CEO Adviser: Are You Protected?

Nearly two of three Seattle area companies with online services that received venture capital funding in the past year have a big kick me sign on their backs when it comes to class-action risks. Only one in nine have written clauses in their terms of service to protect against these risks in a form with a decent chance of being upheld nationwide.

I recently did an informal survey of a database with every Seattle area private company that completed a venture funding round in the past year not brand-new startups but the group of companies gaining enough traction to attract seven-digit investments from VCs. Of this group, 27 had online services with posted terms for consumers. Of those, only 10 made any attempt to require arbitration of disputes. In my opinion, only three of 27 just one in nine had arbitration clauses with class-action waivers that had a chance of being upheld in tough jurisdictions like California.

When I worked in-house as a general counsel, I defended companies in many lawsuits, including a consumer class action that had one striking attribute: The settlement had virtually nothing to do with the merits of the case. It was simply about the plaintiffs attorneys finding ways to justify to the court the huge payday they would extract from filing the complaint and defending early motions. Plaintiffs lawyers dont have to have a winning case to extract millions of dollars in settlement; they just have to bring a case to court at the far end of plausible so it cant be dismissed quickly.

If they can achieve that goal, then they find themselves in the same position as patent trolls. A company has to pay far more to go to trial and prove it is innocent than to just settle the case. I realize that good can come from some class actions, but many do little more than line the pockets of class-action lawyers, while consumers receive so little it is not uncommon to have less than 1 percent of the class even bother to submit a claim.

In-house, I was determined to find a way to avoid this experience again, and soon it became clear that there was one effective tool to thwart abusive class actions: binding terms of service with arbitration clauses that had valid class-action waivers. This is not as simple as copying and pasting a couple of paragraphs from another sample. But if done correctly, it allows any consumer with a grievance to have a fair and affordable way to seek relief, and also prevents plaintiffs lawyers from turning a small claim into a multimillion-dollar extraction effort with little or no benefit to consumers.

Is it enough to use a contract provision that works in your state? Well, are your customers all local? Or do you have online customers from California? That is the jurisdiction to worry about. Historically, California courts in particular have been hostile toward the use of these clauses to prevent consumers from bringing class actions in California courts, even if the terms of service called for venue in another state and required individual arbitration. For decades, federal courts, including the U.S. Supreme Court, have overruled California courts on the application of the Federal Arbitration Act in an effort to bring the California system under control. While appeals continue even into this next term of the U.S. Supreme Court (see Direct TV Inc. v. Imburgia, Docket No. 14-462), Californias rules are slowly becoming more predictable and reliable.

For companies advertising and offering online services, there is virtually nothing to lose and everything to gain by using a well-crafted program for handling consumer complaints fairly through arbitration and valid waivers of class actions. Dont be one of the eight in nine who hasnt addressed this adequately. If you wait until you have the problem, it is too late.

Greg Wrenn, a veteran Silicon Valley general counsel, recently returned to his native Washington as a partner at Paradigm Counsel. He has 25 years of experience as a corporate and technology transactions attorney. Reach him at [email protected].