Avoiding and Managing Us Business Litigation Risks: A Comprehensive Guide for Business Owners and the Attorneys Who Advise Them

By Kent Schmidt

Why are companies so frequently sued in the United States, and how might these business litigation liabilities be avoided through preventative measures and more effectively managed? This book answers those two weighty questions. The central premise of the work is that many costly and protracted lawsuits in the US are traceable to unforced errors companies make time and again. By better understanding the sources of commercial litigation, preventive steps can be implemented, reducing these risks. The author draws on two decades of experience defending companies throughout the US in almost every conceivable type of commercial litigation. He applies a “lessons-learned” approach from these experiences, to examine how corporate defendants can avoid claims by developing and enhancing their litigation risk profile.

The book is written for a diverse audience. The primary intended audience is attorneys who may find it useful as desk-reference for quickly accessing relevant information and issue-spotting for their clients. But the book will also interest any person - lawyer or non-lawyer - whose responsibilities include managing US litigation risks. These persons include those in venture capital, CFOs and other members of management, risk management and compliance professionals, and entrepreneurs seeking to implement best practices as they launch a start-up. Whether as an initial overview of the subject matter or a useful desk-reference, Avoiding and Managing US Business Litigation Risks is an invaluable resource for individuals tasked with addressing this challenging topic.

• Language: English
• Publisher: Globe Law and Business
• Release date: Jul 31, 2021
• ISBN: 9781787425224

Book preview

Introduction

This book is written based on a sobering truth: one of the most formidable barriers to launching and leading a successful company is the ever-present risk of business litigation. Many savvy entrepreneurs watch in dismay each year as their otherwise successful enterprise is damaged or even destroyed due to unforeseen litigation.

Lawsuits plague not just nascent start-ups and mom-and-pop businesses. Fortune 500 companies and midsize businesses allocate increasing chunks of their operating budgets to managing and settling a variety of claims brought by plaintiffs. The sources of these claims range from disgruntled employees to disappointed consumers, vigilant shareholders and litigious competitors.

Sometimes the lawsuit comes out of the blue, like an unexpected tornado, leveling the company in a short period of time and sending it into bankruptcy or dissolution. Other companies face a series of smaller recurring claims such as employment lawsuits that, while less sensational and dramatic, hit the bottom line each month, pilfering away profits from stakeholders.

Litigation costs can be astronomical. Besides the litigation expense that most people immediately think of – battalions of trial lawyers performing never-ending tasks at handsome hourly rates – there are hidden costs. The ongoing distraction of litigation diverts the time and focus of executives and members of the management team whose attention should be on more profitable endeavors. Instead of concentrating on a strategic plan for the next quarter of growth and expansion, key employees are forced to spend time preparing for a deposition or reviewing emails and other voluminous documents for production to an adversary, perhaps the company’s chief competitor.

There are further intangible costs of business litigation. The first conflict sometimes breeds secondary crises. As the instinct of self-preservation takes over, employees and jilted ex-employees point fingers at one another. The ranks are divided and company morale is damaged as the blame game ensues, with charges being leveled about who dropped the ball that triggered the claim. The ripple effects of either quiet or noisy departures can continue for months or even years.

And then there is the bad press, which may be even more devastating than the lawsuit itself. Customers, competitors, and the general public may read, tweet and re-tweet stories detailing sensational charges and claims about the product, service, or executive. When the truth is revealed months later after the company is vindicated by the lawsuit’s dismissal, no one knows or cares how the story ended.

Principles of preventive medicine applicable to commercial litigation avoidance

For over two decades, my commercial litigation practice has provided the opportunity to defend hundreds of corporations against a diverse array of lawsuits. This front row seat has afforded me insight into some of the calamities and travails that come with defending against lawsuits and how those clients may have avoided litigation in the first place, or at least had an easier path through the ordeal.

It is not uncommon for facts to emerge during litigation revealing an unforced error that led to the claim. Sometimes this mistake is readily apparent. But in some instances, answering the Why did we get sued? question requires a great deal of thought and analysis. It takes even more insight and understanding to fully consider practical steps or safeguards that might be implemented to avoid similar claims in the future or make defense of such claims infinitely easier.

In counseling clients and speaking on this topic to in-house lawyers, it has been striking how few companies seriously undertake this practice of litigation avoidance and prevention. Apart from sexual harassment and corporate governance training, and perhaps a visit from an insurance representative or a workplace safety consultant, many companies do little more than whistle past the graveyard of litigation risks.

The thesis of this book is that companies can take many preventive measures to mitigate against litigation risks. As daunting as this endeavor may seem given the varied risks from hundreds of types of claims, litigation risk management is achievable through strategic planning and consideration of how claims frequently arise.

Reduced to its essence, the concept is relatively straightforward. Litigation risk management requires converging two spheres of knowledge and information: (1) how the ever-evolving legal and regulatory landscape triggers a variety of claims and lawsuits; and (2) the day-to-day realities of the business plan. The company’s management team presumably has the second component covered. My objective in this book is to provide insights relating to the first.

The starting point in this process is an assessment of the enterprise’s litigation vulnerabilities. What are the litigation risks inherent in your business model? How can you – whether an owner or stakeholder, in-house counsel, outside counsel, or another loss prevention professional – be proactive in identifying and avoiding these risks? What types of claims are being asserted against competitors or similarly-situated players in your industry?

While some readers may find it useful to read each chapter in order, there are portions that will be more applicable to particular types of businesses than others. The section on proactive product liability prevention will not apply to financial institutions and real estate developers. Other chapters – such as chapter four, on how to understand breach of contract lawsuits – relate to virtually all businesses because almost every company enters contracts on a near-daily basis, triggering the possibility if not probability of a breach of contract claim at some point in time.

For those sections applicable to your business model, understand that what is summarized in the pages that follow is only the beginning. Consider these ideas as merely a prompt to prime the pump for further analysis and strategic thinking. Space does not permit an exhaustive discussion of every consumer protection statute and other source of litigation. Just as preventive medicine cannot be summarized in a single book or 20-minute visit with your healthcare provider, a serious effort to minimize and eliminate litigation risks requires a long-term commitment to the concept, lots of thought and reflection, and ultimately the dedication of sufficient time and resources.

Effective management of business litigation

To further extend the healthcare analogy, it is an unfortunate reality that even those who go to their physicians for routine check-ups, exercise regularly, and choose healthy foods are occasionally stricken with an illness. Similarly, all the litigation risk management measures in the world will not ensure that your company will not see the inside of a courtroom. For many companies, litigation is inevitable given the number of employees on the payroll, the volume and complexity of their business model, and whether they sell to consumers.

For those who have never experienced this ordeal first-hand, the world of litigation is filled with unknowns and mysteries. Movies and television dramas are poor guideposts for navigating the strange and intimidating world of high-stakes litigation. The unexpected hassles, burdens, and intrusions are reflected in familiar refrains I hear from clients on a daily basis:

They really can’t get those documents, can they?

We don’t have to give them the last known contact information for that ex-employee we fired last year, do we?

The trial is really going to take that many days and involve this incredible number of witnesses?

Whether you routinely manage a bevy of litigation and other legal claims brought against your business or have enjoyed the good fortune of avoiding courthouses and arbitration venues up to this point, managing litigation after an action has been filed presents a daunting challenge. The second part of this book provides a realistic and practical guide equipping you to deal with the unique challenges that litigation brings.

Some of the topics explored in this section include:

• The basic sequencing of litigation, from the filing of the lawsuit through settlement, trial, or arbitration;

• The lawyers: your own counsel and opposing counsel, who may seem equally demanding and intrusive throughout the ordeal;

• The adverse parties causing these headaches (former partners, shareholders, competitors, suppliers, employees or customers);

• The mediators who will attempt to negotiate a settlement and may be viewed as unreasonable by urging that you pay an exorbitant sum to dispose of a frivolous claim; and

• The judges, juries, and arbitrators who will resolve the dispute.

The objective in this section is to answer several questions typically asked by those in the trenches managing and overseeing litigation – often a CFO or other executive with no formal legal training:

• What are the most important things to think about early in the litigation process?

• How can we make this entire process less expensive and onerous, particularly for the business units and key personnel on whose performance we are depending to make next quarter’s projections?

• What can we expect in terms of key decisions, time commitments and other resources?

• How can we make sure the depositions are not disasters that increase the likelihood of an adverse result for the company?

• What are we going to do about that disgruntled ex-employee who was deeply involved in the customer dispute that is now the centerpiece of litigation?

A business owner or other executive’s ability to make informed decisions about litigation, anticipating and preparing for the financial and time commitments called for in the ordeal, can save hundreds of thousands of dollars from the time the lawsuit is filed until it is resolved. Informed decisions made by management early in the process may even determine whether the company weathers the storm. These concepts are covered in the second part of the book.

A California emphasis

Although this book is written for businesses all over the world, there is an apparent emphasis on California statutes, cases and practices. There are a few reasons for this, the first of which is rooted in a practical reality – I have practiced in this state for most of my legal career and California law is a familiar reference point. But apart from my own familiarity with commercial litigation in the Golden State, it happens to be one of the most popular locations for businesses. Although accounting for just 12 percent of the US population, one in five companies on the New York Stock Exchange and NASDAQ is based in California.¹

The reach of California litigation is significant. Not surprisingly, the most populous state has the largest market of consumers who buy products and services from all over the world. Even for those companies that have no physical presence here, it is not uncommon to face litigation originating in California. Well over 70 percent of my litigation work spanning over two decades has been defending out-of-state clients sued in California on matters ranging from small customer disputes to class action lawsuits. In-house lawyers who track their litigation expenses often discover that, while California may represent a small percentage of their company’s sales, it represents a disproportionate allocation of its litigation budget. It is difficult to avoid California litigation once a company sells products or services to businesses and consumers in the state. As the Eagles sang of that mythical destination, Hotel California, You can check out any time you like, but you can never leave.

Besides the sheer size of the market that makes it almost impossible to operate a significant business or other enterprise insulated from California regulations, its consumer- and employee-friendly laws increase the likelihood that a business will be sued in California. With few exceptions such as medical malpractice claims, our body of statutes, regulations and case law are more favorable to consumers, employees and shareholders than those of almost any other jurisdiction.

For each of these reasons, it is a prudent approach to consider the liabilities arising from California as a benchmark of best practices in litigation avoidance. It is an oversimplification to say that, if your business practices conform to California law, compliance is achieved in the other 49 states and international jurisdictions. But being aware of litigation risks lurking in the Golden State is a good starting point.

A litigator’s unique perspective

In the pages that follow, we will touch on dozens of topics of substantive law, ranging from corporate transactions to intellectual property. I seek to address these areas not from the perspective of a transactional or regulatory lawyer delving into the intricacies of codes and technical requirements, but instead by approaching each topic with insights gained from my experience in the trenches as a commercial litigator.

That litigation perspective focuses in large part on how a plaintiff’s attorney views these substantive areas of the law as an opportunity for a significant settlement or verdict. If I have accomplished my objectives in this book, the reader will have a better understanding of how these issues emerge in lawsuits and this insight will spur the thought processes that lead to effective loss-prevention measures.

To the extent that this book contains substantive expertise, it is a product of what I have learned over the years from a few hundred talented colleagues at my law firm, both through my litigation practice and in writing this book. If being a partner at a large international law firm has taught me anything, it is how much I do not know about the vast and ever-evolving legal landscape. My colleagues’ specialties and skillsets range from knowing how to patent a new drug to understanding the labyrinth of SEC regulations, how to take a company public or navigate the complexities of the brave new world of cryptocurrency transactions. It is a privilege to collaborate with these talented lawyers on litigation ranging from real estate disputes to shareholder lawsuits.

That experience and exposure to diverse practice areas is reflected in this work. I am grateful to those colleagues at my firm who have made this book possible by providing their expertise in reviewing and commenting on selected chapters applicable to their respective practices. Their names and areas of expertise are indicated in the acknowledgments.

Assumptions and audiences

Albert Einstein said, Everything should be made as simple as possible, but no simpler. The legal landscape in general and commercial litigation in particular are becoming more complex each day. Regulations are cumbersome e-discovery multiplies complexities. Rules designed to streamline the process sometimes seem to do the opposite.

These complexities are unpacked in this work for a diverse audience with varying levels of sophistication and knowledge of business litigation. The potential audience and uses range from the following:

• A CFO of a small private corporation tasked with managing litigation who would like to focus more on preventing litigation than just approving litigation counsel’s invoices and authorizing an endless stream of claim settlements.

• An entrepreneur or one in the venture capital space will find these concepts relevant in considering a new business or acquisition of an existing business and ensuring that entities, affiliates and investors are insulated to the extent possible from potential liabilities.

• Attorneys acting in an in-house role and those in private practice are accustomed to the role of issue spotting. They may find it useful to supplement their understanding of risk mitigation by thinking through some of the new and emerging liabilities and how risks are assessed and categorized in this work.

Because readers have varying degrees of familiarity with the legal concepts discussed, parts of the book may seem either too technical or too rudimentary. To the extent possible, I attempt to break down complex concepts into concise explanations understandable to a layperson, supplemented by illustrations and metaphors. For the seasoned lawyer seeking to take a deeper dive into a particular subject, citations to regulations, statutes, cases and other authorities are provided in the endnotes.

*  *  *

I am fond of saying that, like the village undertaker, commercial litigators are invariably called upon to ply their craft only in the wake of the most unpleasant circumstances. In contrast to transactional lawyers, whose work may result in popping champagne bottles to celebrate the issuance of an important patent or the completion of a game-changing acquisition, something bad has invariably happened in the days or weeks before a client’s urgent call to a trial lawyer. A key business relationship has soured, an employee has bolted with valuable trade secrets, a summons and complaint have just been served, or some other crisis is afoot.

Although I enjoy the challenge and comradery that comes from working with clients to assess the damage and attempt to find a solution to the problem, there is a special joy that comes in advising clients on how they might avoid these problems in the first instance. To that end, this book is written to provide thoughts and a few modest nuggets of wisdom to perhaps prevent a catastrophe, or, if that fails, help you weather the storm so you can get back to doing what you do best – run a successful business.

References

1 New York Times, 20 September 2016, DealBook/Business and Public Policy, Steven Davidoff Solomon, Public Companies See Gold in California: www.nytimes.com/2016/09/21/business/dealbook/public-companies-see-gold-in-california.html?ref=dealbook&_r=0.

PART ONE:

UNDERSTANDING WHY COMPANIES ARE ENSNARED IN COSTLY LITIGATION

Chapter 1:

The Five Cs of Business Litigation Risks

Sharks have been on my mind recently. A few years back, two younger litigation associates in my office allowed me to join them in training for a triathlon off the coast of Malibu. Ignoring advice I routinely give to clients in my practice – such as using common sense and carefully assessing costs and benefits – I signed up online and paid the non-refundable $200 registration fee after thinking it through for all of ten minutes. Thus began six months of training, motivated in large part by vanity – specifically, not wanting to be thought of as the old, out-of-shape guy in the office – and a desire not to forfeit the registration fee.

Although one of the best decisions I ever made, it was a grueling and terrifying process to train for this race. Of the three events – swimming, biking, and running – the swim was by far the most daunting. This was not just because of my less-than-stellar freestyle stroke. After months of training, including swimming in a local lake and doing laps in a pool, I recognized the need to venture into the chilly Pacific to learn the skills necessary to complete an open-water swim.

There was not one time I entered the water – including on race day – that the fear of a shark bite or worse did not enter my psyche. The fear did not leave me when crashing past the breakers at the beginning of the swim. I thought about sharks the entire time, especially when a piece of seaweed would brush up against my leg or I saw some sort of dark shadow in the water when my face was submerged. I found myself reading with renewed interest news reports about shark attacks off the coasts of Orange County and San Diego, paying particular attention to those incidents involving triathletes doing open-water swims.

For the first time in my life, I gave serious consideration to the question of whether there are ways to mitigate the risk of a shark attack – other than just staying out of the water and sticking to running and cycling. I shared my anxiety with one of my clients who is an avid triathlete and regularly swims near his home in Cape Cod. He confessed that he is constantly nervous about sharks and uses an iPhone app that tracks at least those sharks tagged by marine biologists. I immediately downloaded the app to see what it might reveal lurking near Southern California beaches. The app showed nothing. But that was little comfort, given that my limited understanding of sharks is that they are loners and do not typically swim in schools. I cannot imagine marine biologists have tagged and are tracking more than a small sliver of the shark population. It follows that, just because the few tagged sharks are not in the vicinity, one cannot conclude that that their brothers, sisters, or cousins are not.

A story about a shark-repelling wetsuit developed in Australia caught my eye. The wetsuit had a graphic design engineered to confuse and repel sharks. That seemed a bit farfetched and even less reliable than the shark tracking app. In the end, I decided to concentrate on the statistics, overcome my anxiety, and just dive into the ocean, mind over matter. This decision was based on the reluctant realization that no precautions could be taken that would meaningfully mitigate the risk of a shark attack. I had to embrace precisely the same risk that every other ocean swimmer and surfer encounters.

Such is not the case with owning and running a business and avoiding the risks of a devastating attack in the form of a lawsuit. Meaningful and deliberative steps can be undertaken to avoid, if not eliminate, the risks of costly litigation. That is the purpose of this book and the emphasis of the first of its two parts.

Creating a business litigation risk profile

Any student of business understands that the critical first step in launching a successful enterprise is the creation of a sound business plan. Successful entrepreneurs not only carefully chart out their initial launch, they also revisit and revise the business plan regularly. Enormous amounts of time and consulting dollars are spent to assess the niche the business intends to fill, the costs of operation, and countless other factors. A smart business plan not only focuses on the upside, but the risks that may cause the business to fail. Only after being persuaded that the upside of a proposed venture outweighs the ever-present risk of a failure does a prudent entrepreneur take the dive.

What is often neglected in this otherwise careful and deliberative process is a thoughtful attempt to gain a real understanding of the possibility that litigation will adversely affect the business. Think about the businesses you have been a part of in your career. How often have the C-suite executives taken time during an off-site retreat to engage in serious contemplation of this precise question: If we are hit with a devastating and costly piece of litigation next year, where will it originate? Here is the unvarnished truth – if you do not understand your litigation risk profile, you do not fully understand your business.

The closest that many companies come to engaging in this introspective process is obtaining insurance coverage for certain risks. Purchasing an insurance policy is certainly a step in the right direction, but it does nothing – or is certainly insufficient – to reduce other risks. When insurance brokers show up to obtain information for a policy, they are only interested in the risks that are being insured. If the insurer is writing a policy for workers’ compensation insurance, the focus might be on reducing the risk of a claim by enhancing workplace safety, ranging from ergonomic chairs to assessing air quality and making sure there are adequate first aid kits.

While this exercise may reduce the insurer’s exposure, what about the risks that are not insured? Most general liability policies have pages of exclusions. To be candid, the insurer could not care less about those claims that might be asserted against the company if its coverage is effectively excluded. Who is looking after those risks and, just as important, devising ways to mitigate or avoid them?

Insufficient though it may be, let us use the underwriter’s process as a starting point, a template of sorts for our uninsured litigation risks. Management should approach these litigation risks with even greater diligence, contemplative foresight, and care than the insurance underwriter approaches the risks that are being insured. But how can this daunting task be accomplished when the sources and types of litigation are so varied? As the following pages show, it can be done through an effective litigation risk management approach.

A case study: Sarah’s seaside inn

Suppose that Sarah is opening a new inn, converting a dilapidated and rundown motel into an attractive seaside tourist destination. She will need a commercial general liability (CGL) policy before welcoming her first guest. In order to write that insurance policy, the underwriter will ask a host of questions focused on those risks within the policy.

He or she will ask about slick floors, steep staircases, and unlit paths, as there are substantial risks of slip-and-fall and trip-and-fall claims. They will next inquire about asbestos and related environmental hazards, each assessment of risk following the contours of the coverages in the policy.

After the underwriter has obtained answers to these questions, addresses concerns and issues the policy, Sarah should focus on potential claims for which there will be no coverage. These non-covered claims pose the greater risk to the business because, if they materialize into real lawsuits, Sarah’s bottom line will be impacted by having to pay for the defense of the claims and any settlement or judgment out of her operating budget.

Here are a few claims that Sarah might consider:

• She will hire employees. Those employees are vested with substantial rights such that a failure to meticulously comply with dozens of state, federal, and local regulations will trigger costly claims. These include violating wage-and-hour laws, not informing an employee of his or her rights, and invading the privacy rights of an employee.

• Sarah will welcome guests at the inn, some with disabilities and certain rights under the federal Americans with Disabilities Act (ADA) and parallel state laws.

• Several commercial contracts will be signed with vendors and suppliers of everything from room furnishings to roofing materials. Each vendor will be a contracting party, creating potential for a breach of contract claim that might end up in court or arbitration.

• To attract new customers, Sarah may issue gift cards with expiration dates. She may advertise to the general public that her rates are substantially discounted over a rack rate even though she has never actually sold a room at that rate. These and other marketing activities create the risk of claims for false advertising and unfair business practices.

• Suppose Sarah obtained most funds to open the inn from Brian, an investor who has a 70 percent interest in a limited liability company (LLC) formed to operate the inn. Sarah may now owe Brian and any other investors certain duties including fiduciary duties, the highest form of duty recognized in the law. While Sarah is busy choosing the right wine and cheese for the evening reception and is engaged in other tasks necessary to operate the inn, she needs to think of herself as a fiduciary to Brian and other investors.

• Sarah understands the power of social media and internet advertising. But does she also understand the litigation risks that come from posting on Pinterest or Instagram a photo of a guest at the inn without their express authorization? Does she understand the issues that may arise by obtaining guests’ email addresses and cell phone numbers to notify them of weekend specials or discount rates? Did Sarah contemplate what would happen if credit card or other private information is hacked? Has she paid a travel blogger with a large online following to post, pin, and tweet about his stay at the inn without disclosing that this is native advertising and influencer marketing?

As this parade of horribles illustrates, these litigation risks are extensive and varied. Few are likely covered by a CGL policy. The risks are not limited to businesses that make reckless decisions. Even if Sarah does everything right and exercises unquestionable prudence and integrity in all her dealings with employees, customers, contracting partners, and investors, significant risks of litigation lurk beneath the surface.

Having touched on the qualitative natures of these risks, let us also consider the quantitative aspects.

Suppose that the business plan calls for netting $80,000 a month in taxable income through distributions from the LLC. Suppose further that just one of these potential claims materializes into an ugly lawsuit with a plaintiff represented by a motivated attorney paid on a contingency. As Sarah has done nothing wrong, she believes this is a shakedown for money and will fight off the shark, as she likes to say, for the principle of the matter.

Rather than settling, the parties fight on and the lawsuit becomes protracted over many months. That single claim could gobble up all the income the inn is generating. Worse yet, if the source is one of the risks discussed above other than Brian and the investors, Sarah may have another problem.

Suppose that Brian, who has known Sarah for many years, thinks that she did nothing wrong in whatever act or omission caused the lawsuit to be filed, but Alice, a minority investor, does not take the same charitable view. Alice invested far less than Brian but had far less money to lose. She is incensed and now suggests that Sarah breached her duties to the entity and her investors, jeopardizing their substantial investments in the new business by her mismanagement. Alice has now retained a lawyer to assert that her investment has been destroyed through Sarah’s malfeasance. Hindsight being what it is and plaintiff lawyers being who they are, Alice’s attorney thinks the malfeasance is obvious and that any trier of fact will surely find liability.

This sad tale is not an exaggerated summary of litigation risks. Though often on a larger scale in both the amounts of money at stake and the complexities of the claims, these are the very types of lawsuits filed, litigated, settled, and tried every day all over the country. Like many illustrations throughout this book, these facts and claims are similar to the lawsuits over which I have commiserated with clients including business owners, entrepreneurs, and in-house counsel.

Sarah’s litigation woes illustrate several points that will be further unpacked in the first part of this book. But the threshold point is this: making sure there is insurance to cover a guest’s slip and fall is not the end of the risk analysis, but only the beginning. Sarah would be well-served to thoughtfully consider and guard against all of the other litigation risks.

If this is true for Sarah and the rather modest enterprise she is launching, consider the litigation exposure for a midsize to large company with hundreds of employees and more complex business relationships, services, products, and infrastructure. Although the litigation risk assessment is exponentially more complicated for such companies, the same litigation-avoidance measures can be taken by adopting the concepts discussed in the following pages.

The closely-related regulatory risk profile

The risk of civil lawsuits brought by aggrieved parties is not the end of the story; there are also a host of regulatory risks. A few decades ago, regulatory concerns posed manageable issues for small business owners, particularly those in an enterprise like Sarah’s seaside inn. Secure a business license, pay your taxes, comply with minimum wage laws, see if a city code requires a permit, and you are good to go. Such is not the case today.

Whether we like it or not, and irrespective of what politicians say about rolling back unnecessary regulations, they are here to stay. It is amusing when lawmakers and political commentators talk about de-regulation. That term is often a misnomer at best. There is no such thing as a de-regulated industry today. I have never heard of any industry that went from being regulated to truly unregulated. True, some regulations are cut back, but layers of regulations remain in virtually every industry.

Let us return to Sarah’s seaside inn, an operation which no one would consider a heavily-regulated business. But consider for a moment some of the regulations and regulatory bodies that Sarah should ponder:

• The Occupational Safety and Health Administration (OSHA) and Cal/OSHA regulate workplace safety, including equipment in the kitchen that could cause injuries.

• State and federal environmental protection agencies will have a keen interest in whether guests and employees are exposed to carcinogens or other chemicals that might cause cancer or reproductive harm.

• Various civil rights regulators such as the Department of Fair Employment and Housing will ensure that Sarah engages in no discriminatory practices. Even a seemingly benign advertisement for a Ladies’ Getaway special is, on its face, gender discrimination.

• Certain consumer protection agencies will be interested in whether advertisements relating to discounts and incidental charges are fairly disclosed to consumers and whether the fine print in a Groupon promotional advertisement constitutes a baitand-switch tactic prohibited by law.

• State, county, and municipal agencies must be consulted to ensure that dishes and drinks served to guests are sanitary and safe and that the kitchen has obtained proper licenses.

• Local, state, and federal taxing authorities will obtain their pound of flesh at various levels, from guest check-ins to the dividends paid to investors, and will require proper documentation and filings.

• Corporate governance regulations will apply to the formation and maintenance of the business entities and the rights of the investors as members of an LLC, partners in a partnership, or shareholders in a corporation.

• Consumer privacy and the risks of a computer hack compromising personal information of customers, including credit card numbers, will interest agencies charged with protecting the privacy of the public.

As this list illustrates, regulations proliferate at every level of government – federal, state, county, and city. The degree and intensity of local regulations is a relatively new phenomenon.

The disposition and enforcement philosophy of many regulators has also evolved. In a bygone era, the quintessential local regulator was the rough equivalent of Andy Griffith strolling the streets of Mayberry. The regulatory cop might occasionally protect public health and safety by nudging along a small business owner to comply with a commonsense ordinance. In place of the Mayberry regulatory approach, today’s regulators meticulously enforce cumbersome regulations and appear to take pleasure in harshly punishing the most trivial nonconformities, seemingly channeling Inspector Javert pursuing Jean Valjean.

There are increasingly overlapping and redundant regulations. Perhaps the best example of this new breed of local regulations is the city of San Francisco with its own Office of Labor Standards Enforcement that promulgates and enforces ordinances with which certain businesses must comply. According to its website, These laws regulate hours, retention, scheduling, and treatment of part-time employees at some Formula Retail Establishments.¹ Thus San Francisco businesses must comply with federal regulations and arguably the most employee-friendly and cumbersome state regulatory schemes in the country, with local regulators now completing the troika. Other large metropolitan cities are also getting in on the act, layering on their own employment regulations.² This trend of expansive local regulations will continue, particularly in large cities where local government is typically more progressive.

This is also true of state regulations, and California of course leads the way. The Golden State has no fewer than 343 separate regulatory agencies. The regulatory thicket is so dense that California even has a government agency, the Office of Administrative Law, which is tasked with keeping track of all of the other agencies and the mountains of regulations they enact. There might be an overregulation problem if a regulator of the regulators is necessary because of the proliferation of these bureaucracies.

Considering all of these risks, it is a wonder that anyone starts a business venture at all. It brings to mind advertisements for drugs that include the obligatory disclaimer of side effects ranging from sleeplessness to suicidal thoughts and death. We could surely ask whether the cure is worse than the disease.

Returning to our hypothetical, Sarah might have second thoughts about the prudence of wading into these scary waters, where shark fins are not just exaggerated fears but a real part of the watery landscape. But like my first foray into the ocean for a distance swim, Sarah assumes the risk of sharks and plunges into the murky waters. Unlike me, she can take steps to be a savvy business owner and reduce the risks of litigation and regulatory violations. This book is designed to assist in that navigation.

Assessing commercial litigation risks – a five-part framework

One of the privileges I have enjoyed over the course of my career is the opportunity to meet and interact with so many business owners who, like Sarah, courageously take on these risks and, against incredible odds, succeed in the venture. A few years ago, I was asked to speak about business litigation risks to a group of entrepreneurs and other executives. Preparing for that presentation led me to think about the major categories of business litigation. This process and countless conversations with other lawyers, loss-prevention professionals, and business owners have led to a categorization that I call the five Cs of ligation risks (with a bit of contortion on the last category). One would be hard pressed to come up with a recurring business litigation claim that does not fit into one of these buckets of risks. Not all apply to every type of business, but one of these types of claims more than likely represents your company’s next lawsuit.

1. Lawsuits related to corporate governance failures

The first business litigation risk is that the creation and maintenance of the business entity will spawn claims against the owners of the business. Potential plaintiffs include shareholders in a corporation, the members of an LLC, or partners in a partnership. The constituents of the business are owed certain duties by the parties that control the enterprise. A failure to understand the scope and extent of corporate duties – the fiduciary and loyalty duty, the obligation to provide information, the need to avoid self-dealing – is at the root of many of these lawsuits.

Shareholders and other stakeholders bring a wide variety of claims against their business, its directors and officers. In some instances, these claims are brought as shareholder derivative actions in which the constituent brings claims in the name of the corporate entity.

While most of these litigation risks relate to claims by the corporate constituents, implementing good corporate governance also mitigates other risks of legal pitfalls. These include third parties seeking to pierce the corporate veil through an alter ego theory, creditors asserting claims for fraudulent transfers, and state and federal regulators inquiring whether there has been a prohibited sale of unregulated securities.

Notwithstanding the proliferation of these claims and the eagerness with which some shareholders or joint venture partners will rush to assert claims of malfeasance, there are a number of practical steps that can be taken to avoid these types of lawsuits. These efforts fall under the general heading of implementing and refining a robust corporate governance strategy and practicing good corporate hygiene. From the originating corporate documents describing shareholders’ rights to the implementation of a corporate compliance program and sales force training, a variety of best practices in this area can reduce these potential liabilities.

Following an introduction to some of the corporate structural concepts in chapter two, we will explore in chapter three ten common corporate governance mistakes and how these acts or omissions create litigation risks in the form of claims typically brought by shareholders, members, partners, stakeholders, regulators, and third parties.

2. Lawsuits related to contract disputes

The second area of litigation risks for almost any company arises from the wide variety of contracts that are formed as part of the business. These contracts include standard agreements needed to run any business (office leases, contract for a new phone system, and other vendor contracts) and more complicated commercial supply agreements with customers. Notwithstanding the wide variety of contracts, most lawsuits claiming a breach of contract fall into a few categories of claims and are based in fundamental contract principles that are introduced in chapter four. This discussion is followed by chapter five, which surveys 17 strategies to consider in reducing contract liabilities or being in a better position in litigation arising from contractual rights and obligations. These contract provisions and concepts include merger or integration clauses; consent-to-jurisdiction, choice-of-law and forum-selection clauses; and arbitration provisions and limits on damages and remedies. Such contract provisions are often overlooked when the deal is being negotiated but are of paramount importance once a dispute arises and the parties are racing to the courthouse.

It is essential that responsible parties understand the significance of these contract provisions, which are sometimes buried deep in a voluminous agreement. Using this knowledge during negotiations can reduce the risk of a contract claim down the road or at least make it less difficult to defend against a claim. Chapter six addresses the implied covenant of good faith and fair dealing and the closely-related, various types of lawsuits and claims brought by jilted parties when preliminary contract negotiations do not materialize into a final deal.

3. Lawsuits related to customer claims

The very lifeblood of most businesses – the customers who acquire the products and the services every day – represents the next type of business litigation, often brought as contract claims. Chapters seven through 11 expand on the contract principles addressed in the preceding chapters.

Contract claims are but one of the types of claims that customers often bring. Some lawsuits ostensibly brought by customers claiming injury present no real injury at all and are propelled by consumer class action attorneys who send their client into a grocery store or online to buy a product or engage in a transaction solely for the purpose of filing a class action. If your business sells products or services to consumers, being aware of the consumer protection claims de jour is the first step in avoiding these types of lawsuits. These claims have become a significant burden to businesses in the last few decades, and nowhere are class actions more prevalent, and in some cases specious, than in California. Supported by robust consumer protection statutes designed to protect the public from unfair business practices, consumer plaintiff attorneys bring these claims on a regular basis and demand sizeable settlements. Chapter eight addresses class actions, including a framework for mitigating the risk of these types of lawsuits. Many customers buy products which create unique liabilities, three of which are addressed in chapter nine: breach of warranty claims including enhanced remedies under state and federal warranty protection statutes; product liability claims for defective products placed in the stream of commerce and Prop 65 claims for consumer exposures to certain chemicals.

If a customer (or even a third party) is injured or dies from a product, a claim for product liability can be brought under a variety of theories. Chapter nine explores the concepts underlying modern product liability, including how juries determine whether a product fits within one of three types of actionable defects, and how a series of risk-mitigation steps can reduce the likelihood of a devastating product liability claim.

The final type of customer lawsuit, which is a relatively recent phenomenon, is addressed in chapter 11 – the risk of litigation and regulatory action from breaches of data privacy and hacking. As the headlines frequently remind us, the mere retention of customer data – credit card information, personal identifying information, health records and financial records – triggers significant risks that must be weighed.

4. Lawsuits from competitors

The fourth of the five Cs of litigation risks is defined by the source of the threat. As the business grows and market share increases, competitors often sit up and take notice. These potential plaintiffs are likely to sharpen their focus on your business and consider a variety of potential lawsuits. Chapter 12 explores the eight most common types of lawsuits brought by competitors and practical steps that can be taken to avoid these predatory lawsuits, often brought for no purpose other than to flex muscles and send a message to a market participant.

Competitor lawsuits include claims for misappropriating trade secrets, raiding employees, infringing intellectual property, false advertising that provides a competitive advantage, trade defamation and similar disparagement, antitrust claims, unfair competition claims under state statutes, and interference torts including interference with prospective economic advantage. An aggressive competitor with a creative and knowledgeable trial lawyer can wreak havoc, even if the claim is ultimately unsuccessful, by consuming valuable time and financial resources, obtaining access to key information through the discovery process, and disrupting an otherwise successful business.

5. Lawsuits associated with the crewmembers – employee claims

The fifth and final risk to any business, addressed in chapter 13, is claims brought by employees. Employees – who are essential to the business – often bring claims ranging from sexual harassment to wage-and-hour class actions. These broad claims reflect expansive federal, state, and local regulations. In this chapter, we will look at the most common employee claims and several preventive measures to avoid these types of lawsuits and government investigations.

*  *  *

Merely understanding the Five Cs of business litigation risk is not a simple proposition, and the material in the pages that follow is at some points challenging. To obtain the full benefit of this book, you must apply these concepts to your unique business model, paying close attention to the categories of risk that are most significant. In doing so, you will learn how these lawsuits emerge and what measures might be taken to avoid getting bitten by the sharks.

Swim safely, my friends.

References

1 http://sfgov.org/olse/formula-retail-employee-rights-ordinances.

2 Seattle has recently joined San Francisco and other cities in enacting a host of new employee protections that go far beyond state or federal law. The secure scheduling ordinance addresses such matters as how far in advance an employer must provide notice of changes to scheduling, and when additional hours must be offered to existing employees before new employees are added.

PART TWO:

CORPORATE GOVERNANCE LITIGATION RISKS – CLAIMS FROM SHAREHOLDERS AND OTHER CONSTITUENTS OF THE BUSINESS

Chapter 2:

Basics of Corporate Governance Litigation

We begin with the first of the five Cs of litigation risks – lawsuits related to corporate governance brought by the company’s constituents, such as owners of the company or corporate shareholders. These lawsuits are some of the more contentious disputes I have litigated over the past several years.

Corporate governance claims range from a federal shareholder lawsuit against a publicly-traded company for accounting irregularities to a dispute among three or four medical professionals who have been operating under a limited liability agreement and have a disagreement over the calculation of profits and distributions. A common question in all these lawsuits is whether the controlling parties fulfilled their obligations to the business entity and, by extension, its constituents — the ultimate owners of the enterprise.

One may note the use of the word constituent in this discussion. That is my preferred term in describing these claimants because it metaphorically and collectively describes the various types of stakeholders in a business: corporations have shareholders, limited partnerships have limited and general partners,¹ and LLCs have members.² Regardless of the form of the business, the duties and claims that arise in these cases are typically much the same (if unmodified by agreement).

For example, if a member of an LLC brings a claim – directly or derivatively – arising from the managing member’s alleged breach of fiduciary duties, those issues would be litigated much the same as a shareholder’s direct or derivative claim against corporate management. Like many others writing on this topic, I will sometimes use the term shareholder litigation to collectively refer to litigation brought not only by shareholders in a corporation, but also by other stakeholders in the alternative corporate forms, noting at various points how partnerships and LLCs face unique issues.

Shareholder litigation is almost always complex. Even disputes arising from a relatively small business can spawn complicated substantive and procedural questions. Among other complexities, one must sort out the underlying facts (who did what and for what reason), determine what law controls, consider whether the parties’ agreements override certain default statutory protections for minority constituents, assess whether best practices were followed in maintaining books and records, determine whether directors or other controlling persons breached common law or statutory fiduciary duties through self-dealing and other bad acts, and address who has interim control when directors are at war with one another.

Given these complexities, we will devote two chapters in this book to litigation risks arising from corporate governance issues. In this chapter, we will use the following roadmap to consider some of the general concepts useful to understanding the dynamics and recurring issues in shareholder litigation.

• We will begin with expanding on a previously-referenced metaphor that is useful to understanding the human dynamics of shareholder litigation.

• That discussion will be followed by a case study of a typical shareholder dispute from a start-up, illustrating many of the concepts just introduced.

• The third part of this chapter is an overview of the four root causes of the vast majority of shareholder litigation.

• This chapter concludes with a short list of the most critical legal concepts that invariably arise in corporate governance lawsuits – an introduction for some and a refresher for others more familiar with these legal concepts.

The foundational concepts addressed in this chapter will provide necessary context for a survey of the primary risks of shareholder lawsuits addressed in chapter three.

Understanding shareholder litigation – a useful metaphor

Although many are unfamiliar with concepts of corporate governance and claims brought by shareholders, most have a basic understanding of civil government issues and dynamics. Fortunately, the dynamics and principles of corporate governance and shareholder litigation are strikingly similar to those observed in both contemporary political developments like our latest general election and in historical movements such as the French Revolution.

First, there is a set of ideals concerning how the enterprise (business or government) will be formed for the mutual benefit of its constituents. To advance those objectives, a series of governing documents are drawn up at a constitutional convention of sorts, clearly articulating the enterprise’s aspirations, powers, roles, and rights. Those entrusted with power understand that with their title and position come duties owed to constituents. There are checks and limits on power, as well as rights and remedies of the governed, set forth to protect against oppression by those in control.

A small number of individuals are then appointed, installed or elected to office. These individuals impliedly or expressly promise to operate within those strictures, mindful of their responsibilities and the fact that they serve the constituents – not the other way around.

Notwithstanding all these efforts and ideals, a series of conflicts then emerges. Pointed questions are asked along with demands for an inspection of certain books and records. Resistance from those in power only compounds the suspicion.

A review of certain records then reveals fraud and a misuse of funds. Finger-pointing ensues. Have those governing forgotten that they serve the governed? Disputes quickly escalate into a full-fledged revolt. Divisions and voting blocs are formed as subgroups of the constituents devise how to band together to take control and throw out the incumbents. Bitter conflicts emerge as charges of self-dealing and waste are leveled. Throw the bums out! is the rallying cry. You have forgotten those who gave you this posh post.

At the core, these conflicts arise because the constituents contend that the controlling parties are serving their own interests rather than the interests of the entity and its ultimate constituents. As we shall see, there are a wide variety of remedies – some rather draconian – available to the constituents.

Those possessing the power and prestige of managing and directing the business are well-advised to understand the duties that come with their powers and the consequences of failing to do so. In the pages that follow, we will discuss how to avoid some unforced errors and engender the trust and confidence of the constituency so that peace and tranquility can be maintained and a revolution averted.

Keep this constituency metaphor and related concepts in mind as we now consider a hypothetical to illuminate how some of these issues arise.