On Alternative Dispute Resolution for Family Business Owners

Family business owners should consider adopting alternative dispute resolution (“ADR”) requirements in all of their family agreements, including their companies’ governing documents, owner agreements, insider contracts, and even trust agreements.  When a family member brings a legal claim against other family members, the family business, or affiliated fiduciaries (such as directors, officers, managers, and trustees), ADR can provide a better net result for the family and the business than conventional litigation.

What is “alternative dispute resolution?”

The term “alternative dispute resolution” (and especially when referred to as “ADR”) means mediation and arbitration.  These are “alternatives” to litigation in state or federal courts.  A mediation clause can require that the parties to engage in mediation before they resort to litigation, and, an arbitration clause can require the parties to engage in binding arbitration instead of litigation.

What is mediation?

Mediation is a process under which a neutral individual, called a mediator, helps the parties negotiate the settlement of a legal dispute. The mediator can be an independent individual who has expertise with respect to the subject matter of the dispute, or the mediator can be an advisor or family friend who is trusted by all the parties. Some lawyers and judges are trained to serve as mediators.

Mediation is an attempt to reach an agreement among the parties, through negotiation and compromise. The result can be consistent with legal theory, but it does not need to be. For example, a mediation settlement may involve a compromise that is more tax efficient for the parties than the actual terms of the contract or transaction that is in dispute. Mediation can lead to a “win-win” result, under which each party achieves his or her most important objective in the dispute.  In contrast, litigation (and arbitration) can lead to a “winner takes all” result that can leaves one side or the other damaged and bitter.

Mediation can be private, unlike litigation, and the parties can ensure confidentiality by signing a nondisclosure agreement.  This can be important in the context of a family business, because public clashes among family members can harm the family’s legacy or the business’s reputation.

Mediation, however, resolves the dispute only if the parties reach an agreement voluntarily.  The mediator has no power to decide the dispute or compel a resolution.  If the parties do not sign a binding settlement agreement, they usually retain their legal rights to seek a contested result either in arbitration or the courts.  (A “med-arb” clause in a contract provides that if mediation fails, then the parties must proceed to binding arbitration, rather than pursuing their claims in court.)

What is arbitration?

Arbitration is a process under which the parties in dispute present their legal positions and evidence to an arbitrator or a panel of (usually three) arbitrators for a binding decision based on an application of the law to the facts.  Arbitration does not result in a compromise; it usually results in a decision that the arbitrator or panel determines is required as a matter of law.  Usually, a party cannot appeal an arbitrator’s decision, in the absence of fraud or arbitrator misconduct.

Although arbitration involves contested proceedings, it has several advantages over traditional litigation, especially for a family business.  Like mediation, arbitration can be a private process and thus can be less harmful to the family’s legacy and the business’s reputation.

Further, the parties can select an arbitrator who specializes in the subject matter of the dispute, such as contract law or trust law.  In contrast, the decision makers in litigation may be jurors or judges who have no relevant knowledge or experience.

Arbitration is generally less expensive to conduct than a jury trial, and arbitration usually avoids the expense of the appeals process. Also, an arbitration clause can require the losing party to pay the winning party’s attorneys’ fees or can empower the arbitrator to allocate payment of attorneys’ fees in an equitable manner.  Such fee-shifting provisions can discourage parties from making weak or frivolous claims and can encourage both parties to attempt to settle the matter in mediation. (In contrast, the winning party in conventional litigation almost always has to pay his or her own attorneys’ fees.)

Are there other alternatives?

Methods of resolving disputes without litigation can include other mechanisms that apply to specific issues, but often, like mediation, they need arbitration as a backstop.

For example, many buy-sell agreements include clauses that define stock price as the price determined by a business valuation professional, which will be binding on the parties.  (Courts sometimes construe this as an arbitration provision.)  Similarly, company bylaws or operating agreements can provide for family-member compensation to be determined by a committee of independent directors.

In the estate planning context, a trust can include a penalty clause (also referred to as an “in terrorem” clause), which reduces or eliminates a beneficiary’s interest if he or she contests how the trust is drafted or administered. Sometimes this can be a means to force a beneficiary into a med-arb process, to keep trust contests out of court.

What is the action item?

For the reasons described above, it is usually beneficial to family businesses and their owners to include med-arb provisions in all agreements and legal documents that involve the rights or interests of family members, and to make sure that those provisions are properly drafted to be enforceable and final.  This includes the company’s governing documents, owners agreements (such as voting agreements or buy-sell agreements), contracts among family members for goods or services (including leases, consulting agreements, or even employment agreements), and, as mentioned above, estate planning instruments.

Enforcement of arbitration agreements are often controlled by state law, and they should be drafted and reviewed carefully—not as boiler plate. For example, the language should be specific about whether enforcement of the arbitration clause is itself subject to arbitration.  Also, arbitration clauses in employment agreements are mostly disfavored under the law, so they may require special procedures to ensure that they will be enforced.

Family business owners should review the agreements described above and determine whether they include ADR provisions.  If an agreement does not, they should confer with their attorney about whether an ADR provision would be desirable.

Gregory Monday