It's a big enough shock to entrepreneurs when a business contract "goes bad" or a customer refuses to pay. But it's a much bigger shock when business owners learn that in most cases, they have to dig into their own pockets to pay their legal fees when they go to court.
The reason for this seemingly unfair trap is something called "the American Rule." In its simplest form, the rule states that in the United States, each side to a civil lawsuit is only obligated to pay the cost of their own attorney. The result is that even if you win your lawsuit or collection case, you may never come out "whole" from a financial standpoint. That's because any recovery you may obtain in court will be reduced by the amount you have to spend to cover your legal fees.
Oh, but wait, you may say, I'll just have my lawyer handle my collection case on a contingent-fee basis (which means your lawyer will receive no fee unless there's a recovery obtained). Good thinking, but even that won't make you whole. Assuming you're able to find a lawyer who'll take your case on a contingent basis, the contingent fee is typically based on a percentage--anywhere from 15 to even 50 percent--of the recovery. So for every dollar your lawyer collects, you'll still only receive a net amount of anywhere from 50 to 85 cents.
The good news is, there's a way to legally reverse the American Rule in many instances, and that's through adding a "legal fees clause" to all your business contracts. A legal fees clause requires that the court award the payment of legal fees if a contractual dispute or collection matter ends up in court.
There are at least two "typical" legal fees clauses that every business owner should be aware of:
Legal Fees Clause #1: the "Customer Pays Legal Fees" clause. The first version of the legal fees clause can read something like this:
"If the Customer breaches or attempts to breach any of the terms of this Contract or fails to make any payments when due under this Contract, the Customer shall pay to Company as part of a judgment all of the Company's costs and expenses, including reasonable legal fees, incurred by the Company in enforcing the terms of this Contract or collecting any payment due under this Contract."
If this Clause sound pretty one-sided, you're right. It is one-sided.
But this type of legal fees clause can be very common in contracts and agreements with banks, insurance companies and credit card companies. In other words, if one party, such as a bank, has a very high leverage position and won't permit any changes to their "standard agreements," then it's certainly possible this type of one-sided clause will be in the contract.
Legal Fees Clause #2: the "Loser Pays Legal Fees" clause. Fear not. You don't have to be a behemoth bank in order to add a legal fees clause to your contracts. There's a more equitable and practical clause that can read something like this:
"If either party to this Contract breaches or attempts to breach any of the terms hereof or if either party fails to make any payments when due under this Contract, that party shall pay to the non-defaulting party as part of a judgment all of the non-defaulting party's costs and expenses, including reasonable legal fees, incurred by that party in enforcing the terms of this Agreement or collecting any payment due under this Contract."
In other words, the losing party to the contract will not only be required to pay for any damages under the contract, it will be required to pay the other side's legal fees as well.
By the way, the key to making the "Loser Pays Legal Fees" clause effective for your business is to be sure your company isn't the losing party!
Benefits And Caveats
As you can see, there are many advantages to adding a legal fees clause to your contracts. It gives you the opportunity to be made financially whole if you have to go to court to enforce a contract or to collect money. It also gives the other side more incentive to pay or to negotiate a fair settlement rather than go to court. Finally, it may help inoculate your business from the disease of "lawsuitphobia" which can strike a business when it believes that it will cost more to go to court than it's worth.
As in all things involving the law, there are a few thorns among the roses that you need to aware of in the area of legal fees clauses.
Not all states under all circumstances will allow your contract to defeat the American Rule, so you'll need to check with a lawyer in your state for advice. Another point to keep in mind is that courts often require that the amount of the legal fees be "reasonable," which can mean that the court could award your business less money than you actually spent on your legal fees.
Finally, and perhaps most important, please remember that while having a legal fees clause in your business contracts can be very beneficial, it's no substitute for using good business judgment when negotiating an agreement or extending credit to a customer. If you find out that the other party or customer doesn't have any money or assets, then having one more turbocharged clause in your contract won't put a single penny in your bank account.
Chris Kelleher is an award-winning small-business advisor and attorney. He's also a sought-after speaker and the founder and resident legal guru of The Law Firm For Businesses, a boutique law firm that helps business owners creatively solve their business and legal problems.