Dealing with the unknown - Which law really applies to your international contract?

When parties negotiate the terms of an international sale or trade agreement it is common practice to include a choice of law clause in their agreement but which law should they choose? Traditionally the choice is between the law of one of the parties' home states or the law of a third neutral state. It often comes as a surprise to the parties when they later discover that the law which ultimately governs their rights and obligations under the contract is not the law which they meant to apply. Why is that?

In 1980 the United Nations Commission on International Trade Law introduced the United Nations Convention on Contracts for the International Sale of Goods 1980 (CISG) - also known as the Vienna Sales Convention. The CISG was designed to facilitate international trade by establishing a system of uniform sale of goods rules which could apply to an international sales contract in place of the sometimes bewildering array of differing legal systems and different business expectations common in cross-border commerce. Not only were the rules designed to take account of different legal traditions but they also tried to ensure a fair risk allocation between buyer and seller.

It's still one of the great unknowns in international trade. In this article we'll look at what it is, how it works, and why it can be an advantage.

When does the CISG apply?

It is critical for the parties to understand when and how the CISG applies and what control parties can take with respect to the applicable law, because the CISG can apply when parties least expect it.

Broadly speaking the CISG applies to sales contracts (but not service contracts) between parties from different states if:

• the parties have specifically chosen the CISG to govern their contract;
• the parties have chosen the law of one of the Contracting States to govern their contract;
• both parties are residents in Contracting States (if parties have made no explicit choice); or
• the relevant conflict of laws rules lead to the application of the law of a Contracting State.

The second situation is the most likely to result in the application of the CISG and at the same time is the least likely to have been considered by the parties. Accordingly, if one puts this provision into context, the CISG applies if the parties have agreed that the contract be governed by the law of a Contracting State. As the CISG forms part of that country's body of law it applies as the lex specialis in that case.

To date the CISG has 70 signatories (or Contracting States), including Australia, China, Germany, Korea, the Russian Federation, New Zealand and the USA. Accordingly, if the substantive law clause in a contract points to one of the laws of those countries the CISG applies.

If the parties have not specifically agreed upon a law to apply to their contract the chances are high that the CISG applies. This is the case when either both parties are residents (or domiciled) in a country or state which is a Contracting State or where the conflict of law rules point to the law of one of those countries.

To illustrate this further, the following scenarios show common situations in which the CISG applies but which might not be immediately obvious to the parties involved:

Scenario 1: Japanese car parts manufacturer and Australian importer enter into a sales & delivery contract choosing Singaporean law to apply to their contract.

Scenario 2: Australian resources company and Chinese steel manufacturer enter into a contract for the delivery of iron ore to China sales contract specifying the laws in Western Australia to govern their contract.

Scenario 3: Australian seller and Indonesian purchaser enter into a sales contract without choosing a specific law to govern their contract.

What these three scenarios have in common is that the CISG applies although the parties have not explicitly agreed to the application of the CISG (and may not even have considered the application of the CISG at all).

In scenario 1 the CISG applies because the parties have agreed to the application of the laws of Singapore, a Contracting State. In that scenario it is of no relevance that Japan is not a signatory to the CISG.

In scenario 2 the CISG applies as the parties have agreed that the laws in Western Australia shall govern their contract. Each of the States and Territories in Australia has incorporated the CISG into their legislation.

In scenario 3 the CISG applies by virtue of the application of private international law (conflict of laws), which (in most situation) will point to the law of the seller - in this case Australia, a Contracting State - as the law which has the closest connection to the transaction.

Contracts to which the CISG does not apply

The CISG does not apply to certain types of goods and contracts, such as:

• goods bought for private use;
• goods sold by auction;
• the sale of shares;
• stocks and investment securities;
• the sale of ships, vessels or aircrafts; and
• contracts for the sale of electricity.

Sales at commodity exchanges are not, however, regarded as auctions and the CISG generally applies to those type of contracts.

The CISG is also excluded for contracts in which the predominant part of the obligation of the party who furnishes the goods consists of the supply of labour and services, for example turnkey contracts. It cannot be assumed however that all construction or infrastructure contracts are excluded from the application of the CISG - you must carefully analyse what the predominant obligations are under the contract (service and labour / delivery of goods).

How you can exclude the CISG…

As the previous examples demonstrate choosing a national law for a contract is not always sufficient to exclude the application of the CISG. The CISG applies as part of national law unless the parties choose to exclude it. Therefore if parties intend to exclude the application of the CISG they need to do this explicitly, for example by stating: "The laws of [state], excluding the CISG, shall apply".

… and why you shouldn't

For many people the CISG is an unknown, and the natural behaviour would be to exclude the CISG for that reason, but before doing so one should carefully consider the advantages the CISG may have to offer.

The CISG is tailored to meet the specific needs of cross-border transactions, which may vary significantly from domestic or local sales contracts, due to long transport distances and different trade cultures. In the 28 years since the CISG was introduced it has become a well tested and highly regarded body of law in both arbitral and court proceedings.

The CISG governs contract formation, the obligation of the parties in performing their contractual duties and the remedies available for the parties in case of a breach of contract. An important aspect of the CISG is its informality - for example, the CISG does not require that contracts for the sale of goods be in writing.

Importantly, the CISG does not impact on the parties' freedom of contract. Accordingly, parties are free to agree on their respective rights and obligations under the contract and may tailor their risk and reward scenarios to a particular transaction.

In contrast, parties may arguably prefer to exclude the application of the CISG for bulk commodity contracts which are regularly entered into on an Incoterms 2000 CIF or FOB basis, because of the way in which the obligations are discharged and the very limited time available for the inspection of the goods and documents.

Lessons learned

Individual users and corporations involved in cross-border transactions need to understand that despite what the governing law appears to be on the face of the contract, a different law may potentially apply. Having said that, the CISG has many advantages and potential users should lose their fear of the unknown.