It is advisable to have an attorney to draft any arbitration or mediation clause.
Even though there are considerable risks involved in litigation, there are significant opportunities available to the small business owner to control these factors.
Certain strategies for reducing litigation risks primarily benefit defendants in litigation or the targets of a claim, while other strategies primarily benefit plaintiffs or have a claim against another party. However, most strategies can benefit each party. Making use of these techniques may reduce exposure to day-to-day liability risks and maximize asset protection planning.
The following are some of the most common risk mitigation strategies:
Using mediation and arbitration as an alternative to the court system allows you to mitigate, or completely avoid, many of the risk factors found in the civil litigation system, including the leverage created by the lack of a loser pays system, the possible exclusion of evidence from the trial and the emotional (and sometimes unreasonable) conclusions reached by jurors.
For these reasons, mediation and arbitration primarily benefit defendants in a civil action. However, the strategy also may benefit plaintiffs whose claims are fairly small and when the lack of a loser pays system precludes reimbursement of attorney's fees and related costs. Mediation and arbitration are also helpful when the facts of the case are technical and complex.
The consensual nature of the agreement requires the execution of mediation and arbitration clause by all parties.
Mediation. In mediation, the parties hire a mediator who makes recommendations on a resolution of their dispute. A mediator (in contrast to an arbitrator) cannot, without consent from both parties, make a decision binding on the parties. A mediator's role is limited to:
For this reason, parties who are unable to resolve their dispute through mediation usually agree to proceed to arbitration.
Arbitration. Arbitration is a way to resolve a dispute. As a condition of arbitration, the parties waive their rights to sue in court and, instead, agree to have their dispute decided privately, outside of the court system, by an arbitrator. After a hearing (as opposed to a trial), the arbitrator renders a decision, called an award (as opposed to a judgment). The arbitrator's decision usually is binding on the parties, although it is possible to enter into "non-binding" arbitration.
Usually, one arbitrator will hear the case, at his or her office or at a conference room at an area hotel. The hearing is much more informal and usually much less costly than a court trial. Normally, there is no stenographer, no jury and no rules of evidence. While a trial might take one or two years to schedule, arbitration hearing usually will be scheduled in two or three months.
For these reasons, attorney's fees and related costs usually are much lower in an arbitration proceeding.
Further, voir dire, or the choosing of a jury, can be used to stack a jury with sympathetic jurors who are already inclined to side with one party. Because there is no jury in an arbitration hearing, there is no significant ability to manipulate the make-up of the body that will decide the case.
The complex rules of evidence, which can prevent significant evidence from reaching a jury, and thus may distort the outcome of a trial, simply do not apply in an arbitration hearing. The arbitrator will hear and weigh all of the relevant evidence and, thus, render a much more reasonable decision than would a jury prevented from hearing important pieces of evidence.
While state laws differ, usually the grounds upon which an appeal may be taken to a court after an arbitration decision are severely limited. Thus, it usually is best to consider that arbitration will likely be the final step in the resolution of the dispute.
Mediation and arbitration are consensual. This means that both parties must agree to mediate or arbitrate the dispute. Usually, this is done before the dispute arises, in a contract between the two parties, although it is possible to agree to mediation or arbitration after a dispute arises.
While courts tend to disfavor exculpatory clauses, they strongly support mediation and arbitration clauses because the courts encourage parties to resolve their disputes outside of the court system.
It is advisable to have an attorney to draft any arbitration or mediation clause.
Common situations for arbitration. It is advisable to include mediation and arbitration clauses in the following circumstances:
Arbitration for consumer product sales. Arbitration clauses between business owners and consumers have been upheld by the courts when the clauses were disclosed in the instructions enclosed with a product, and even when the clauses were printed on the outside of the box that contained the product. In these situations, to better ensure that the clause will be upheld, it may be advisable to allow the consumer a certain period (e.g., 60 days) to void the arbitration clause, by notifying the business in writing of this decision. Professional legal guidance should always be sought in using arbitration clauses, especially in consumer contracts.
In 1997, a U.S. Court of Appeals upheld an arbitration clause that was included in the packaging materials that Gateway shipped along with its computers. The clause could be voided by consumers within a fixed period, but became binding after that period had expired. The plaintiff, who had purchased a Gateway computer, had sought to invalidate the clause after this period had expired and sue Gateway in court. The Court ruled that the clause was valid and binding, and that, accordingly, the consumer's only remedy was through an arbitration hearing.
Provide for mediation. Because mediation is more informal, and usually less costly, consideration should be given to including a mediation clause in addition to an arbitration clause. In this situation, the mediation clause would provide that, if mediation failed to resolve the dispute, the matter would proceed to arbitration.
Common conditions and terms. The following terms are often found in arbitration agreements.
An exculpatory clause is a waiver of a right to sue. Clearly, if you have such a clause in your business contracts and, if challenged later, the court deems the clause enforceable, then you will have completely avoided liability beyond any remedies provided in the contract.
However, the courts tend to disfavor exculpatory clauses and frequently deem these clauses invalid as against public policy. This is especially true when consumer contracts are involved. When intentional, reckless or criminal conduct is involved, the clause is almost assuredly invalid.
Nevertheless, in the right context, the courts will enforce the clause. An exculpatory clause is much more likely to be enforced if some combination of the following conditions apply in the case:
While limited in scope, exculpatory clauses are at least worth considering, because, when valid, they do result in a complete elimination of liability. In practice, the validity of an exculpatory clause will depend on the unique circumstances of the particular business. Legal guidance should be sought in determining the extent to which exculpatory clauses can be used in the particular business, and in drafting the language for these clauses.
Disclaimers are closely related to exculpatory clauses. Disclaimers, in fact, are essentially a more limited waiver of a right to sue. The waiver may apply only to a narrow cause of action or to a particular type of damages. In general, the courts will apply the same exculpatory clause guidelines to test the validity of disclaimers. But unlike exculpatory clauses, disclaimers are more likely to be upheld by the courts, because they are narrower in scope.
Disclaimers of the implied-in-law warranties of merchantability and fitness for a particular purpose are frequently used in consumer contracts.
Unless disclaimed, the implied-in-law warranty of merchantability automatically applies to any sale of goods by a merchant. The warranty, which arises automatically by way of statute, and not through any written or verbal representations by the merchant, means that the merchant is guaranteeing to the consumer that the product will perform the general purpose for which it was intended.
Moreover, unless disclaimed, the implied-in-law warranty of fitness for a particular purpose will apply whenever a consumer makes known to the merchant the unique purpose for which he will use the product, and then relies on the merchant's recommendation of a product. Thus, while this warranty, too, arises automatically by way of statute, the circumstances in which it applies are somewhat narrower than those involved in the implied warranty of merchantability.
Disclaimer of each of these warranties means the consumer, of course, does not receive these guarantees. In other words, the disclaimer means that the consumer will have waived his right to sue based on these warranties.
The disclaimer of these warranties should mention the warranties by name and be prominently displayed in the contract. Statutes, which dictate the exact parameters that the language and disclosure must take to be valid, differ slightly among these states. Thus, it is wise to obtain legal advice on the exact wording required in the particular state. In general, however, if the disclaimer meets the statutory requirements, it will be valid, even though the contract is a form or "adhesion" contract.
A business owner must be cautious when disclaiming the implied warranties of merchantability and fitness for a particular purpose, while also granting an express warranty.
An express warranty is granted through actual language in the agreement between the parties. When the implied-in-law warranties are disclaimed in the same agreement in which an express warranty is granted, the disclaimer may be deemed an unfair business practice, on the grounds that the consumer is actually receiving less of a warranty than if the agreement contained no express warranty and also no disclaimer of the implied-in-law warranties.
Usually, the prominent display of the disclaimer, in the same portion of the agreement that contains the express warranty, will eliminate this possibility. However, especially when using this combination, legal advice should be sought in drafting the actual agreement.
In addition, disclaimers in which a party waives the right to sue for "consequential damages" and "incidental damages" also are frequently used in practice, in both consumer contracts and contracts between business parties.
In consumer contracts, disclaimers of liability for personal injuries are not valid. Disclaimers of liability for consequential and incidental damages to property may be valid. Some states may further limit the rights of businesses to disclaim consequential and incidental damages. Thus, as discussed above, it is wise to obtain legal advice on how these disclaimers may be used in the particular state.
For example, in its agreement with its customers, a photo processing business will almost certainly limit the consumers' remedy, in the event of a breach of contract, to a replacement roll of film (and thus eliminate the pain and suffering, etc., that might arise because film that was lost, damaged or destroyed).
Limitations on consumers' remedies, in the event of warranty claims, also can significantly reduce a business's liability for these claims. Commonly, when an express warranty is granted, the agreement will limit consumers' rights to obtaining repair or replacement of the products at the business's discretion, and disclaim liability for incidental and consequential damages.
This limitation allows the business to choose the most economical route to satisfy warranty claims (i.e., repair or replacement) and eliminates the rights of consumers to claim a cash refund, or consequential or incidental damages.
When the seller grants no express warranty, but one is granted by the manufacturer of the product, the agreement commonly will limit the consumers' rights to making claims against the manufacturer based on its warranty. Thus, the agreement might state that no express warranty is being granted by the retailer and also disclaim liability for the implied-in-law warranties of merchantability and fitness for a particular purpose, and for consequential and incidental damages, in the event of a breach of contract.
In contracts between business parties, the courts routinely uphold disclaimers of liability for consequential and incidental damages. In fact, these disclaimers are especially valuable in a contract between two business parties.
In one case, IBM sold a computer to a transportation company that operated a fleet of over 3,000 temperature-controlled trailers.
One year later, the computer failed and the transportation company sued IBM for breach of contract. As a result of the downtime, the transportation company lost $470,000 in profits and sued for this amount as consequential damages. The company also spent $4,500 to restore the company's lost data and sought to recover this amount as incidental damages.
The transportation company lost on both issues, because it had signed a contract with IBM that contained a disclaimer of liability for consequential damages and incidental damages. The appellate court upheld the disclaimer. Thus, the disclaimer saved IBM almost $500,000 in damages.
Note that consequential damages and incidental damages are additional damages that a party may recover. If it did prove that IBM breached the contract, the transportation company in this case still might recover its basic measure of compensatory damages, which would be the cost to repair the computer hardware.
Litigation outside of your home state can only make litigation even more expensive. Travel and hotel costs, time lost from work, and the difficulty of finding an attorney in a different state can cause a party to forfeit making a claim or defending against a claim. A choice of law clause can eliminate these possibilities because it controls two issues: the choice of the state in which the action must be filed and the choice of which state's laws will be applied.
Control where action is filed. Usually, the clause specifies the state in which the action must be filed and designate that this state's laws also will govern the dispute. You should use a choice of law clause in purchase agreements with out-of-state vendors or in sales agreements with out-of-state consumers. Here, the clause normally would specify that disputes must be brought in the state in which you operate and that this state's laws would apply in the case. Note, too, that the choice of law clause should apply not only to actual court actions, but mediation and arbitration proceedings as well.
The courts do not always uphold choices of law clauses. There must be sufficient connections to a state for the state to have authority to decide the case or for its laws to apply in a case. If you designate the state in which you operate, this should not be a real issue. However, when a party or an action has sufficient connections to more than one state, the courts may reject the clause and allow an action in the other state, or apply the other state's laws. When a small business owner confines his activities to a single state, this too should not represent a significant issue.
The small business owner should be aware that it is common for franchise agreements to provide that any disputes between the franchisee and franchisor must be brought in the franchisor's home state, and that this state's laws will govern the dispute. This may be a serious problem to a franchisee who would like to sue the franchisor, especially because the franchisor may be located in many states and far from the franchise. A potential franchisee should demand that this clause be changed to allow the franchisee to file an action in the state in which he will operate the franchise.
As is true with contract negotiations, in general, nothing can compel the franchisor to accept this demand. If the franchisor refuses to change the clause, the franchisee must consider assuming the risks of signing the agreement with the existing clause or simply moving on to a different opportunity.
Specify governing law. Finally, it may be desirable to designate that the action must be filed in one state, but that a different state's laws will govern the agreement. For example, owners who will operate their limited liability company (LLC) in Connecticut may form the LLC in Delaware to take advantage of Delaware's favorable LLC statute.
An operating agreement for a business entity, such as an LLC, should always have a choice of law clause. In this situation, the operating agreement may specify that any litigation among the owners must take place in Connecticut, but that Delaware law will control the agreement, the relationships between the parties and the internal operations of the entity. In this way, the litigation will take place in a convenient forum, but a more desirable set of laws will govern the outcome.
If you have a relatively small claim, the cost of bringing the claim in court may exceed the recovery. Because attorney's fees and related costs generally will not be reimbursed, even when the plaintiff is successful, it may be more economical to forego the claim and simply write it off as a loss. Of course, this happens frequently in practice, especially among larger businesses. However, you can significantly lower the cost of bringing a court action and, thus, make recovery of the claim more economical by filing in the small claims court.
Parties may proceed "pro se," or without an attorney, in a lawsuit. Doing so, however, usually puts a party at a significant disadvantage, because of the complexity of the trial system. Even attorneys who are personally involved in litigation usually hire legal counsel, especially when operating outside their area of expertise.
One exception may be a small claims proceeding. The rules that govern a small claims action are very relaxed. The pleadings are simplified. While, in many states, plaintiffs must know how to draft a formal civil complaint according to criteria specified in the state's practice book, in a small claims case the complaint form almost always is a pre-printed form obtained at the court house.
Similarly, while service of process (i.e., the delivery of the complaint and summons to the defendant) in a regular action requires hiring a sheriff, who hand-delivers the complaint and summons to the defendant, in a small claims action service usually is by way of a certified letter. This simplifies and lowers the cost of the service of process in a small claims action. In addition, the court entry fee usually is significantly lower in a small claims action.
Simplified procedures also govern the actual trial process. Rules of evidence are relaxed in the small claims case, which makes it much easier to proceed pro se. There is no jury in a small claims case, which eliminates a complex and time-consuming aspect of a regular action--choosing of the jury.
In short, the costs and complexity of bringing a small claims action are much reduced compared to regular litigation, thus allowing the plaintiff to proceed pro se, avoid attorney's fees altogether, and bring an action that otherwise would be too uneconomical to file on the regular court docket.
However, a small claims action only can be brought when the amount of the claim is "small." While the jurisdictional limit of small claims courts differs among the states, the limit is usually in the range of $2,000 to $5,000. So, obviously the small claims alternative will not be appropriate in all cases.
In addition, a small claims case is argued before a judge or attorney who is termed a "magistrate." When the small business owner believes he would benefit by an emotional appeal to the trier of fact, a court action on the regular docket with a jury may be in order. Moreover, usually a small claims decision is final, with few rights of appeal. Thus, the finality of a small claims action should be carefully weighed against the benefits of bringing the case to small claims court.
Finally, as is true with any case in general, the small business owner also must consider whether he will be able to collect the judgment if he wins. A judgment against a defendant with no resources will still be uneconomical, even if secured in a small claims action.