Shift Risks by Making Loser Pay Legal Expenses

In most lawsuits, each party must pay his or her own court costs, including attorneys' fees. This is usually more of a burden on the defendant who must pay out of his or her own pocket. The plaintiff's attorneys frequently take a portion of the damage award as their fees, reducing the amount received, but sparing the plaintiff any out of pocket expenses.

The United States legal system generally requires someone who loses a lawsuit to reimburse the other party for the expenses of litigation. However, two exceptions exist: the contract exception and the statutory exception. 

With either of these two exceptions, the loser in the court action will have to reimburse the winner for his attorney's fees and related costs. These exceptions do not always apply to both parties to the court action. Typically, the exceptions authorize reimbursement only to the plaintiff, when the plaintiff wins the action.

With careful planning, however, you may be able to use the contract exception to provide for reimbursement in the event you are sued and you win the case. Further, in some situations, a statute may provide an exception that authorizes reimbursement to the defendant when he or she prevails in the action.

Contract Clauses Can Require Loser to Pay All Costs

Simply put, the parties to a contract may agree in writing that the loser in a legal dispute must reimburse the other party for his attorney's fees and related costs. This is a standard clause used by large commercial parties in many types of contracts.

 However, in those contracts, the clause is almost always one-sided. Specifically, the clause usually will provide that, if the large commercial party brings an action to enforce the contract, the other party (i.e., a small business party or a consumer) will reimburse the large commercial party for its attorney's fees and related costs. For example, a franchise agreement almost certainly will provide for this result, if the franchisor has to enforce the agreement against the franchisee.

However, the law clearly allows the parties to contract for a more equitable arrangement. Thus, a more complete clause might provide simply that the loser in a legal dispute must reimburse the other party for his attorney's fees and related courts. This would mean that either party, as either a plaintiff or as a defendant, would be awarded reimbursement, if he or she prevailed in the action. For example, this type of clause would mean a franchisee would be awarded reimbursement if he brought a successful claim against the franchisor, or if the franchisee successfully defended a claim brought by the franchisor.

The clause also could be expanded beyond a standard one-sided clause, but still made more limited than a complete clause. For example, the clause might authorize reimbursement to either party who successfully brought a claim, but not authorize reimbursement to either party who successfully defended against a claim.

Although the law allows the parties to control the reimbursement clause, in practice, the nature of the clause will be limited by two factors--the relative bargaining power of the parties and legal limitations that may apply to contracts between a business entity and consumers.

For instance, a franchisee may not have sufficient bargaining power to force a franchisor to include a complete or an expanded clause in a franchise agreement. With respect to consumer contracts, courts normally uphold a one-sided clause that authorizes reimbursement only to the business party who successfully brings a claim. However, a broader one-sided clause that also authorizes reimbursement to the business party who successfully defends against a claim, but further provides for no reimbursement to the consumer in any situation, may be deemed unfair and, therefore, invalid, as a violation of public policy.

In general, the small business owner should consider whether he or she is likely to be a plaintiff or a defendant, with respect to the agreement, and draft the reimbursement clause accordingly. The small business owner should always seek professional guidance when drafting or reviewing contracts in general, and in drafting the reimbursement clause in particular.

Take Advantage of Laws Requiring Payment of Legal Expenses

The general rule that governs a common law cause of action is that, absent a contract clause to the contrary, the winner of the action will not be reimbursed by the loser for attorney's fees and related costs. However, a second exception exists when a cause of action is based on a statute that specifically authorizes reimbursement. Note that not every statute that authorizes a private cause of action also authorizes reimbursement. Moreover, the statutes that do authorize reimbursement typically work in a very narrow way, sanctioning reimbursement only to the plaintiff when he prevails in the action.

State Versions of the FTC Act. The small business owner who is a plaintiff will be at a distinct advantage if he can base his claim on a statute that authorizes reimbursement of attorney's fees and related costs. Perhaps the most common statute used for this purpose will be the state's version of the Federal Trade Commission (FTC) Act.

The FTC Act itself does not authorize private causes of actions. However, every state has a version of the FTC Act that does authorize the filing of private actions. While consumers who believe they have been the victims of "unfair and deceptive" business practices typically use the statutes, the statutes are not limited to protecting consumers. Small business owners can file actions against other commercial parties under these statutes. 

The term "unfair and deceptive" business practices is interpreted very broadly by the courts. Thus, it usually is not too difficult to fit most claims under these statutes.

State Franchise Acts. The FTC also extensively regulates franchise agreements. A violation of the FTC's franchise rules automatically is deemed to be an unfair and deceptive business practice, and thus a violation of the FTC Act. However, because the FTC Act does not authorize private actions, this relationship also means that a franchisee cannot sue under the federal statute for a violation of the FTC's franchise regulations.

Fifteen states have franchise laws based on the FTC's franchise regulations. These states include:

Each of these state statutes authorizes a private cause of action and reimbursement to the plaintiff for attorney's fees and related costs, if the plaintiff prevails in the action. The acts also authorize awards of punitive damages. Because of the extensive disclosures required by these statutes, it often is not difficult to find a violation by a franchisor. Because many small business owners will operate franchises, and disputes frequently occur between franchisors and franchisees, these state statutes can offer small business owners a distinct advantage in litigating the dispute.

RICO. The Racketeering Influenced and Corrupt Organizations (RICO) Act is the federal statute originally enacted to combat organized crime. It is perhaps best known for its criminal provisions.

However, RICO also authorizes the filing of private civil causes of actions by parties who suffer losses due to "racketeering." The statute also authorizes reimbursement of attorney's fees and related costs to a plaintiff who prevails in the action.

Ordinarily, small business owners would not have reason to sue an organized crime syndicate. Thus, it may initially seem that RICO would be of little use to small business owners. However, as is true with many other areas in the law (e.g., the definition of unfair and deceptive trade practices), the term "racketeering" has been very broadly construed by the courts, so as to extend well beyond organized crime syndicates.

Specifically, RICO is violated if an organization carries on a pattern of illegal activities. A business entity can meet the legal definition of an organization, which usually is defined simply as a group comprised of two or more individuals. A pattern of illegal activities exists if a party repeats the illegal activity as little as two different times. Further, the illegal activities do not have to be criminal in nature, but instead can be in the nature of unfair or fraudulent business practices that may or may not result in a monetary loss to another party.

An action may be based on RICO in many situations that arise in ordinary business relationships. For example, a franchise relationship could form the basis for a RICO cause of action by the franchisee against the franchisor, if the franchisor had committed a series of fraudulent or deceptive acts.

In fact, successful civil actions under RICO have been brought against banks, insurance companies, brokerage houses and even protestors. In general, if the small business owner is the victim of any type of fraudulent scheme carried out by another party, a RICO action may be available.

Statutes providing reimbursement to either party. Finally, certain statutes apply a broader rule, authorizing reimbursement to either party who prevails in the action. For example, a federal statute that outlaws copyright infringement also authorizes a private cause of action. This statute allows the court to order reimbursement of attorney's fees and related costs to either party, including the defendant, when that party prevails in the action.

These types of statutes are relatively unusual, as most statutes merely authorize reimbursement to plaintiffs who prevail in the action.

Counterclaims Can Limit Risk

A counterclaim can be an indirect way for a defendant to make the loser pay and recover his attorney's fees and related costs, in the absence of a contract or statutory exception that otherwise allows it. In fact, a successful counterclaim will result in the defendant being awarded damages that will be more than sufficient to compensate for these fees and costs. In addition, a counterclaim can be used as significant leverage to convince the plaintiff to drop the lawsuit.

The defendant can assert a counterclaim against the plaintiff in answer to the complaint. In the counterclaim, the defendant goes on the offensive, reversing the roles of the two parties. In essence, the defendant seeks monetary damages from the plaintiff. Clearly, for this to be effective, the defendant must have a sound cause of action against the plaintiff. 

In many suits between business parties, this is a real possibility, especially in light of the court's expansive definitions for the terms "unfair and deceptive" business practices and "racketeering," as well as the complex provisions imposed by many laws (e.g., the Federal Trade Commission Act (FTC) and state laws that govern franchisors).

Ideally, the defendant will be in a position where he or she also can seek punitive damages in his counterclaim. The same standards and limitations that govern punitive damage awards to plaintiffs also would apply to the defendants in a counterclaim.

Finally, in a counterclaim, the defendant is essentially acting as a plaintiff. Thus, a one-sided provision in a statute or a contract that authorizes reimbursement only to a successful party who brings the claim would fully apply to a counterclaim. So, a defendant may be able to base his counterclaim on a cause of action that authorizes reimbursement of attorney's fees and related costs, such as a state's version of the FTC Act, RICO, or a provision in a contract between the parties. Here, the reimbursement would be for the attorney's fees and related costs incurred in bringing the counterclaim. However, this reimbursement, of course, would be in addition to the compensatory (and possibly punitive) damages that would be awarded to the defendant for the counterclaim itself.

Clearly, a counterclaim based on a provision that authorizes such reimbursement and one that seeks punitive damages would be especially likely to provoke a favorable outcome. The party who brought the suit would then face a triple-threat from the defendant:

• the possibility of an award of compensatory damages for the counterclaim itself
• reimbursement to the defendant of his attorney's fees and related costs incurred in bringing the counterclaim
• a separate award for punitive damages

Even a plaintiff who is a big risk taker may decide to drop the claim when faced with these risks.

Punitive Damages Can Be Awarded in Extreme Cases

Punitive damages exist to punish the other party for their outrageous and harmful behavior. Punitive damages generally are available in any action--except one based solely on breach of contract--when it is proven that the defendant acted willfully and maliciously.

In addition, punitive damages can be an effective way to recover attorney's fees and related costs. Punitive damages can allow a plaintiff to bring an action that otherwise would not be economically justified. Punitive damages can more than offset a plaintiff's outlay for attorney's fees and related costs. In addition, a defendant can seek punitive damages against a plaintiff by way of a counterclaim. Thus, a defendant also can use a recovery of punitive damages to offset his attorney's fees and related costs.

Small business owners who suffer losses due to fraud usually will be able to seek punitive damages under common law actions for fraud or under statutory actions based on the states' versions of the FTC Act and the federal RICO statute.

Statutes May Limit on Punitive Damage Awards

Many states now have statutes that limit punitive damage awards, although the nature of the limits varies widely from state to state. In some states, the limits apply only to certain causes of action. In some states, the limits apply to all causes of action. In still other states, the limits apply to all causes of action, but are subject to exceptions.

These limitations generally favor the small business owner, by reducing the possibility that he will suffer an unreasonably large and unjustified award of punitive damages. At the same time, the option of punitive damages means that, when reimbursement of attorney's fees and related costs is not possible, the small business owner can seek punitive damages as a substitute way of recovering these fees and costs. This strategy might be used, for example, against another commercial party in a suit based on fraud.

Case Law Limits Punitive Damages to Reasonable Ratio

Even if your state does not bar or limit punitive damage awards, the U.S. Supreme Court has indicated that punitive damages are to be awarded only for egregious behavior and only in a reasonable ratio to actual damages.

Until 1996, punitive damages were more of a risk factor inherent in litigation than an opportunity to control risk factors for small business owners. Specifically, during the 20-year period leading up to 1996, business owners suffered extremely large punitive damages awards. These awards, in many cases involving larger businesses, amounted to tens of millions of dollars, and some awards exceeded $100 million dollars. In 1996, however, the U.S. Supreme Court established guidelines for punitive damages awards that have significantly reduced the size of awards since that time.

In a case against BMW, a trial court awarded the plaintiff $2 million in punitive damages, in addition to $25,000 of compensatory damages, because BMW had failed to disclose that a new car he had purchased had been re-painted. The U. S. Supreme Court ruled that the punitive damages award was grossly excessive. Upon remand, the lower court reduced the punitive damage award to $50,000.

Importantly, the Court also established guidelines that courts must apply in awarding punitive damages. Courts now primarily examine three factors in determining the amount of punitive damages:

• The degree to which the defendant's conduct was reprehensible.
• The ratio of the punitive damages to the compensatory damages.
• The amount of civil and criminal fines that could be levied against the defendant by the government.

In the case against BMW, the defendant's conduct was not especially outrageous. Further, the ratio of punitive damages to compensatory damages, based on the original award, at 80:1, appeared extreme. The ratio, based on the revised award, at 12.5:1 seems more reasonable and in line with the U.S. Supreme Court's guidelines. Finally, the comparable civil penalty that could have been levied by the government amounted only to $2,000. This fact, too, suggested a much lower punitive damage award.

In April of 2003, the U.S. Supreme Court provided further guidance regarding punitive damages. In State Farm Mutual Auto. Ins. Co. v. Campbell, the High Court described the kinds of actions eligible for punitive damages awards and ruled that "few awards exceeding a single-digit ratio between punitive and compensatory damages . . . will satisfy due process" under the Fourteenth Amendment to the U.S. Constitution.

In their decision, the Court ruled that the business practices of a company as a whole may not be used as the basis for these damages, but rather punitive damages may only be awarded for specific acts of harm caused to a specific plaintiff. This, then, led to their conclusion that punitive damage awards exceeding a 9-to-1 ratio (in relation to compensatory damages) would likely not pass constitutional muster.