Background
In most derivative master agreements, parties indicate the substantive law that will govern disputes arising from the agreement through a provision stating the agreement will be governed by and construed in accordance with the laws of a specified jurisdiction. Indeed, this is the standard governing law provision in the both the 1992 and 2002 International Swaps and Derivatives Association Master Agreement standard forms of Schedule.
What happens, however, when the dispute relates to a series of transactions, not all of which were entered into under the ISDA agreement? Is the standard language designating the choice of New York law broad enough to cover such a dispute?
Finance One v. Lehman Brothers
The Dispute
The U.S. Court of Appeals for the Second Circuit addressed that question in Finance One Public Co. v. Lehman Brothers Special Financing. It held the provision in the parties' ISDA Master Agreement Schedule specifying New York law as governing agreement law did not mean New York law governed whether Lehman was entitled to set off amounts it owed Finance One under the ISDA agreement against amounts due Lehman from Finance One for unrelated transactions that did not arise under the agreement.
The dispute arose during Thailand's financial crisis in 1997, when the ThaiMinistry of Finance issued an order suspending the business operations of Finance One, a Thai company that was conducting certain business transactions with Lehman. Lehman attempted to off-set the value of payments due to it under bills of exchange issued by Finance One against Lehman's obligations to Finance One in certain derivatives transactions.
Lehman argued that although the Schedule to the ISDA Master Agreement executed by Finance One and Lehman did not include a contractual right of set-off, Lehman was entitled to set-off because New York law provided such a right, and the New York choice of law provision in the parties' ISDA Master Agreement was sufficiently broad to encompass that right.
The Second Circuit's Analysis
The Second Circuit noted the parties could have included a set-off provision in their agreement but had not done so. In holding that the New York choice of law provision in the ISDA Master Agreement did not confer on Lehman a right to set off under New York law, the Court of Appeals referred to decisions by the New York State courts that demonstrated "reluctance on the part of New York courts to construe contractual choice-of-law clauses broadly to encompass extra-contractual causes of action." The court explained, for example, that under New York law the inclusion of a New York choice of law provision in a contract does not mean New York law will govern fraud or other tort claims arising incidentally to that contract. The court reasoned Lehman's right of set-off, which had not been provided for in the ISDA Master Agreement, accordingly did not arise from that agreement.
In reaching this conclusion, the court noted the difference between the ISDA Master Agreement's choice of law clause and its forum selection clause. Whereas the choice of law clause in the standard ISDA form provides: "This Agreement will be governed by and construed in accordance with" New York law, the forum selection clause in that standard form is considerably broader, covering, "any suit, action or proceedings relating to this Agreement". The court observed that if the parties wanted to draft a broader choice of law clause they could have done so.
Having concluded the choice-of-law provision did not encompass New York law set-off rights, the Second Circuit then applied a choice-of-law "interest analysis" to determine what law should govern whether Lehman had rights of set-off against Finance One. In an interest analysis, a court proceeds as if the parties' agreement did not include any choice-of-law provision. To determine what law will govern, the court considers the place of contracting, the place of performance, the location of the contractual subject matter, and the location of the parties' respective places of business and incorporation. If this analysis indicates that New York has a substantial interest in the conflict, then New York law governs the dispute.
Based on the interest analysis, the court determined the law of Thailand applied to the question of Lehman's set-off rights against Finance One. Fortunately for Lehman, the court ruled that under Thai law Lehman had the right to set off amounts Lehman was owed under the Thai bills of exchange against amounts Lehman owed under its derivatives obligations to Finance One.
Lessons From Finance One
Extra-Contractual Rights
Although the 1992 ISDA Master Agreement form--in use at the time of the Lehman-Finance One transactions--did not include a set-off provision, Section 6(f) of the 2002 Master Agreement form does include one. The significance of Finance One is not, however, limited to set-off rights. Both the 1992 and 2002 ISDA Master Agreement forms include a provision in Section 9(d) indicating that the parties to an ISDA Master Agreement are relying not only on the rights expressly stated in the Agreement, but also on rights they may have under applicable statutory or common law. Section 9(d) states:
Remedies Cumulative. Except as provided in this Agreement, the rights, powers, remedies and privileges provided in this Agreement are cumulative and not exclusive of any rights, powers, remedies and privileges provided by law.
Although Section 6 of the ISDA Master Agreement permits the non-defaulting party to close out all existing transactions between the parties, the non-defaulting party may choose to bring a legal action against the defaulting party based on the particular default, e.g., failure to make a required payment under a transaction. The lesson of Finance One is that, if the parties want to rely on extra-contractual rights or remedies that may be available under New York law, they should include in their ISDA Master Agreement Schedule a choice-of-law provision that is broad enough to cover those rights and remedies. Courts will give effect to the parties' intent in choosing New York law as the governing law, but will not broaden a narrowly tailored choice of law provision to encompass disputes beyond those relating to the parties' express agreement.
Crafting The Choice-Of-Law Provision
If parties to a contract want New York law to govern conflicts relating to transactions entered into under their contract, they must draft a choice-of-law provision that is broad enough to encompass extra-contractual disputes. Use of the term "arising out of or relating to this Agreement" has been held by New York courts to broaden sufficiently the scope of the choice of law provision to encompass not only conflicts that require the interpretation of the agreement, but also to conflicts arising out of or relating to transactions governed by the agreement.
Thus, courts have held that "a choice of law provision expressly stating that controversies 'arising out of or relating to' the contract was sufficiently broad to include tort claims related to the contract." Williams v. Deutsche Bank Securities, No. 04 Civ. 7588(GEL), 2005 WL 1414435, at 4. (S.D.N.Y. June 13, 2005) (citing Turtur v. Rothschild Registry Int'l, Inc., 26 F.3d 304, 310 (2d cir. 1994)).
While cases concerning the scope of choice of law provisions typically involve the question of whether the choice of law clause in the contract also extends to tort or fraud claims, the lessons from those cases are applicable in the contractual context. Where a broad choice of law provision is present, a court will apply the law chosen by the parties to contract disputes "related" to the agreement as well as to disputes concerning the interpretation of the agreement itself. Without such a broad choice of law provision, parties run the risk that the choice of law they selected will not be applied to resolve issues related to the agreement, such as assignability and, as in the Finance One case, set-off rights.
New York's Statutory Choice-Of-Law Provision
When parties insert a New York choice of law provision in their contract, they do so for a variety of reasons. For example, under Section 5-1401 of the New York General Obligations Law, a choice of law provision specifying the application of New York law in an agreement relating to a transaction covering at least USD250,000 in the aggregate will be upheld, regardless of whether the agreement bears any relationship to the State of New York.
To ensure that expectations are met, parties seeking the application of New York law to any potential contract-related dispute should include a sufficiently broad choice of law provision so that the law they choose is the law that actually will be applied.
This week's Learning Curve was written by Sherri Venokur, special counsel, Melvin Brosterman, partner, and Sheea Sybblis, associate, at Stroock & Stroock & Lavanin New York.
