How to plan for business legal disputes

At one point years ago, my business partner and I were discussing how the arbitrator costs for a month of pre-hearing activity was 1/3 of our original out of pocket claim.

What is the “deductible” on business claims? How expensive is it, really, to sue a business on a contract claim? And what are the reasonable responses to these costs for businesses of various sizes?

Litigation is expensive, no matter which side you’re on. If you’re defending a lawsuit, you have no choice but to pay cash (there’s not really anything to calculate a contingency fee on, and the prospect of getting a cut of a reduced verdict doesn’t excite most law firms). If you are suing someone else, the likelihood of finding someone to take that contract claim on contingency are very, very slim. There are two reasons for this: first, the possible amount you can recover is usually limited to the amount of the contract claim (such as the amount that hasn’t been paid) plus legal fees if the contract provides for that and if they are actually awarded; second, if you’re suing someone who hasn’t paid, often that party isn’t necessarily a good risk so that even if you win, the judgment might not be collectible. Law firms, if not lawyers, are more risk-averse than many professionals – possibly less risk-averse than accountants, but clearly more risk-averse than consultants or investment bankers. This tendency, layered on top of lawyers not being in the business of gauging creditworthiness of the companies you’re suing, leads to lawyers often preferring a known fixed amount over a chance at a larger percentage of the recovery.

(This is different than the situation in personal injury cases because

• injured plaintiffs seldom have the money to fund litigation
• insurance companies are good credit risks on payment
• the amount of the jury verdict can be very high and isn’t automatically limited)

So, what does it cost? I’ve told clients that unless the number is over $25,000, they should at least consider writing it off. Lawyer time costs money, which while hard to estimate, is easy to measure. Management (i.e., your) time also costs money, but it’s hard to measure. In my experience, most people underestimate the loss to the business from management distraction. Sure, you can count a day or three or ten from depositions and court appearances, but the hours of responding to and reviewing discovery or reviewing motions and briefs and other filings are seldom tracked and never valued. Even then, that’s still not the right number. The number that you have to track to make a good decision is the opportunity cost of those hours against the potential recovery, after you’ve discounted it to a risk-adjusted number.

What can you do well? You can file in small claims court. It’s easy, relatively painless, and you have a decent shot of keeping your costs low. However, small claims courts have, by their nature, fairly low limits on what cases they can handle. For example, $5000 is the limit for small claims court in New York City.

If your case is too much for small claims but not large enough to get a lawyer, you might consider bringing the lawsuit yourself. That would depend on your available time (the opportunity cost is going to go up a lot if you do this), your skill and inclination, whether the other side is likely to get a lawyer, the nature of your case, and frankly, how mad you are. While I would say letting go of the anger would help you make a more economically rational decision, I’d be lying if I said I didn’t believe that personal animosity fuels many lawsuits (divorce lawyers bank on it, I’m sure). Many courts have “pro se” offices, clerks, or resources to help you file on your own. Or you might be able to get limited representation from a lawyer to do certain parts of your case, like the initial complaint or drafting discovery demands, while you handle the rest.

What can a company to do to avoid this black hole?

Large businesses — focus more on credit policies and passing on bad debt expense as a cost of doing business. If the debt is not from a repeat customer, consider selling it off.

Mid-size — substantial risk here because there’s little room for error when a contract is large enough to have a material effect on the company and there’s not necessarily enough business activity to spread the costs out.

Small businesses — consider being exceptionally tight with credit, especially over the small claims limit in your area. Ask for payment or deposits upfront. Use mechanics’ liens (such as for contractors) to assist in recovery if they are available to you. Don’t allow more unpaid work to be outstanding than you can afford to lose. It’s hard when you are starting out or otherwise struggling, but there is real, long-term value in training clients and customers that they have to pay you for the work you do.

Here is some more background on the small claims court process.