By Carolyn Hochstadter
Question: Is it advisable and legally viable for a start-up to use arbitration clauses as a risk-mitigation tool?
How to Implement this Tool: A start-up company can easily include an “arbitration clause” in any relevant contract. This provision typically requires the parties to bring any disputes related to the contract exclusively before an arbitration tribunal and correspondingly requires the parties to waive their rights to bring this dispute in a court of law. A corollary right that is thereby waived is the ability to bring a class action, because it can be brought only in a court of law. A specific arbitrator may be designated, or a process for choosing one may be provided in the contract. Further details may be specified.
Is it legal? This topic has been percolating for over a year and the subject of much media attention. The courts are split on whether such clauses are or should be valid. The Consumer Financial Protection Bureau has been drafting rules to prohibit the use of such clauses. Disruptive industry leaders such as Airbnb and Uber continue to use them, touting their efficacy in pre-empting frivolous mass litigation. Proponents of the class action tool emphasize its key role in providing most workers and end-users with the only affordable and feasible tool for redress.
What is the issue? It is the U.S. constitutional precept that a person cannot be deprived of life, liberty or property without due process of law. Prior to losing any legal rights, a person must be provided notice of, and the opportunity to seek, redress before a court of law under the relevant judicial, executive or administrative branch of government. An arbitration tribunal is not such a court of law. Moreover, decisions made by the Arbitrator are “final,” meaning that they are generally not appealable within a court of law. These decisions preclude any further redress.
How can arbitration clauses be constitutional? Generally, as long as proper notice of a party’s rights to be heard in a court of law is provided by the contract, a party may voluntarily give up any of those rights in that contract. Therefore, to be valid, an arbitration clause must provide clear notice of the exclusive choice made by the parties of the arbitration resolution mode, and the waiver of a right to a jury or bench trial. The parties to a contract create their own law that governs the transaction. This is enforceable in a court of law if it is legally valid. (Note that a contract with illegal provisions may be drafted. This will become an issue only in the event that the contract is disputed and brought before a tribunal for resolution.)
If arbitration clauses are valid, how can they be voided? Equity principles of contract law come into play. One party may be weaker and have no bargaining power. That party is therefore arguably forced to sign the contract with no ability to negotiate a fair deal. This is known as an adhesion contract, which is considered illegal and therefore can be voided by a court.
Correspondingly, if there is an ambiguity in a contract, a court must interpret the contract in favor of the weaker party that did not draft the contract. This is known as “construing the contract against its drafter”.
The law presumes that the stronger party with leverage who drafted the contract had the opportunity to include language beneficial to itself. Therefore, a court is required to rule in favor of the weaker party who did not have input.
Drafting Tip: In order to be enforceable, an arbitration clause must clearly spell out its terms, and provide for a valid substitute arbitrator. For example, the NAF – the National Arbitration Forum – a previously popular choice for arbitrator, is no longer a viable one under the law.
Follow-up questions:
Below are links to some articles that touch on these questions and concepts.
Please feel free to reach out at [email protected]
Carolyn Hochstadter is a Lecturer in Wharton’s Legal Studies and Business Ethics Department. She teaches LGST 213 -- the Legal Aspects of Entrepreneurship (offered in the Spring).
Question: Is it advisable and legally viable for a start-up to use arbitration clauses as a risk-mitigation tool?
How to Implement this Tool: A start-up company can easily include an “arbitration clause” in any relevant contract. This provision typically requires the parties to bring any disputes related to the contract exclusively before an arbitration tribunal and correspondingly requires the parties to waive their rights to bring this dispute in a court of law. A corollary right that is thereby waived is the ability to bring a class action, because it can be brought only in a court of law. A specific arbitrator may be designated, or a process for choosing one may be provided in the contract. Further details may be specified.
Is it legal? This topic has been percolating for over a year and the subject of much media attention. The courts are split on whether such clauses are or should be valid. The Consumer Financial Protection Bureau has been drafting rules to prohibit the use of such clauses. Disruptive industry leaders such as Airbnb and Uber continue to use them, touting their efficacy in pre-empting frivolous mass litigation. Proponents of the class action tool emphasize its key role in providing most workers and end-users with the only affordable and feasible tool for redress.
What is the issue? It is the U.S. constitutional precept that a person cannot be deprived of life, liberty or property without due process of law. Prior to losing any legal rights, a person must be provided notice of, and the opportunity to seek, redress before a court of law under the relevant judicial, executive or administrative branch of government. An arbitration tribunal is not such a court of law. Moreover, decisions made by the Arbitrator are “final,” meaning that they are generally not appealable within a court of law. These decisions preclude any further redress.
How can arbitration clauses be constitutional? Generally, as long as proper notice of a party’s rights to be heard in a court of law is provided by the contract, a party may voluntarily give up any of those rights in that contract. Therefore, to be valid, an arbitration clause must provide clear notice of the exclusive choice made by the parties of the arbitration resolution mode, and the waiver of a right to a jury or bench trial. The parties to a contract create their own law that governs the transaction. This is enforceable in a court of law if it is legally valid. (Note that a contract with illegal provisions may be drafted. This will become an issue only in the event that the contract is disputed and brought before a tribunal for resolution.)
If arbitration clauses are valid, how can they be voided? Equity principles of contract law come into play. One party may be weaker and have no bargaining power. That party is therefore arguably forced to sign the contract with no ability to negotiate a fair deal. This is known as an adhesion contract, which is considered illegal and therefore can be voided by a court.
Correspondingly, if there is an ambiguity in a contract, a court must interpret the contract in favor of the weaker party that did not draft the contract. This is known as “construing the contract against its drafter”.
The law presumes that the stronger party with leverage who drafted the contract had the opportunity to include language beneficial to itself. Therefore, a court is required to rule in favor of the weaker party who did not have input.
Drafting Tip: In order to be enforceable, an arbitration clause must clearly spell out its terms, and provide for a valid substitute arbitrator. For example, the NAF – the National Arbitration Forum – a previously popular choice for arbitrator, is no longer a viable one under the law.
Follow-up questions:
- Do you support arbitration clauses that exclude any ability to bring action in court, including class actions?
- Can you propose a solution to any of the problems raised by both sides in the controversy that might preserve the weaker party’s rights, while protecting the other party from frivolous class actions?
Below are links to some articles that touch on these questions and concepts.
- http://www.nytimes.com/2016/11/02/technology/federal-judge-blocks-racial-discrimination-suit-against-airbnb.html?_r=0
- http://www.seattletimes.com/business/uber-tries-to-limit-size-in-class-action-lawsuits-with-new-driver-contract/
- http://www.bna.com/banks-may-face-n73014446986/
- http://www.nytimes.com/2015/11/01/business/dealbook/arbitration-everywhere-stacking-the-deck-of-justice.html
- https://library.nclc.org/latest-actions-limit-forced-arbitration
Please feel free to reach out at [email protected]
Carolyn Hochstadter is a Lecturer in Wharton’s Legal Studies and Business Ethics Department. She teaches LGST 213 -- the Legal Aspects of Entrepreneurship (offered in the Spring).
“The Most Knowledgeable Branch”
Summary by Daniel Romeu
Contemporary governments are now often faced with policy questions that have no easy solution and require significant technical information to properly answer. More than ever, policymakers rely on “experts” to provide analysis on important issues, and governments worldwide have never valued information more highly. If this is taken to be true and characteristic of the future, then one might wonder how well-adapted our current policymaking institutions are to the changing nature of government decision making. Cass Sunstein argues that the executive branch, in comparison with the legislature and judiciary, benefits from superior information gathering capabilities, expertise, and scale.
Sunstein holds that, since the judicial branch is a passive institution by constitutional design, judges and juries have almost zero ability to gather information on their own and are reliant legal briefs and arguments, which are both crafted by attorneys to present highly subjective and biased accounts.
Next, Sunstein admits that Congress does have the power to gather information through the hearing process. However, he goes on to explain that members of Congress are generalists who must spread their attention to a large number of issues. Additionally, legislators are exposed to what Sunstein calls 'electoral pressures' which result in a political lack of motivation to go through the cumbersome process of gathering highly specialized relevant information.
Sunstein then contrasts the executive branch from the aforementioned branches. The author sets great store by the “immense stock of knowledge” that is represented by the thousands of career civil servants that form the bureaucracy of the executive branch. He suggests that employees of a regulatory agency are more qualified in their respective fields than a member of Congress could ever hope to be.
One might reasonably assume that Sunstein would now go on to advocate for the dismantling of the legislature and judiciary. Instead, he still favors the current, three-tiered system. In particular, he mentions the way that ex-post judicial review can serve as a valuable check on the constitutionality of regulatory action and how a Congress, composed of politicians from both parties, can reduce the polarization of a one-party executive branch.
Full link to the article can be found at:
http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=9547&context=penn_law_review
Contemporary governments are now often faced with policy questions that have no easy solution and require significant technical information to properly answer. More than ever, policymakers rely on “experts” to provide analysis on important issues, and governments worldwide have never valued information more highly. If this is taken to be true and characteristic of the future, then one might wonder how well-adapted our current policymaking institutions are to the changing nature of government decision making. Cass Sunstein argues that the executive branch, in comparison with the legislature and judiciary, benefits from superior information gathering capabilities, expertise, and scale.
Sunstein holds that, since the judicial branch is a passive institution by constitutional design, judges and juries have almost zero ability to gather information on their own and are reliant legal briefs and arguments, which are both crafted by attorneys to present highly subjective and biased accounts.
Next, Sunstein admits that Congress does have the power to gather information through the hearing process. However, he goes on to explain that members of Congress are generalists who must spread their attention to a large number of issues. Additionally, legislators are exposed to what Sunstein calls 'electoral pressures' which result in a political lack of motivation to go through the cumbersome process of gathering highly specialized relevant information.
Sunstein then contrasts the executive branch from the aforementioned branches. The author sets great store by the “immense stock of knowledge” that is represented by the thousands of career civil servants that form the bureaucracy of the executive branch. He suggests that employees of a regulatory agency are more qualified in their respective fields than a member of Congress could ever hope to be.
One might reasonably assume that Sunstein would now go on to advocate for the dismantling of the legislature and judiciary. Instead, he still favors the current, three-tiered system. In particular, he mentions the way that ex-post judicial review can serve as a valuable check on the constitutionality of regulatory action and how a Congress, composed of politicians from both parties, can reduce the polarization of a one-party executive branch.
Full link to the article can be found at:
http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=9547&context=penn_law_review
“Creating a Fair Tax System”
Summary by Amrajan Aujla
In Economics Makes Strange Bedfellows: Pensions, Trusts, and Hedge Fund in an Era of Financial Re-intermediation, J.W. Verret discusses how government regulations have systematically altered the actions of pensions and trusts. In the old format, these firms would invest in a multitude of companies in different industries in order to fulfill the diversity requirement the government had stipulated, leading to small returns for the vast majority of funds.
In the new world order, however, these institutions have redefined themselves so as to accommodate the government’s laws and regulations, now investing in other financial intermediaries, primarily hedge funds, to make their returns. This not only allows these pensions and trusts to meet their diversification quota by investing in hedge firms in multiple industries and sectors, but also reduces their risk. This process has been aided by the changing political landscape, as the section of the Gramm-Leach-Bliley Act that previously disallowed these institutions from using investor money to pay fees to corporate managers has now been amended.
Verret discusses the many potential moral and legal issues of this system, with the overarching theme revolving around dilemmas over conflict of interest. One interesting example used is the possible exploitation of the disconnect between Congress and the Federal Reserve. Verret explains how the financial intermediaries, now having major financial capital behind them, might use some of it to try to lobby Congress to pass statutes granting exemption to certain activities that the Federal Reserve had regulated and restricted.
Ultimately, Verret lists out five policy recommendations that he sees creating value in the financial system and for those who have their money invested in it. Ranging from amending the Employee Retirement Income Security Act of 1974 (ERISA) to creating regulatory boards to monitor the interactions of these different financial intermediaries, these policies try to uphold the integrity of this practice, which, ultimately, ensure that investors maintain their trust in the financial system.
Full link to the article can be found at: http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1294&context=jbl
In Economics Makes Strange Bedfellows: Pensions, Trusts, and Hedge Fund in an Era of Financial Re-intermediation, J.W. Verret discusses how government regulations have systematically altered the actions of pensions and trusts. In the old format, these firms would invest in a multitude of companies in different industries in order to fulfill the diversity requirement the government had stipulated, leading to small returns for the vast majority of funds.
In the new world order, however, these institutions have redefined themselves so as to accommodate the government’s laws and regulations, now investing in other financial intermediaries, primarily hedge funds, to make their returns. This not only allows these pensions and trusts to meet their diversification quota by investing in hedge firms in multiple industries and sectors, but also reduces their risk. This process has been aided by the changing political landscape, as the section of the Gramm-Leach-Bliley Act that previously disallowed these institutions from using investor money to pay fees to corporate managers has now been amended.
Verret discusses the many potential moral and legal issues of this system, with the overarching theme revolving around dilemmas over conflict of interest. One interesting example used is the possible exploitation of the disconnect between Congress and the Federal Reserve. Verret explains how the financial intermediaries, now having major financial capital behind them, might use some of it to try to lobby Congress to pass statutes granting exemption to certain activities that the Federal Reserve had regulated and restricted.
Ultimately, Verret lists out five policy recommendations that he sees creating value in the financial system and for those who have their money invested in it. Ranging from amending the Employee Retirement Income Security Act of 1974 (ERISA) to creating regulatory boards to monitor the interactions of these different financial intermediaries, these policies try to uphold the integrity of this practice, which, ultimately, ensure that investors maintain their trust in the financial system.
Full link to the article can be found at: http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1294&context=jbl
“MANIPULATIVE GAMES OF GIFTS BY CORPORATE EXECUTIVES”
Summary by Daniel Romeu
Governments can encourage charitable giving by providing tax deductions on donations to nonprofits. By and large, this does substantial good in providing sorely needed funds to charities all over the world. Unfortunately, Avci, Schipani, and Seyhun contend in "Manipulative Games of Gifts by Corporate Executives" that these well-intentioned laws are often commandeered by canny executives who use charitable giving as a legal way to avoid capital gains taxation and deduct earnings.
In the abstract, this does not necessarily present a conflict of interest as corporate managers are also salaried employees who have a right to maximize potential utility by avoiding taxation legally. However, executives hold powerful sway over the stock price of a company and are privy to important financial information before it becomes public knowledge. Avci and colleagues describe how large executive charitable contributions are often succeeded by a significant drop in the price of a company's stock. This suggests that corporate insiders might possibly be manipulating financial disclosures for personal benefit, a clear ethical violation.
The Sarbanes-Oxley Act of 2002 regulates many possible conflicts of interest such as insider trading that might arise from knowledge of sensitive information that has not yet been disclosed. Even so, the authors of the paper point out that charitable donations are exempt from these regulations and are thus regularly exploited as a loophole. In particular, the authors highlight two techniques of charitable giving that "raise securities law concerns": spring-loading and bullet-dodging. Spring-loading refers to the practice of releasing pertinent corporate information at a time that is personally advantageous. Bullet-dodging is the opposite, ensuring that potentially harmful information is released only after the donation, thereby maximizing the value of the donation and accompanying deduction.
The article also pinpoints areas of federal antitrust and anti-fraud law that these practices violate. So, the authors conclude that the tax code's current guidelines for charitable giving create an atmosphere conducive to unethical behavior. They conclude by recommending regulations that close loopholes such as anomalous contribution dating practices as well as creating oversight protocols that monitor stock price fluctuations around large charitable donations.
Full link to the article can be found at:
http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1522&context=jbl
Governments can encourage charitable giving by providing tax deductions on donations to nonprofits. By and large, this does substantial good in providing sorely needed funds to charities all over the world. Unfortunately, Avci, Schipani, and Seyhun contend in "Manipulative Games of Gifts by Corporate Executives" that these well-intentioned laws are often commandeered by canny executives who use charitable giving as a legal way to avoid capital gains taxation and deduct earnings.
In the abstract, this does not necessarily present a conflict of interest as corporate managers are also salaried employees who have a right to maximize potential utility by avoiding taxation legally. However, executives hold powerful sway over the stock price of a company and are privy to important financial information before it becomes public knowledge. Avci and colleagues describe how large executive charitable contributions are often succeeded by a significant drop in the price of a company's stock. This suggests that corporate insiders might possibly be manipulating financial disclosures for personal benefit, a clear ethical violation.
The Sarbanes-Oxley Act of 2002 regulates many possible conflicts of interest such as insider trading that might arise from knowledge of sensitive information that has not yet been disclosed. Even so, the authors of the paper point out that charitable donations are exempt from these regulations and are thus regularly exploited as a loophole. In particular, the authors highlight two techniques of charitable giving that "raise securities law concerns": spring-loading and bullet-dodging. Spring-loading refers to the practice of releasing pertinent corporate information at a time that is personally advantageous. Bullet-dodging is the opposite, ensuring that potentially harmful information is released only after the donation, thereby maximizing the value of the donation and accompanying deduction.
The article also pinpoints areas of federal antitrust and anti-fraud law that these practices violate. So, the authors conclude that the tax code's current guidelines for charitable giving create an atmosphere conducive to unethical behavior. They conclude by recommending regulations that close loopholes such as anomalous contribution dating practices as well as creating oversight protocols that monitor stock price fluctuations around large charitable donations.
Full link to the article can be found at:
http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1522&context=jbl
“ECONOMICS MAKES STRANGE BEDFELLOWS: PENSIONS, TRUSTS, AND HEDGE FUNDS IN AN ERA OF FINANCIAL RE-INTERMEDIATION”
Summary by Amrajan Aujla
In Economics Makes Strange Bedfellows: Pensions, Trusts, and Hedge Fund in an Era of Financial Re-intermediation, J.W. Verret discusses how government regulations have systematically altered the actions of pensions and trusts. In the old format, these firms would invest in a multitude of companies in different industries in order to fulfill the diversity requirement the government had stipulated, leading to small returns for the vast majority of funds.
In the new world order, however, these institutions have redefined themselves so as to accommodate the government’s laws and regulations, now investing in other financial intermediaries, primarily hedge funds, to make their returns. This not only allows these pensions and trusts to meet their diversification quota by investing in hedge firms in multiple industries and sectors, but also reduces their risk. This process has been aided by the changing political landscape, as the section of the Gramm-Leach-Bliley Act that previously disallowed these institutions from using investor money to pay fees to corporate managers has now been amended.
Verret discusses the many potential moral and legal issues of this system, with the overarching theme revolving around dilemmas over conflict of interest. One interesting example used is the possible exploitation of the disconnect between Congress and the Federal Reserve. Verret explains how the financial intermediaries, now having major financial capital behind them, might use some of it to try to lobby Congress to pass statutes granting exemption to certain activities that the Federal Reserve had regulated and restricted.
Ultimately, Verret lists out five policy recommendations that he sees creating value in the financial system and for those who have their money invested in it. Ranging from amending the Employee Retirement Income Security Act of 1974 (ERISA) to creating regulatory boards to monitor the interactions of these different financial intermediaries, these policies try to uphold the integrity of this practice, which, ultimately, ensure that investors maintain their trust in the financial system.
Full link to the article can be found at: http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1294&context=jbl
Found in the University of Pennsylvania Journal of Business Law, Fall 2007
In Economics Makes Strange Bedfellows: Pensions, Trusts, and Hedge Fund in an Era of Financial Re-intermediation, J.W. Verret discusses how government regulations have systematically altered the actions of pensions and trusts. In the old format, these firms would invest in a multitude of companies in different industries in order to fulfill the diversity requirement the government had stipulated, leading to small returns for the vast majority of funds.
In the new world order, however, these institutions have redefined themselves so as to accommodate the government’s laws and regulations, now investing in other financial intermediaries, primarily hedge funds, to make their returns. This not only allows these pensions and trusts to meet their diversification quota by investing in hedge firms in multiple industries and sectors, but also reduces their risk. This process has been aided by the changing political landscape, as the section of the Gramm-Leach-Bliley Act that previously disallowed these institutions from using investor money to pay fees to corporate managers has now been amended.
Verret discusses the many potential moral and legal issues of this system, with the overarching theme revolving around dilemmas over conflict of interest. One interesting example used is the possible exploitation of the disconnect between Congress and the Federal Reserve. Verret explains how the financial intermediaries, now having major financial capital behind them, might use some of it to try to lobby Congress to pass statutes granting exemption to certain activities that the Federal Reserve had regulated and restricted.
Ultimately, Verret lists out five policy recommendations that he sees creating value in the financial system and for those who have their money invested in it. Ranging from amending the Employee Retirement Income Security Act of 1974 (ERISA) to creating regulatory boards to monitor the interactions of these different financial intermediaries, these policies try to uphold the integrity of this practice, which, ultimately, ensure that investors maintain their trust in the financial system.
Full link to the article can be found at: http://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=1294&context=jbl
Found in the University of Pennsylvania Journal of Business Law, Fall 2007