Last month, the Delaware Superior Court issued a key ruling on the enforceability of Delaware choice-of-law provisions. These contract clauses provide that, if litigation arises over the terms of a contract (often a settlement agreement or an employment agreement), that the law to be applied to the contract will be Delaware contract law (as opposed to the law of the state where the employee works).
The Defendants in the case, Change Capital Partners Fund I, LLC v. Volt Electrical Systems, LLC, et al., filed an Amended Counterclaim wherein “Counts One and Two allege violations of New York laws and Counts Three and Four allege violations of Texas law.” Plaintiff moved to dismiss the Amended Counterclaim, arguing that Delaware law should prevail. The Court sided with Plaintiff and dismissed the Counterclaim.
Delaware Courts are known to honor the principle of freedom to contract. In this case, the agreement in dispute established Delaware choice of law. Delaware has a stature governing these provisions, which provides:
(a) The parties to any contract, agreement or other undertaking, contingent or otherwise, may agree in writing that the contract, agreement or other undertaking shall be governed by or construed under the laws of this State, without regard to principles of conflict of laws, or that the laws of this State shall govern, in whole or in part, any or all of their rights, remedies, liabilities, powers and duties if the parties, either as provided by law or in the manner specified in such writing are:
(1) Subject to the jurisdiction of the courts of, or arbitration in, Delaware; and
(2) May be served with legal process.
Thus, if both parties agree, Delaware will be the default state. This provision is significant, but it has important exceptions. Restatement (Second) of Conflicts § 187 states:
(2) 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’ choices, 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 § 188, would be the state of the applicable law in the absence of an effective choice of law by the parties.”
While parties have the option to choose to use Delaware law, there can sometimes be, and have been, exceptions. Defendants, in their Amended Counterclaim, referenced the 2015 Delaware Chancery Court case Ascension Ins. Holdings, LLC v. Underwood in which a non-compete clause issued by a Delaware LLC based in California was ruled unenforceable because California, not Delaware, law should be applied due to Restatement (Second)of Conflicts § 187(2)(b).
The Defendants in Change Capital relied upon Ascension to argue that Texas and New York law should apply because Plaintiff is a Delaware LLC headquartered in New York, Defendant Volt is a Texas LLC, Defendant Boudreaux is a Texas resident, and the loan agreement was executed in New York. They asserted that Texas and New York would become the “default state” in the absence of a choice-of-law provision, that the loan would be contrary to public policy of Texas and New York, and that Texas and New York have a materially greater interest in the determination of the agreement.
The Court disagreed. In Change Capital, there is the matter of choosing to enforce both Texas and New York law, both of which Defendants thought should be the default state for different claims. The Court saw this as casting “too wide a net.”
With Ascension, there was only the matter of one state: California. The Court states:
“Furthermore, the contract at issue in Ascension was a non-compete clause in a ‘contract between a corporation doing business in California and an employee residing in California, entered into in California and to be performed predominantly in California—not in Delaware’ The contract ‘was negotiated in California and involved an agreement not to compete that was limited almost completely to areas within California, by virtue of the geographic scope of the Plaintiff’s business.’ It is axiomatic that, absent the Delaware choice of law, the state in which the non-compete clause was intended to apply would be the default state.”
While the Court disagreed with the matter of the default state, it did concede that “enforcement of the loan transaction would be contrary to New York and/or Texas public policy.” The Texas Finance Code, § 302.001 (b) penalizes contracts for excessive interest rates. New York, too, has public policy prohibiting interest rates exceeding 25%, whereas Delaware law has no cap on interest rates. But this alone was not enough for the Court to deny the Motion to Dismiss
The Court found that the Defendants did not demonstrate that either Texas or New York had a “materially greater interest” than Delaware in the loan. Furthermore, the Court felt that the original agreement established Delaware choice of law, and thus was tied significantly enough to Delaware. Quoting the 2006 case Abry Partners V, L.P. v. F & W Acquisition LLC, the Court said, “to enter into a contract under Delaware law and then tell the other contracting party that the contract is unenforceable due to the public policy of another state is neither a position that tugs at the heartstrings of equity nor is it commercially reasonable.”
What is more, it is unclear which state, if any, has the greatest material interest. As stated before, Ascension was a case in which most of the relevant factors had to do with California. The company did business in California. The employee was a resident of California. The contract itself was negotiated in California. It referenced where the employee could not compete in California. Moreover, as we have noted in other articles, the contract at issue in Ascension was a non-competition agreement, an issue to which California law is notoriously hostile.
In Change Capital, the loan agreement was executed in New York. It was between a Delaware LLC headquartered in New York, a Texas LLC, and a Texas citizen. Loans do not restrict a party geographically as do non-compete clauses. Thus, to argue that any one state had a greater material interest than another would be misconstruing the facts of Ascension and overlooking many facts in Change Capital.
The Court touched upon other fundamental differences between this case and Ascension. The types of contracts in each case were different. Ascension and the three proceeding Chancery Court decisions of a similar nature (EBP Lifestyle Brands Holdings, Inc.; Fyfe Co.; and Kan-Di-Ki, LLC,) all involved enforcement on a non-compete. The contract in question in Change Capital was a loan. Whereas a non-compete has geographic restrictions written into it, a loan does not.
Furthermore, the Court asserted that, while Defendants argued that both New York and Texas laws should prevail over certain counts, there was no single “default state” to govern the agreement. Each of the preceding Chancery Court cases involved two states: Delaware and California.
“Defendants have failed to identify a “default state” whose law would apply absent the choice-of-law provision, which identifies Delaware…Defendants appear to argue that because ‘Defendants are located in Texas’ and ‘Azadian is headquartered in New York City and the transaction was handled [in New York]’ either Texas or New York should be the default state.”
Nuanced but significant differences exist between Change Capital and Ascension. It is without question that this case will become a touchstone in future choice-of-law provision cases.