The Test Courts Use for Contracts

Most contracts that end up in court across a state line contain no governing law clause at all, or contain one that does not reach the claim being made. A court then has to choose between two states' contract law, and the modern approach to that choice is a structured weighing exercise rather than a rule.

The five contacts

The place of contracting. Where the last act necessary to form the contract occurred — usually acceptance. In modern commerce this is frequently fortuitous, and courts discount it accordingly.

The place of negotiation. Where the parties dealt with each other. Meaningful where there was a genuine negotiation in one place, and close to meaningless where the exchange was by email between three time zones.

The place of performance. Where the obligations are to be carried out. This is usually the heaviest contact, because it identifies where the contract actually operates and where the consequences of breach fall.

The location of the subject matter. Where the goods, the land, the business or the assets are. Where a contract concerns specific property, this frequently decides the question, and for land it is close to conclusive for the reasons in why land follows the state it sits in.

The parties' own connections. Domicile, residence, place of incorporation and principal place of business. These matter most where the other contacts are dispersed, and they are the contacts least likely to be accidental.

The factors that weigh them

The relevant policies of the interested states. What each state's rule is trying to achieve, and how much it would be undermined by applying the other's.

The protection of justified expectations. What the parties reasonably understood would govern them. This factor does substantial work, because contract law exists to enforce bargains people believed they were making.

Certainty, predictability and uniformity of result. A consideration favoring rules that produce the same answer whichever court asks, and one reason courts hesitate before novel outcomes.

The needs of the interstate system. Whether the result facilitates or obstructs commerce across state lines, which in practice favors outcomes that commercial parties can anticipate.

Ease in the determination and application of the law. A modest factor, and a real one where a court would otherwise have to apply an unfamiliar body of foreign state law, as described in proving another state's law in court.

How it plays out

Performance and subject matter usually align. In most disputes the place where the contract was to be performed and the location of what it concerned point at the same state, and the analysis is short.

Dispersed performance is the hard case. A services agreement performed in four states, or a supply contract with deliveries in several, forces a court to identify the center of the arrangement rather than a single location.

Issue-by-issue analysis is permitted. Different questions within one contract can be governed by different states' law where the contacts differ — the doctrine examined in two laws, one transaction.

Sales of goods have their own overlay. The uniform commercial code has been adopted in every state, so for many transactions the substantive rules are similar whichever law applies, and the choice matters only at the margins where states have varied the text.

And the forum's approach decides the method. A minority of states still apply the older place-of-contracting rule, so the analysis itself depends on which court is asking, which is one more reason a clause is worth having.

What parties should take from it

Include a clause. The entire apparatus above exists because the parties did not settle the question themselves. A single sentence removes it.

Draft the clause broadly. A clause covering all claims arising out of or relating to the agreement prevents the analysis reappearing for tort and statutory claims.

Name a state with a genuine connection. Which makes the clause robust against the challenges described in when a court sets the chosen law aside.

Think about performance when structuring. Where the contract will be performed carries the most weight in the fallback analysis, so a party with a choice about where work happens is also influencing which law would apply.

And record the negotiation. Where a dispute reaches the fallback test, evidence of where the parties dealt, what they expected and where obligations were to be met is what the analysis runs on, and it is far easier to preserve at the time than to reconstruct later.

Why this matters more than it used to

Commerce has stopped having a location. A contract negotiated over video between people in three states, signed electronically, performed partly by software running somewhere neither party knows, has contacts that resist the framework the test was built around. Courts apply it anyway, and the answers are less predictable than they were when a contract was signed in a room.

Which raises the value of the clause and lowers the value of arguing. The fallback test was designed as a residual mechanism for the minority of cases where parties had not addressed the question. It is now doing more work than it was built for, and the results are correspondingly harder to forecast.

Small businesses are the most exposed. Large commercial parties include governing law clauses as a matter of routine. Contracts between small businesses, and between a business and a supplier or contractor in another state, frequently have none, and those are precisely the parties least able to fund an argument about which state's law applies before the merits are reached.

The cost of the argument frequently exceeds the difference. Two states' contract law is usually similar in outcome, particularly for the sale of goods where the uniform code applies in both. Litigating the choice can therefore cost more than the choice is worth, which is an argument for settling it in the contract and, where that has not happened, for agreeing it with the other side early rather than briefing it.

And the answer shapes everything downstream. Which law governs decides the limitation period through borrowing statutes, the availability of consequential damages, whether a liquidated damages clause is enforceable, what implied terms exist and what defenses are available. It is not a preliminary skirmish; it is frequently the case.

The short version, for anyone signing agreements across state lines, is that a governing law clause costs one line and removes an entire layer of dispute. Its absence does not mean no law applies; it means a court will pick one, some time after the dispute has begun, using a test that weighs facts nobody thought to record. Parties who understand that tend to include the clause, and parties who have been through the fallback analysis once never omit it again.