The civil litigation system itself represents a significant risk factor and exposure to liability. Therefore, it is important that small business owners employ the various strategies that allow them to control the risk factors in litigation.
The cost of litigation can be extreme. Due to the lack of a loser pays system, these costs can force defendants to pay settlements for unjustified claims or plaintiffs to forego legitimate claims.
Litigation in a foreign jurisdiction (i.e., a different state) can only make these costs more expensive, exacerbating these problems. Travel and hotel costs, time lost from work, and the difficulty of finding an attorney in a different state can cause a party to forfeit making a claim or defending against a claim.
A choice of law clause can eliminate these possibilities because it controls two issues: the choice of the state in which the action must be filed and the choice of which state's laws will be applied.
A choice of law clause is especially appropriate when parties reside in two different states. Usually, the clause would specify the state in which the action must be filed and designate that this state's laws also will govern the dispute. The small business owner should use a choice of law clause in purchase agreements with out-of-state vendors or in sales agreements with out-of-state consumers. Here, the clause normally would specify that disputes must be brought in the state in which the small business owner operates, and that this state's laws would apply in the case. Note, too, that the choice of law clause should apply not only to actual court actions, but mediation and arbitration actions as well.
The courts do not always uphold choices of law clauses. There must be sufficient connections to a state for the state to have authority to decide the case or for its laws to apply in a case. If a small business owner designates the state in which he operates, this should not be a real issue. However, when a party or an action has sufficient connections to more than one state, the courts may reject the clause and allow an action in the other state, or apply the other state's laws. When a small business owner confines his activities to a single state, this too should not represent a significant issue.
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Warning
The small business owner should be aware that it is common for franchise agreements to provide that any disputes between the franchisee and franchisor must be brought in the franchisor's home state, and that this state's laws will govern the dispute. This may be a serious problem to a franchisee who would like to sue the franchisor, especially because the franchisor may be located in many states and far from the franchise. A potential franchisee should demand that this clause be changed to allow the franchisee to file an action in the state in which he will operate the franchise.
As is true with contract negotiations, in general, nothing can compel the franchisor to accept this demand. If the franchisor refuses to change the clause, the franchisee must consider assuming the risks of signing the agreement with the existing clause or simply moving on to a different opportunity.
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Finally, it may be desirable to designate that the action must be filed in one state, but that a different state's laws will govern the agreement. For example, owners who will operate their limited liability company (LLC) in Connecticut may form the LLC in Delaware to take advantage of Delaware's favorable LLC statute.
An operating agreement for a business entity, such as an LLC, should always have a choice of law clause. In this situation, the operating agreement may specify that any litigation among the owners must take place in Connecticut, but that Delaware law will control the agreement, the relationships between the parties and the internal operations of the entity. In this way, the litigation will take place in a convenient forum, but a more desirable set of laws will govern the outcome.