seeking to enforce a non-compete covenant contained in an employee investment agreement (EIA) in which the parties also expressly agreed to Delaware choice of law and venue. Recognizing that Delaware law permits and enforces reasonable non-compete covenants, the defendants argued that the covenant nevertheless was unenforceable because the statutory law and public policy of California, the state where the contract was executed, did not permit the non-compete in question. With the parties having agreed that issuance of an injunction turned on the enforceability of the choice-of-law provision, the court analyzed it under the standard of Section 187 of the Restatement (Second) of Conflict of Laws (1971).

Section 187 of the Restatement provides that the parties' chosen law will apply unless: "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 would be the state of the applicable law in the absence of an effective choice of law by the parties."

Using this framework, the court ruled that absent the Delaware choice-of-law provision, California law would apply because: (1) the contract was negotiated and executed in California, (2) between a California resident and a Delaware LLC with its principal place of business in California, and (3) enforcement of the non-compete was sought predominantly in California counties (14 counties) and one county each in Arizona and Nevada. The court also found that California law by statute generally disallows contractual agreements not to compete and that the EIA in question did not fall within any exception to the California prohibition.

The Court of Chancery acknowledged that Delaware is a strongly contractarian state that recognizes the right of parties to self-order and promotes the certainty of contractual obligations and benefits. Applying the Restatement test, the court ruled, however, that California's specific non-compete prohibition on public policy grounds materially outweighed Delaware's general interest in freedom of contract. Specifically, the court ruled that California had a greater interest in deciding whether a California resident, employed there and seeking largely to compete in California and not Delaware, should be prevented from engaging in the competing activity.

This case illustrates the difficulty of applying the Restatement test and being assured of obtaining the benefit of the chosen law for which the parties bargained. In a similar case also involving enforcement of a non-compete covenant under a Delaware choice-of-law provision, Delaware's federal district court granted a preliminary injunction, in Coface Collections North America v. Newton, 430 Fed. Appx. 162 (3d Cir. 2011). The contract in question was entered into by a Louisiana resident in Louisiana, a state that generally prohibits non-compete covenants except in limited instances accompanying the sale of a business and involving a duration of two years or less. On appeal, the U.S. Court of Appeals for the Third Circuit upheld the district court's preliminary injunction order after applying the same Restatement Section 187 analysis. The Third Circuit reasoned that the parties' choice of Delaware law and the plaintiff buyer's incorporation in Delaware provided an adequate substantial relationship with Delaware. The court went on to conclude that Louisiana did not have a "materially greater interest" than Delaware in determining the effect of the non-compete covenant. Specifically, the court found that the facts of the defendant's citizenship in Louisiana, the agreement's execution there and the presence there of the competing business were not enough to outweigh Delaware's "substantial interest in enforcing this voluntarily negotiated contract clause that explicitly designates Delaware law to govern." Having found that Louisiana did not have a superior interest, the court did not address whether enforcement of the non-compete would violate Louisiana's public policy. It expressed skepticism, however, that enforcing a non-compete provision under the parties' contractually designated law of another state would violate a fundamental policy of Louisiana.

The Court of Chancery did not distinguish or discuss Coface. And Coface involved competition on a national scale unlike the more California-centric competition described in Ascension. The fact that two courts applying the same Restatement analysis, however, can reach different conclusions on very similar facts illustrates the difficulty of predicting the enforceability of choice-of-law provisions. To improve the prospects that a Delaware court would honor a Delaware choice-of-law provision, practitioners may wish to include with the choice of law an acknowledgment in the parties' agreement that they have selected Delaware law to promote the parties' mutual commercial goals, and waive the application of non-Delaware law notwithstanding that other provisions of their agreement may be inconsistent with the law or public policy of another jurisdiction.

Delaware Business Court Insider  |  February 11, 2015

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