Startup Law 101 Series – Tips for Entrepreneurs About Lawsuits

Introduction

Many entrepreneurs do not understand the basics of how a lawsuit works. Below, I sum this up in a nutshell. I do so from a perspective that should give you a basis for making strategic decisions about the process. Though I write for entrepreneurs, I explain the legal processes. If you don’t understand those, you can’t think strategically about your options in dealing with this area.

After explaining the lawsuit process, I add some helpful and practical tips for how entrepreneurs can prevent or minimize lawsuit risks.

How Lawsuits Work

1. Lawsuits are done through a public court system, either federal or state. Other dispute-resolution mechanisms, such as arbitration, use private resources but can have the force of law behind them. For example, legal authorities say that arbitration can be binding and, if parties agree to it by contract, the courts will enforce such provisions. If someone gets an arbitration award, laws exist by which it can be enforced through court systems.
2. Lawsuits are initiated by the filing of a complaint. A complaint sets forth allegations and asks for remedies. Remedies may be money damages or some form of non-monetary remedy, such as an injunction.
3. Once a complaint is filed, the party sued ultimately files an answer. An answer sets forth responses to the allegations in the complaint, typically denials.
4. When allegations have been formally denied in the answer, issues have been framed. These may be factual or legal issues. That is, disputes over what happened or about its legal significance.
5. The point of a trial is for a so-called trier of fact to consider all admissible evidence and to decide each material factual issue. In other words, to determine the facts of the case after sifting through what each side claims are the facts. A trier of fact decides who to believe where there is conflicting testimony. And so on.
6. A trier of fact can be a judge or jury. If the case is one triable to a jury (as most damage cases are), and if one of the parties has demanded a jury trial and preserved its right to it, the case will be tried to a jury. In such a case, the jury decides all material facts. If there is no jury trial, a judge will decide the facts and will be deemed the trier of fact.
7. Once the facts are determined, the law is applied to them to come to a legal verdict or decision about the case. If there is a jury, the jury will be instructed by the judge on the applicable legal standards but it will be up to the jury to apply such standards to determine a verdict. If there is no jury, the judge applies the law to the facts to come to a decision.
8. The whole point of a trial is to resolve both the legal and factual issues to come to a verdict.
9. In between the initial framing of the issues and the trial, a pretrial process occurs. During the pretrial process, parties can conduct discovery. Discovery involves formal legal mechanisms by which one party can compel another party or a non-party to the case to answer written questions under oath, make admissions, produce documents, or answer questions in a deposition format under oath.
10. Parties can also file what are called motions for varying purposes. A motion is a formal application to the court asking the court to rule in a certain way on a specific issue. The subject of a motion can vary from ones concerning housekeeping details all the way to others asking the court to throw out the whole case.
11. Pleadings are not limited to the complaint and the answer made by the primary parties. They can include any number of cross-complaints and answers to cross-complaints as well. In other words, “you sue me, I’ll sue you back.” Or, “I’ll sue the other guy too.”
12. Owing to the complexities that can arise, and to keep the case moving toward an ultimate trial, all courts have pre-trial procedures for supervising a case. In federal courts, there is a single-judge assignment system. Your case gets assigned to and stays with one judge (or possibly a magistrate assigned by that judge) from start to finish. In state courts, a master-calendar system is often used. This means that judges are assigned to perform specialized functions and will stick with one basic function until periodically reassigned. So, one or more judges may hear pretrial motion matters only. Others may conduct trials only. Still others will preside over the court’s calendar and deal with scheduling matters as they arise in all cases before the court. In such a system, your case may be handled by several judges on its path between filing and trial.
13. Under either a single-judge or master calendar system, your case will come up periodically for status review and for assignment to the next step in the court’s system for moving the case toward trial. Once the case is what they call “fully at issue” (meaning that all parties have been named and served and have formally appeared in the case or have had defaults taken against them), and discovery is complete, the case will be assigned to trial.
14. At the end of a trial, any party or both can appeal and ask a reviewing court to reverse or modify any judgment entered at the trial.

Why Lawsuits Are Frustrating for Entrepreneurs

This system of jurisprudence is one of the most refined and effective in the world. Why then are lawsuits so frustrating for entrepreneurs.

Here are a few reasons:

1. So-called “notice pleading” resolves all allegations made by a party in favor of that party. This means that the law has made a policy judgment that all cases and issues except those that are frivolous or plainly lacking in merit will have their “day in court,” i.e., will proceed to a full trial on the merits. Because of this policy judgment, parties get multiple opportunities to fix their allegations in order to attempt to state viable claims. In addition, for most purposes, if a party alleges something, the courts must abide by rules stating that such allegations must be assumed to be true (for the most part) until the case gets to trial. This means that a party can conduct often extensive discovery based on the thinnest of allegations, sometimes even preposterous ones. It also means that the mechanisms enabling judges to toss unmeritorious cases are very limited, and all but the most obviously baseless of cases tend to get through them.
2. The net result: if somebody sues you, and is determined to push the case toward a trial, you normally must endure a process by which you cannot simply and easily get rid of the claim.
3. Liabilities as defined by judges and legislators have been continually expanding over recent decades. This means that something that was perfectly legal in the past can now be made the subject of a lawsuit. There are policy reasons for this, ones that (much like the idea behind notice pleading) assume it is good that every person aggrieved by something should have a day in court. For example, it once was the case that a realtor had little or no liability exposure over a residential sale unless the realtor committed some sort of fraud or did something equally egregious. No more. Today, there are all sorts of technical reasons for which a realtor can be sued (or dragged into an arbitration). Like it or not, such legal developments are a fact of life.
4. The net result: courts are clogged. This means delays and longs ones too. From the time a case is filed, it is not uncommon in most court systems for that case to take a year or more to get to trial. Even when it is set for trial, it is not uncommon for a case to have to be reset to a later date because no courtroom is available. If a case is appealed after a trial, it can take years to resolve.
5. “Justice delayed is justice denied” might be an appropriate motto for some situations that arise in our court systems.
6. More than that, each step in the long and drawn-out process costs money, and it is not uncommon for a case to run up tens of thousands of dollars in legal bills on both sides (millions for the really big cases).
7. Bottom line: litigation is a slow, cumbersome, and expensive process.

Tips for Minimizing Lawsuit Risks

How do you deal with this as an entrepreneur?

1. Obviously, try to avoid situations that might give rise to lawsuits. In business, this often involves people issues.

First, avoid doing inflammatory things. Even if you are generally in the right, if something that you do really reeks, you have just set yourself up to have a case against you shopped to a contingency-fee lawyer who knows very well how such things appear to a jury.

Second, if you are about to enter into a contract with someone who displays lousy character, watch out. Whatever is done to others can and will be done to you as well. Formal contract provisions might mean that you are technically right in the long run, but if you have to litigate the meaning of a contract or some complicated pattern of performance under a contract with someone who is what the lawyers call a “snake in the grass,” you will pay dearly for the privilege of proving that you are in the right. It is unfashionable to say it, but don’t do opportunistic deals with shady or disreputable people. This likely will only lead to trouble. And, believe me, the very persons who are the most disreputable are also those who know the ins and outs of litigation all too well and who will abuse the litigation process at your expense.

Third, don’t cut corners with your contracts. Make sure you work with a good business lawyer to ensure that contracts are well-drafted and tight. Be extra careful with using form contracts that have not be customized for your deal. This is a high-risk way to approach any deal. In all but extremely routine situations, always make sure to customize your contracts.

Fourth, in appropriate cases, work with your business lawyer to do compliance reviews in regular and recurring areas such as employment policies. In general, be preventive in your approach in those areas where problems are likely to arise, even if only because of the law of averages.

2. If you need to bring a lawsuit, make sure you are very sure of the merits of your case before launching. Count the cost as well. Cost is not a one-sided thing, after all. If you are in the right and have a strong case with a lot at stake, it will be worth funding a needed fight if there are no other good alternatives. The party on the other side will incur costs as well. And that party will need to assess whether those costs are worth it if, in the end, there may be a fat judgment awaiting him. In certain cases, you might even find a good business lawyer willing to take your case under a contingency-fee arrangement, though this is far less common with business cases than it is in other areas such as personal injury.
3. If you get sued, have the case evaluated by a skilled attorney and settle upon a manageable strategy for dealing with it. Sometimes this will mean fighting it out to the end, especially if it is frivolous and if you need to make an example of the case so that others are discouraged from bringing such cases. Sometimes it will mean attempting to settle it. A word of caution, though: human nature being what it is, you will not often be able to settle cases in the early phases. Lawsuits often are very basic. If an adversary senses blood, the settlement demands will escalate. Thus, it is often crucial that a case be vigorously defended until a party has some sense pounded into him before attempting to settle. Some parties never do. And some cases therefore will go to trial. This will cost you but it is sometimes necessary.

Non-binding mediation processes can and do facilitate settlement but mostly once the parties have reached a settling frame of mind. Thus, later-stage mediations will tend to be more effective than early-stage ones.

4. It can help in commercial situations to add attorneys’ fee clauses to your contracts if you believe these will discourage frivolous suits. Without an attorneys’ fee clause, under the U.S. system, each party normally bears his own attorneys’ fees for a case even if he wins it. With such a clause, the prevailing party in the lawsuit will normally be able to have fees awarded to him. This can be a double-edged sword, though, because you will have to pay the other side’s fees if you lose. But it does make sense for many commercial situations to have such clauses in your contracts to increase your leverage with potential adverse parties.
5. Consider using binding arbitration clauses in the right situations. Arbitrations are no panaceas. They can be long and complex proceedings in their own right. But they do tend to be somewhat simpler and less expensive. They are less public as well.

Be careful with arbitrations, though. For example, you should be cautious about stipulating in your contracts that issues affecting intellectual property ownership rights and the like will be subject to binding arbitration. Arbitration has no effective appeal process. If you get a bum decision, you are normally stuck with it unless the arbitrator was bribed or something equally egregious happened. For example, if an arbitrator merely bungled the meaning of the law applying to your IP ownership, you very likely would have no remedy from a bad decision.

Arbitration is ideally suited for regular and recurring situations in your business where you would derive significant advantage from taking away a claimant’s right to a jury trial. For such cases, do try to weave binding arbitration clauses into your contracts. Remember, though, that social policy can override such clauses in some situations and, if that happens, such clauses will not stick and you will wind up in court.

The overriding rule in all cases, then, comes down to something pretty basic: treat others as you yourself would want to be treated. Even if you have to do something that is difficult, such as fire an employee, always use caution in how you take such steps and always be professional and businesslike.

6. If liability risks are of particular concern in your business, and especially if they cannot be dealt with through insurance, set your business up as a corporation, LLC, or other limited-liability vehicle. This is no panacea either. But it does give you leverage if your adversary knows that there is only so much blood to be squeezed out of the turnip in the event of a legal victory.

Along this same vein, be cautious about signing personal guarantees. Whatever shield you get from a limited-liability entity is gone as soon as you personally obligate yourself to something. Sometimes you will have no choice, but don’t make such commitments without careful thought.

Conclusion

Lawsuits are a continuing concern for entrepreneurs. They are unpleasant. But they do come up. And they must be dealt with. Work closely with a good business lawyer and treat them with the seriousness they deserve. They are generally manageable but need to be handled with care.