By

Alternative Dispute Resolution in Terms of Service

joedaliablogpic

As web-based startups grow, they naturally begin to attract users across state lines and international borders. For founders who have worked hard to get this traction, this is rightfully considered cause for celebration, but it is important to consider that this expansion comes with a bit of additional risk. With larger and more widely distributed user bases, startups are exponentially more likely to see an increase in the frequency and complexity of disputes involving its users. While these disputes are to some degree inevitable, a startup can still safeguard its interests by crafting a clear dispute resolution policy in its terms of service.

There are a range of different ways that a dispute resolution policy can be crafted in a company’s Terms of Service, but the startup’s choice essentially boils down to two means of conclusively settling disputes- litigation and arbitration. As described below, the latter presents significant advantages to early-stage companies.

Litigation: If a startup chooses to use litigation as its preferred means for final dispute resolution, its Terms of Service will generally indicate that a particular state’s laws govern (i.e. Delaware or the state where the company is located). This does not, however, ensure that the dispute will be heard in a court in that particular state. Under certain circumstances, users-turned-litigants may be able to have their suits against the company heard in a federal court (referred to as “removal”) that will apply the designated state’s laws, even though the federal court may not be located within that state. Hence, while this method provides a startup with some certainty as to applicable law, there remain a number of drawbacks to a dispute resolution policy crafted in this fashion which include:

Forum: A litigation-based dispute resolution policy doesn’t necessarily provide for certainty as to forum given the possibility of removal to federal courts. Should removal occur, the startup will still have the “home field advantage” in terms of governing law, but, depending on the federal court selected by the user, it might lose the convenience of settling its dispute close to company headquarters. Instead, founders may be forced to travel to a federal court across the country to settle disputes with users. For founders short on time and money, this may pose a tremendous obstacle to mounting a defense.

Expense: It is also important to remember that this type of policy will require founders to incur great expense in the event of a dispute. Litigation involves significant costs in the form of court filing fees and attorneys’ fees, and even if the startup is successful in defending itself in court, it is highly unlikely that the company will be able to recover these expenses. In the event of removal to federal court, the startup may also face significant (and unrecoverable) travel costs. For early-stage companies trying to carefully manage limited funds, these enormous expenses may be prohibitive and the company may be forced to settle disputes on highly unfavorable terms.

Time: Another downside to litigation is that it can be an incredibly drawn-out process. Between initial motions, discovery, and the actual hearing (assuming no settlement is reached), the process can take years. When appeals are taken into account, disputes can continue on seemingly without end.

Public Relations: Beyond the substantive hurdles associated with litigating disputes, there is also the problem of public perception. Lawsuits, particularly suits where users are making incendiary allegations, can turn off users and destroy a company’s momentum. In a similar vein, pending litigation may also turn off investors who may not be willing to associate themselves with a company that has experienced a loss of reputation in the public eye. This sort of damage is incredibly difficult to recover from, even if the company ultimately prevails in handling its dispute.

Arbitration: While some of the issues associated with litigation are unavoidable (disputes with users will always entail a loss of time and money), arbitration presents an alternative that can in many ways mitigate these downsides.

Forum Certainty: An arbitration policy typically identifies not only the particular arbitration company that will be administering the arbitration, but also the location where disputes will be settled.

Reduced Cost: While there is no clear consensus as to whether or not arbitration is cheaper than litigation, there are reasons to think that arbitration can cut costs. While both litigation and arbitration require the use of an attorney, arbitration offers more flexible procedures than courts, so there may be reduced costs associated with motions and discovery. Additionally, where the parties have agreed to “final and binding” arbitration, the costs associated with the appeals process are eliminated.

Increased Efficiency: In addition to being cheaper, arbitration also generally provides for a quicker resolution of disputes than litigation. Additionally, arbitration policies can be crafted to eliminate appeals, further shortening the dispute resolution process.

Confidentiality: While filings and court orders in litigation automatically become part of the public record, arbitration allows for much of the dispute resolution process to occur outside of the public eye. One reason for this is that arbitration companies are private entities and are thus not subject to the same disclosure requirements as their government counterparts. Another is that arbitration provisions may explicitly require parties to agree that dispute resolution in arbitration will be confidential. The consequence of this heightened confidentiality is that the dispute resolution process has much less of a prejudicial effect on the company’s reputation and, by extension, its prospects of obtaining venture financing.

In light of these points, a dispute resolution policy centered around arbitration should be given strong consideration by most early-stage ventures. However, even if an arbitration provision proves to be the appropriate choice for a particular startup, its founders would be wise to consult an experienced startup attorney to handle its drafting, as they are complex provisions and, in light of the Supreme Court’s 2011 decision in AT&T Mobility v. Concepcion, they need to be drafted very carefully to ensure that they are fair and enforceable.

By

The Perils of Contracting Through Third Party Websites

MichelleSargentBlogPicThe internet has a wealth of resources for start-ups, from legal and venture financing blogs to form documents and state entity-formation pages. There are also many pitfalls to leveraging the internet that unknowing and uncounseled start-ups may not identify. One of these is the use of third-party websites to enter agreements.

For example, a start-up wants to use a contractor to develop some code for their mobile application. The start-up finds a website that allows parties to post a project that needs completing and has users make bids to win the project. (There are many such, or similar, websites, such as Freelancer.com, Elance.com, and Guru.com.) The start-up posts its project, and an unknown individual somewhere in the internet world is contracted to complete it.

On its face, this is an easy and low-cost way of finding work for hire. But what may the start-up not consider: Is its intellectual property protected? Is any intellectual property created by the worker assigned to the start-up? What happens if there is a dispute about the completion or quality of the work? What is the worker’s classification for employment and tax purposes?

1.  Worker Classification

Any time a company wants to bring in somebody to do some kind of work for the company, the company must address how to properly categorize the worker for employment and tax purposes. As this blog has previously discussed, in a January 31, 2013 posting by Tasha Francis on Hiring Tips for First Time Entrepreneurs, there are important ramifications to getting the classification correct. And the correct classification may not be the one that matches the start-up’s financial capabilities or expectations. In using third-party websites to locate workers, the classification problem is magnified because (1) there may be no explicit agreement or provision stating how the worker is classified, and (2) it is possible the website loosely uses terms such as “employer” and “employee”—even when categorizing independent contractor relationships.

The purpose of these websites is to allow companies to hire remote, unknown individuals who specifically market and offer their services through the website to perform a specific project, on a specific time schedule, for a specific fee. This seems to create a quintessential independent contractor relationship. Many of these websites’ terms of service, however, explicitly refer to the company seeking services as the “Employer.” And the generic terms of service may not describe the nature of the relationship between the two parties contracting for work—unless the parties independently choose to enter into a separate independent contractor services agreement (the terms of which may not conflict with any terms in the terms of service). Although a start-up may ultimately be protected by the actual nature of its relationship with these electronically engaged workers, the terminology and lack of a defined relationship is just one of many ways relying on a third party may undermine the company’s legal rights and relationships.

2.      Intellectual Property

For many emerging companies, their intellectual property is the company’s main—and potentially only—valuable asset. And seeking to protect this IP is often one of the first steps taken by lawyers representing start-ups. Yet, when an uncounseled start-up engages through a third-party website, it is highly unlikely any of the typical IP assignment or proprietary information protections are contained in the default terms of the relationship.

Now we will return to the company that retains a contractor to develop a mobile application. On the one hand, the company must send proprietary information to the contractor describing its business, what its vision is for the mobile application, specifics for its user interface, the types of users it envisages, etc. Without any nondisclosure agreement, this proprietary information will not be protected from the contractor disclosing it to other parties, or developing the information in third-party products. On the other hand, the contractor will be writing code and developing an interface that will be an integral part of the company’s platform and business plan. But without any intellectual property assignment provision, any copyright and other intellectual property in the work performed by the contractor will not belong to the company. Although it may seem distant to the start-up now, any outstanding, unassigned intellectual property gives individuals a future opportunity to come back and seek something from the company.

It is highly unlikely that a third-party website will contain default provisions sufficient to protect existing company IP or to assign any contractor-created IP. On the contrary, many of these websites include express disclaimers that they are merely acting as a portal and are not subject to liability for any claims under any IP laws. It does not, however, include any IP assignment language from contractors to users, or any default nondisclosure provisions. Therefore, unless a start-up independently identifies the need to draft a separate and independent agreement assigning any IP and protecting the confidentiality of any of its proprietary information, it leaves potential holes in its IP protections.

3.      Dispute Resolution

So what if the relationship created on this third-party website goes wrong, what can a start-up do? Here, there are two main considerations: Does the third-party website impose any dispute resolution conditions on users? And should litigation arise, where would it take place?

A brief survey of the terms of service of several of these third-party websites reveals the existence of mandatory dispute resolution or arbitration provisions. What do these mean? Say the start-up is unsatisfied with the quality of the work performed by a contractor and wants to renegotiate the rate it has agreed to pay for the services based on the poor quality: First, the parties may be required to attempt to independently negotiate and resolve any disputes. They may also, however, be prevented from renegotiating the fee for a project after it has begun. Therefore, the parties would be required to submit the dispute to the third-party website, which may grant itself the full power to resolve the dispute, including the determination of the documents that can be submitted in support of the dispute. Alternatively, the parties may be required to submit to arbitration in which the third-party website selects an arbitration team that makes a binding, irreversible decision on the dispute. In many of the terms of service for these websites, there are no express provisions providing for litigation between users. And insofar as the purpose of the website is to bring together individuals globally to provide services, there is the distinct potential that contractors may be judgment-proof—either geographically isolated or financially unable to be hailed to court in a foreign country to face charges for breach of contract or copyright infringement.

And what if the start-up wants to raise a dispute with the third-party website? There are the obvious broad disclaimers of all kinds of warranties, limitations of liability, and indemnification requirements. But the terms and conditions can also establish that the agreement is subject to foreign law with irrevocable and exclusive jurisdiction in foreign courts. For uncounseled start-ups, the potential pitfalls of being unable to dispute a contract—because litigating abroad is unfeasible—were probably never considered.

These provisions and examples reveal the unforeseen liabilities of entering into agreements through third-party websites. Even for start-ups that may benefit from legal advice in order to draft separate agreements dealing with IP and worker-classification issues, it is likely that the third-party website’s terms and conditions will seek to limit the effect of these agreements to the extent they may be inconsistent with the website’s terms and conditions. And so even extra-website attempts to contractually change dispute resolution procedures may be ineffective. Nonetheless, there are differences in the terms of service across these websites, with some providing for more default, start-up friendly provisions or options to protect IP, classify workers, or dispute services, and at the very least, start-ups may want to consider digging deeper before selecting a third-party service.