Opinion ID: 1349036
Heading Depth: 2
Heading Rank: 2

Heading: breach of the implied covenant

Text: The first step in the analysis of an asserted conflict of laws is to determine whether a choice of law by the court is actually required. In the context of a contractual choice-of-law clause, a conflict is presented only if there is a material difference between the law of the chosen state and the law of the state whose law would apply in the absence of an effective choice by the parties. In this case, the parties agree that if Hong Kong law does not apply, the law of California does. In its original complaint, Seawinds pleaded two theories of liability  breach of contract and breach of the implied covenant of good faith and fair dealing  as part of the same cause of action. In the amended complaint, Seawinds separated these theories, pleading each as a cause of action. I analyze them separately. In its demurrer to the amended complaint, Nedlloyd did not assert that the amended complaint failed to state a cause of action for breach of contract under Hong Kong law. Rather, Nedlloyd challenged the amended complaint's breach of contract allegations only on the ground of uncertainty (Code Civ. Proc., § 430.10, subd. (f)). Thus, the breach of contract cause of action presents no choice-of-law issue at this time. Seawinds' second theory of liability in the amended complaint is breach of the implied covenant of good faith and fair dealing. In its demurrer, Nedlloyd asserted that this theory of liability fails because Hong Kong law governs the contract and, unlike California law, does not recognize an implied covenant of good faith and fair dealing. Accordingly, this theory of liability does present a choice-of-law issue, but only if, as Nedlloyd asserts, there is a material difference between the relevant law of Hong Kong and California. (See Hurtado v. Superior Court (1974) 11 Cal.3d 574, 580 [114 Cal. Rptr. 106, 522 P.2d 666]; Bos Material Handling, Inc. v. Crown Controls Corp. (1982) 137 Cal. App.3d 99, 105 [186 Cal. Rptr. 740]; New Linen Supply v. Eastern Environmental Controls, Inc. (1979) 96 Cal. App.3d 810, 817, fn. 2 [158 Cal. Rptr. 251].) Under California law, every contract contains an implied covenant of good faith and fair dealing. ( Foley v. Interactive Data Corp. (1988) 47 Cal.3d 654, 683 [254 Cal. Rptr. 211, 765 P.2d 373].) This implied covenant requires that neither party do anything which will deprive the other of the benefits of the agreement ( Seaman's Direct Buying Service, Inc. v. Standard Oil Co. (1984) 36 Cal.3d 752, 768 [206 Cal. Rptr. 354, 686 P.2d 1158]), and its breach ordinarily gives rise to contract remedies ( ibid. ). The parties presented evidence of the relevant Hong Kong law. [4] In support of its demurrer, Nedlloyd submitted the declaration of William Catley, a Hong Kong solicitor. Based on his review of the case law, Catley stated in his declaration that Hong Kong courts will not imply a covenant into a contract unless it is necessary either to give effect to the intentions of the parties or to give the contract business efficacy. Noting that in this case the shareholders' agreement contained a clause requiring the shareholders to cooperate in good faith, but that Seawinds was not a shareholder, Catley set forth his view that it was unlikely that a court in Hong Kong would imply a term in the [shareholders' agreement] extending this sub-clause to include Seawinds. [5] In response to Catley's declaration, Seawinds submitted the declaration of another Hong Kong solicitor, Geoffrey Miles. According to Miles, the Hong Kong courts could well take the view that in order to secure the success of the venture it would be necessary, as a matter of business efficacy, to imply such a term extending to Seawinds the good faith duties owed to the shareholders. If Hong Kong law governs the contract, as Nedlloyd contends, Seawinds must show that business efficacy, as Hong Kong courts understand that concept, requires that a good faith term applicable to Seawinds be implied into the contract. But if California law governs the contract, as Seawinds contends, the contract must be deemed to include an implied covenant of good faith and fair dealing. Thus, there appears to be a material difference between Hong Kong and California law, necessitating a choice-of-law analysis.
Although this court has not directly addressed the enforceability of a choice-of-law provision in a contract, the issue has been the subject of a number of appellate court decisions. When a contract specifies the parties' choice of law, California courts have enforced the contractual choice-of-law clause, subject to two qualifications. First, the chosen state must bear some substantial relationship to the parties or the contract, or there must be some other reasonable basis for the parties' choice. Second, application of the chosen state's law must not violate a strong policy of California law. These standards have been adopted, with some variations in language and emphasis, by the overwhelming majority of California decisions. (See Mencor Enterprises, Inc. v. Hets Equities Corp. (1987) 190 Cal. App.3d 432, 435-436 [235 Cal. Rptr. 464] [strong policy and substantial relationship]; Hall v. Superior Court (1983) 150 Cal. App.3d 411, 417 [197 Cal. Rptr. 757] [strong policy]; Ashland Chemical Co. v. Provence (1982) 129 Cal. App.3d 790, 794 [181 Cal. Rptr. 340] [strong policy and substantial relationship]; Bos Material Handling, Inc. v. Crown Controls Corp., supra, 137 Cal. App.3d 99, 108 [substantial relationship]; Gamer v. duPont Glore Forgan, Inc. (1976) 65 Cal. App.3d 280, 287 [135 Cal. Rptr. 230] [strong policy and substantial relationship]; Frame v. Merrill Lynch, Pierce, Fenner & Smith, Inc. (1971) 20 Cal. App.3d 668, 673 [97 Cal. Rptr. 811] [strong policy and substantial relationship]; Ury v. Jewelers Acceptance Corp. (1964) 227 Cal. App.2d 11, 18, 20 [38 Cal. Rptr. 376] [strong policy].) The federal appellate courts, in applying California conflicts law, have also adhered to these rules. ( Consul Ltd. v. Solide Enterprises, Inc. (9th Cir.1986) 802 F.2d 1143, 1146-1147 [strong policy and substantial relationship]; S.A. Empresa, etc. v. Boeing Co. (9th Cir.1981) 641 F.2d 746, 749 [same]; Sarlot-Kantarjian v. First Pa. Mortg. Trust (9th Cir.1979) 599 F.2d 915, 917 [same]; Foreman v. George Foreman Associates, Ltd. (9th Cir.1975) 517 F.2d 354, 357 [strong policy].) The substantial relationship and strong policy standards of California law are similar to the approach of the Restatement Second of Conflict of Laws, section 187, subdivision (2). [6] Although some California courts have referred to this part of the Restatement Second with approval, they have never expressly adopted it. [7] As noted above, this court has not previously and directly determined the enforceability of a choice-of-law clause in a contract. The court has, however, considered the related problem of contractual forum selection clauses. In Smith, Valentino & Smith, Inc. v. Superior Court (1976) 17 Cal.3d 491, 496 [131 Cal. Rptr. 374, 551 P.2d 1206], the court held that forum selection clauses are valid and may be given effect in the court's discretion and in the absence of a showing that enforcement of the clause would be unreasonable. Citing section 187 of the Restatement Second of Conflict of Laws, the court observed in passing that choice of law provisions are usually respected by California courts. (17 Cal.3d at p. 494.) In following the general approach of the Restatement Second, California courts are within the jurisprudential mainstream. [8] In providing that the parties' choice of a state's law to govern a contract will be respected unless either the parties or the contract have no substantial relationship to the chosen state and the parties have no other reasonable basis for the choice, or application of the chosen law would violate a strong policy of the state of the law that would otherwise apply, California choice-of-law analysis reconciles differing and important interests that are in tension in many cases. The first of these interests is party autonomy. Party autonomy means that the parties to a contract are free to select the law that governs the contract. (Scoles & Hay, Conflict of Laws (2d ed. 1992) § 18.1, p. 657.) A basic principle of contract law is that contracts should be interpreted to give effect to the intentions of the parties (Civ. Code, § 1636), and the concept of party autonomy implements that principle in the context of choice-of-law clauses. But to allow parties a completely unrestrained choice of the law they wish to apply to a contract would have unacceptable results. It would license parties to a contract to evade at will the law of the state in which they reside and conduct their activities; they could make contracts, enforceable in their state of residence, that had no substantial connection to the state of the chosen law and that violated the law of the state that would otherwise apply in the absence of a choice-of-law clause. In other words, to allow unrestricted party autonomy in the selection of the governing law would lead to a state's loss of control over the law of contracts and over the activities governed by that law. Thus, contractual choice-of-law analysis recognizes both the parties' interest in autonomy and the interest of a state in applying its own law to contracts that have a substantial connection to that state. Accordingly, California cases recognize that the ability of parties to select the law that governs a contract should be limited to situations in which the state of the chosen law has some substantial connection to the parties or the transaction, or to situations in which the parties have some other reasonable basis for their choice, and in which enforcement of the chosen law will not defeat an important policy of the law of the state that would otherwise apply. (See, e.g., Ashland Chemical Co. v. Provence, supra, 129 Cal. App.3d at p. 794; Gamer v. duPont Glore Forgan, Inc., supra, 65 Cal. App.3d at pp. 287-289.) Application of these standards to this case demonstrates that the parties' choice of Hong Kong law governs Seawinds' cause of action for breach of the implied covenant of good faith and fair dealing. As I shall explain, enforcement of the choice-of-law clause here is appropriate because Hong Kong has a substantial connection to the parties and enforcement of the clause will not defeat an important policy of the law of California, the state whose law would otherwise apply.
As noted above, the purpose of requiring that the parties or the contract have some substantial relationship to the chosen state is to assure that the parties have not selected the chosen state's law to avoid the application of the law of a particular state to their transaction by stipulating to the law of a state that has no interest in having its law applied. (See Seeman v. Phila. Warehouse Co. (1927) 274 U.S. 403, 408 [71 L.Ed. 1123, 1126-1127, 47 S.Ct. 626]; Mencor Enterprises, Inc. v. Hets Equities Corp., supra, 190 Cal. App.3d at p. 437 [235 Cal. Rptr. 464]; see generally Woods-Tucker Leasing Corp., etc. v. Hutcheson-Ingram (5th Cir.1981) 642 F.2d 744, 750-751.) The substantial relationship requirement guards against purposeful evasion of a state's laws. [9] In this case, the substantial relationship requirement is satisfied. The shareholders' agreement, which is incorporated as a part of Seawinds's amended complaint, shows that Seawinds itself is incorporated under the laws of Hong Kong and has a registered office there. Moreover, one of the nine shareholders that is a party to the agreement (Red Coconut Trading Co.) also is incorporated under the laws of Hong Kong and has a registered office there. If one of the parties resides in the chosen state, the parties have a reasonable basis for their choice. ( Consul Ltd. v. Solide Enterprises, Inc., supra, 802 F.2d at p. 1147.) Seawinds contends, however, that the parties and the contract subject matter have contacts with California that are far more extensive than those with Hong Kong. In its amended complaint, Seawinds alleged that its principal place of business was in Redwood City, California; that Nedlloyd transacted a substantial amount of business in California; and that Nedlloyd committed in California the acts alleged in the complaint. [10] But when, as here, the parties have chosen the law of a particular state to apply to their contract, the test is not whether another state has a more significant or substantial connection to the parties or the transaction; rather, the test is whether there is a substantial connection with the chosen state. (See Gamer v. duPont Glore Forgan, Inc., supra, 65 Cal. App.3d at pp. 288-289.) In this case, there is. Once a court has concluded that the parties or the transaction have a substantial connection to the chosen state or there is some other reasonable basis for the parties' choice, the next step in analysis of a contractual choice-of-law provision is to determine whether enforcement of the provision will defeat an important policy of the state whose law would apply in the absence of a choice by the parties.
As I have explained, California's rule that application of the chosen law must not violate a strong policy of the state whose law would otherwise apply is similar to the Restatement Second of Conflict of Laws' fundamental policy rule. That rule provides that the law of the state chosen by the parties will be applied 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. (Rest.2d Conf. of Laws, § 187, subd. (1)(b).) Under section 188 of the Restatement Second, the state of the applicable law is the state that has the most significant relationship to the transaction and the parties.... (Rest.2d Conf. of Laws, § 188, subd. (1).) In this case, the parties agree that in the absence of a choice-of-law clause, California law would apply. I assume for argument's sake that this is correct. Under the Restatement Second of Conflict of Laws, then, the task is to decide whether California's interest in determining the particular issue is materially greater than Hong Kong's interest and, if so, whether application of Hong Kong's law would be contrary to a fundamental policy of California. Because, as I explain below, California's interest in enforcing its substantive law is not materially greater than Hong Kong's, I need not reach the fundamental policy issue. I first assess the nature and strength of California's interest in applying its substantive law to the transaction at issue here. California's interests, however, are not confined to those expressed in its substantive contract rules. As I mentioned earlier, California also has a significant interest in respecting and promoting party autonomy in matters affecting the interpretation and enforcement of contracts. When the parties have by contractual stipulation chosen to have their agreement governed by a law other than California's, our state's separate interests in enforcing its substantive law and in respecting party autonomy are placed in competition with each other. Therefore, to determine California's actual interest in applying its law to override the parties' choice-of-law agreement, I analyze both of the relevant California interests, and then weigh the one against the other. First, I assess the strength of the state's interest in enforcing the legal rule at issue in this particular case. As mentioned earlier, California law deems every contract to contain an implied-in-law duty of good faith and fair dealing. Our state's law has long recognized this obligation (see, e.g., Universal Sales Corp. v. Cal. etc. Mfg. Co. (1942) 20 Cal.2d 751, 771 [128 P.2d 665]); it has also been adopted by the Restatement Second of Contracts (Rest.2d Contracts, § 205) and by the majority of American jurisdictions (see Foley v. Interactive Data Corp., supra, 47 Cal.3d 654, 683 [hereafter Foley ]). California courts have enforced the implied covenant of good faith and fair dealing in a variety of circumstances, including insurance contracts, employment contracts, contracts to sell real property, and ordinary commercial contracts. This court observed in Foley : Initially, the concept of a duty of good faith developed in contract law as `a kind of safety valve to which judges may turn to fill gaps and qualify or limit rights and duties otherwise arising under rules of law and specific contract language.' [Citations.] ( Id. at p. 684.) This court has also recognized, however, that breach of the implied covenant has legal significance that varies with the context of the contract. For example, this court has held that breach of the covenant of good faith by an insurer gives rise to tort remedies, which may include punitive damages. ( Egan v. Mutual of Omaha Ins. Co. (1979) 24 Cal.3d 809, 818-819 [169 Cal. Rptr. 691, 620 P.2d 141] (hereafter Egan ).) On the other hand, we have declined to extend tort remedies for breach of the implied covenant to breaches of employment contracts. ( Foley, supra, 47 Cal.3d 654.) In Egan, the court emphasized the inherently unbalanced relationship of insurer and insured, and observed that the adhesive nature of insurance contracts places the insurer in a superior bargaining position. ( Egan, supra, 24 Cal.3d at p. 820.) The court pointed out that insurers are purveyors of a vital, quasi-public service, and that insureds do not seek to obtain commercial advantage but protection against calamity. ( Id. at pp. 819-820.) The court also observed that `[i]nsurers hold themselves out as fiduciaries, and with the public's trust must go private responsibility consonant with that trust.' ( Id. at p. 820.) By contrast, in Foley the court reasoned that there were significant differences between employer-employee relationships and insurer-insured relationships that justified allowing tort remedies in the one context but not the other. ( Foley, supra, 47 Cal.3d at p. 689.) The court recognized, among other considerations, that the role of the employer differs from that of the `quasi-public' insurance company because the employer is not providing a public service. ( Id. at p. 692.) The court stressed that, as compared to the insurance situation, the interests of employer and employee are most frequently in alignment, and thus the need to place [additional] disincentives on an employer's conduct ... simply does not rise to the same level as that created by the conflicting interests at stake in the insurance context. ( Id. at p. 693.) And the court underscored that predictability of the consequences of actions related to employment contracts is important to commercial stability. ( Id. at p. 696.) These distinctions indicate that although the state has an interest in enforcing the implied covenant of good faith and fair dealing in every contract, the state's interest is stronger when the covenant acts to protect weaker parties in an inherently unbalanced relationship  typically a relationship in which one party enjoys a superior bargaining position so that it is able to dictate the terms of the agreement  and the weaker party seeks not profit but an essential service. Conversely, the state's interest in enforcing the implied covenant is less compelling when the parties are sophisticated business entities of apparently equal bargaining power that have struck a bargain that is tailored to their particular needs, evidently negotiated and drafted by experienced counsel, and made for no motive other than profit. This case concerns a contract between multiple sophisticated business entities engaged in transoceanic shipping; the shareholders' agreement is not a standard form contract, but on its face is drawn to meet the particular needs of the parties, who contemplated large-scale capital investment; commercial advantage was the entire motive behind the contract; and Seawinds seeks damages of $50 million in lost profits for the alleged breaches of the contract's express terms and the implied covenant. Under these circumstances, I have no difficulty concluding, even at the pleading stage, that California's interest in enforcing the implied covenant of good faith and fair dealing is considerably less compelling here than in those contexts in which the covenant acts to protect parties with little bargaining power who seek advantages other than profit. But this does not end the inquiry into California's interest. There is another interest of California that is implicated: respecting and enforcing party autonomy. As I have shown, the value served by enforcing a choice-of-law provision is that of party autonomy. Party autonomy itself serves the important and closely related goals of protecting the parties' justified expectations, and promoting predictability. Generally, these goals are important in every type of contract. But they are not of equivalent importance in every type of contract. Predictability has special importance in the commercial context. This court observed in Foley : [P]redictability about the cost of contractual relationships plays an important role in our commercial system. ( Foley, supra, 47 Cal.3d at p. 683.) Nedlloyd argues that the needs for predictability and protection of the justified expectations of the parties possess even greater force in the international business context. The United States Supreme Court has endorsed this position in a closely related context, stating that a choice-of-forum provision is an almost indispensable precondition to achievement of the orderliness and predictability essential to any international business transaction. ( Scherk v. Alberto-Culver Co. (1974) 417 U.S. 506, 516 [41 L.Ed.2d 270, 279, 94 S.Ct. 2449]; accord The Bremen v. Zapata Off-Shore Co. (1972) 407 U.S. 1, 9, 15-16 [32 L.Ed.2d 513, 519-520, 523-524, 92 S.Ct. 1907].) As the high court has observed: The expansion of American business and industry will hardly be encouraged if, notwithstanding solemn contracts, we insist on a parochial concept that all disputes must be resolved under our laws and in our courts.... We cannot have trade and commerce in world markets and international waters exclusively on our terms.... ( The Bremen v. Zapata Off-Shore Co., supra, 407 U.S. at p. 9 [32 L.Ed.2d at pp. 519-520.) Similarly, due respect by California courts for contractual choice-of-law provisions will assist California's resident businesses and industries to expand and prosper. The desirability of recognizing the international aspects of commercial transactions is underscored when one considers the accelerating frequency of such transactions. In the past few decades, there has been a dramatic increase in the volume and complexity of transactions with transactional elements, especially business and commercial activity.... [T]ransactions with international elements are now routine. (Chow, Limiting Erie in a New Age of International Law: Toward a Federal Common Law of International Choice of Law, supra, 74 Iowa L.Rev. 165, 192-193 (fns. omitted).) As I have noted at the outset, California occupies a position of leadership in international trade, [11] and it is in the interest of this state and its residents that transactions with international aspects not be discouraged. The reasons for giving effect to the parties' choice of law are compelling when the courts are concerned with a sophisticated transactional business transaction. When, as here, the parties to a lawsuit are large-scale international business entities of apparently equal bargaining power seeking commercial advantage, the case does not implicate the concerns the law properly has for individuals and smaller entities that may be offered contractual terms for a vital service or product on a take-it-or-leave-it basis by a party with greater economic power. In this case, California's interest in respecting the parties' choice-of-law agreement is at least as strong as its interest in applying its substantive law to the transaction at issue. Because, on balance, honoring the parties' choice of governing law will serve California's interests as well or better than overriding that choice, California should not be deemed to have a materially greater interest than Hong Kong in determining whether the amended complaint states a cause of action for breach of an implied covenant of good faith and fair dealing. Accordingly, consideration of the pertinent factors in this context leads me to conclude that California has no substantial interest in applying its law to Seawinds' cause of action for breach of the implied covenant of good faith and fair dealing.