Governing Law

What does governing law mean?

Governing law (German: anwendbares Recht) refers to the legal system, that is, the law of a particular state, under which a contract is formed, interpreted and produces its legal effects. The parties' agreement on it is called a choice of law (Rechtswahl); the contract provision is called a governing law clause or choice-of-law clause.

A choice of law is like agreeing on a rulebook before a game: it fixes the rules by which the contract is judged. Who decides in the event of a dispute is a separate question.

A choice of law belongs in every contract with a foreign element: in the company purchase agreement with a foreign acquirer, in the participation agreement with international investors, in supply, licence and customer contracts. Which state court or arbitral tribunal decides disputes, by contrast, is regulated by a jurisdiction or arbitration clause. Both questions together form the final provision governing law & jurisdiction.

Choice of law under the Rome I Regulation

Free choice of law

Which law applies to a contract is determined by German courts under the Rome I Regulation, part of private international law. This EU regulation applies directly in all member states except Denmark. It also applies where the law of a state outside the EU is chosen. Under Article 3, the parties can choose the law freely, expressly or clearly from the circumstances, for the whole contract or only for parts of it. The chosen legal system need not have any connection with the contract.

No choice of law

If there is no choice of law, the regulation determines the law by fixed features of the contract (objective connecting factors). As a rule, what is decisive is the habitual residence of the party that performs the characteristic performance of the contract (Article 4). This is the performance that shapes the contract, for a sale for example the delivery and not the payment. For companies, the place of central administration counts. The result is often hard to predict. Transaction agreements therefore regularly choose the law expressly.

Limits: mandatory law and overriding mandatory provisions

Mandatory provisions are rules from which the parties may not deviate. If all elements of the facts lie in one state, its mandatory provisions remain applicable even if the parties choose another law (Article 3 (3)). Overriding mandatory provisions (Eingriffsnormen) prevail regardless of the choice of law (Article 9). These are provisions by which a state protects public interests, for example competition law. Likewise, state investment screening, by which the federal government reviews stakes of foreign acquirers in sensitive companies, applies whatever law the parties choose. Employees and consumers retain the protection of the mandatory provisions of the law that would apply without a choice of law (Articles 8 and 6).

Company law and form for GmbH shares

Company law is expressly excluded from the scope of the Rome I Regulation (Article 1 (2) (f)). The company itself is governed by its own law, the company statute (Gesellschaftsstatut). Formation, internal constitution, company shares, shareholders' meeting and management of a German GmbH (German limited liability company) are therefore governed by German law, whatever law the participation agreement chooses. A shareholders' agreement under English law can create contractual obligations but can displace neither the articles of association nor the German Limited Liability Companies Act (GmbHG).

The assignment of company shares requires notarial recording under Section 15 (3) GmbHG; a choice of law for the purchase agreement changes nothing about this. Whether a purchase agreement governed by foreign law must also be notarially recorded under Section 15 (4) GmbHG is disputed. In practice, it is often recorded as a precaution in such cases. After the assignment takes effect, the notary involved files the new shareholder list with the commercial register (Section 40 (2) GmbHG). This list is decisive in relation to the company as to who is a shareholder.

The UN Sales Convention and its exclusion

The UN Sales Convention (German: UN-Kaufrecht), the Vienna Convention on the International Sale of Goods (abbreviated CISG), applies automatically to contracts for the sale of goods between parties with places of business in different contracting states. As a treaty, it is part of German law. Choosing German law for international deliveries of goods therefore also leads to the UN Sales Convention unless the parties exclude it (Article 6 of the Convention). It contains its own rules on formation of contract, notice-of-defects duties (the duty to notify defects promptly), warranty and damages. Under it, the seller is in principle liable for damages even without fault of its own.

The UN Sales Convention does not apply to the purchase of company shares, because shares are not goods within the meaning of the Convention. Company purchase agreements nevertheless often exclude it as a precaution, above all with a view to the asset deal. The exclusion has great practical importance in the supply and customer contracts of the target company. A choice-of-law clause in German contracts therefore often reads simply: “This agreement is governed by the law of the Federal Republic of Germany, excluding the UN Sales Convention.”

Choice of law in a funding round and a company acquisition

In funding rounds of German GmbHs, participation agreement and shareholders' agreement are in practice governed by German law, because they are closely interlinked with the articles of association, the GmbHG and notarial recording. This also applies where international investors participate and negotiations are in English. A rule under which English terms are to be understood in the sense of German law is then advisable. Expressions such as indemnity (Freistellung) or best efforts (größtmögliche Anstrengung) otherwise carry meanings from common law, the Anglo-American legal tradition, that German law does not know in that form.

In a company acquisition with seller and target company in Germany, German law is widespread, even when foreign acquirers propose their own law. By comparison: in the US market, growth companies are often subject to the corporate law of the state of Delaware. For a German GmbH it cannot be agreed, because its company law is withdrawn from the choice of law. Investors who insist on it require a US company that stands as a holding above the GmbH.

Practical example: governing law in a share sale to France

A French industrial group acquires all company shares of a German GmbH that manufactures sensors and supplies customers in several EU states. The acquirer proposes French law for the share deal.

• Purchase agreement: The parties agree on German law with a precautionary exclusion of the UN Sales Convention, because warranties and indemnities concern German matters and the agreement is notarially recorded in Germany anyway.
• Assignment: It is notarially recorded, and the notary files the new shareholder list. French law for the purchase agreement would not have changed this.
• Due diligence: The target company's terms of delivery choose German law without excluding the UN Sales Convention. For deliveries to customers in other contracting states, the UN Sales Convention therefore applies, which the acquirer takes into account in assessing the warranty risks.
• Mandatory law: The sellers' non-compete covenant must be measured against the limits of competition law irrespective of the choice of law.
• Forum: Separately, the parties choose arbitration seated in Germany.

In the end, choosing French law would have simplified little, because notarial recording, company law and competition law follow their own rules anyway. The economically more important finding lies in the target company's terms of delivery: because they do not exclude the UN Sales Convention, a different liability regime applies to part of the deliveries than under the German Civil Code (BGB) and the German Commercial Code (HGB). The acquirer assesses this risk separately and brings it into the purchase price negotiation.

Distinctions: governing law, company statute and jurisdiction

• Company statute: the law to which the company itself is subject. For a German GmbH it is German law and is withdrawn from the choice of law.
• Contract language: A contract in English is not governed by English law for that reason. Which law applies follows from the choice of law or, without one, from the objective connecting factors.
• Governing law & jurisdiction: the combined final provision that determines, besides the law, the forum, that is, the state court or arbitral tribunal that decides a dispute. Governing law is only its first part.

Common mistakes

• Wanting to choose company law. A choice of law for the shareholders' agreement changes nothing about the fact that the GmbH is subject to German company law.
• Wanting to avoid notarial recording. A foreign governing law for the contract does not replace the notarial form of the assignment.
• Overlooking the UN Sales Convention. Anyone who chooses German law in supply contracts without excluding the UN Sales Convention also agrees to it for international deliveries of goods.
• Different laws in related contracts. If the purchase agreement, ancillary agreements and shareholders' agreement are governed by different laws, breaks arise in interpretation.

Frequently asked questions

Can the parties freely choose which law applies to their contract?

In principle yes. Article 3 of the Rome I Regulation permits a free choice of law. Limits are set by mandatory provisions in purely domestic cases, by overriding mandatory provisions and by the protection of employees and consumers.

Can the participation agreement of a German GmbH be governed by English or US law?

For the contractual obligations that is possible, but rarely expedient. The company law of the GmbH remains German, and the articles of association and agreements requiring notarial recording follow German rules.

Must a purchase agreement for GmbH shares under foreign law be notarially recorded?

The assignment of the shares in any case. For the purchase agreement itself this is disputed, which is why in practice it is often recorded as a precaution.

What applies if the contract contains no choice of law?

Then the Rome I Regulation determines the law by objective features, mostly by the seat of the party that performs the characteristic performance. In a sale of goods, that is generally the seller. Because the result is not always clear, transaction agreements as a rule contain an express choice of law.

Why is the UN Sales Convention excluded?

Because otherwise it applies automatically to international deliveries of goods and brings its own rules on notice of defects, warranty and damages. Many companies prefer the familiar rules of the BGB and HGB.

The Roemer Capital view

For funding rounds of German GmbHs, Roemer Capital assumes German law for participation agreement and shareholders' agreement, even where negotiations are in English. It raises the choice of law early in the term sheet, so that an investor's model contracts do not have to be rewritten only in the final phase.

In a company acquisition with foreign acquirers, Roemer Capital builds notarial recording in Germany into the timetable from the start. The legal drafting rests with the client's law firm. In coordination, Roemer Capital makes sure that the purchase agreement and ancillary agreements do not follow different laws without reason.