Arbitration v. Litigation: Pros and Cons of Dispute Resolution

More than two centuries before Hamilton became Broadway’s most successful musical, Alexander Hamilton and his nemesis, Aaron Burr (sir), chose to resolve their disputes by dueling at dawn in Weehawken, New Jersey. This fateful duel, as we all know, mortally wounded Hamilton, one of our nation’s founders and greatest patriots. Fortunately, dueling long ago ceased to be used as a method to resolve disputes, but business partners today continue to have conflicts that require efficient resolution. This post reviews the two options that are available to resolve civil claims — arbitration and litigation — and considers the pros and cons from the perspective of both private company majority owners and minority investors. Neither fits all situations, but the choice could be outcome determinative in some cases, and it is therefore advisable for business partners to decide whether to resolve their future disputes in court or through an arbitration proceeding.

The most common agreement that business owners enter into with each other is a buy-sell agreement (BSA), although the company’s underlying governance documents (whether bylaws, an LLC agreement or LP agreement) will also include dispute resolution provisions. The BSA specifies how a majority owner can trigger the right to redeem the minority investor’s ownership interest in the company, and it also provides the means for the investor to secure a buyout of its minority interest. The specific provisions included in BSAs were discussed in a previous post. Before business partners decide to stick with litigation or choose to arbitrate their disputes under the BSA or company governance documents, they will benefit from considering the factors discussed below: (i) privacy or confidentiality, (ii) the scope of permitted discovery, and (iii) the speed to achieve final resolution and related cost.

The choice of the dispute resolution process is important because conflicts between business partners are common, and a protracted legal battle between co-owners can be very disruptive to the business. If the partners can select a process that enables them to resolve their internal disputes promptly and cost-effectively, they will be saving themselves both time and money, as well as preserving the value of their shared business.

Factor 1: Privacy and Confidentiality

• Majority Owner Perspective: Values Privacy

Arbitration proceedings are conducted in outside public purview, while all court filings and hearings, as well as trials in litigation, are generally open or available to the public. This is an important factor but may be seen differently by the partners. The majority owner most often desires to maintain privacy regarding the dispute, so the company’s competitors and customers do not become aware of internal disagreements. In addition, the majority owner will want to ensure that sensitive information about the company’s finances and operations are not available to the public. For this reason, the majority owner may want to resolve all disputes with other partners through a private arbitration process.

• Minority Investor Perspective: Publicity of Litigation May Provide Leverage

By contrast, although litigating claims may be far more expansive and drawn out than in arbitration, minority investors may decide that, for strategic reasons, they do not want to give the majority owner the opportunity to shield their disputes from the public. The minority investor may conclude that significant leverage can be gained in the parties’ later settlement negotiations if the majority owner has a strong desire to keep the minority owner’s claims and disputes away from public disclosure in litigation. 

Factor 2: Scope of Discovery

• Majority Owner Perspective: Prefers Limited Discovery

The majority owner wants a prompt resolution of the dispute and does not want to allow the minority investor to use discovery to conduct a fishing expedition into areas that might cause discomfort and be distracting for the business. If the minority investor suspects that the majority owner engaged in some type of self-dealing with the company, however, the investor will likely seek discovery about ways the owner benefitted financially from dealings with the company.

Discovery can be restricted in arbitration if the parties each agree to accept limits in the arbitration provision. In litigation, the minority investor is more likely to be permitted to conduct wide-ranging discovery. Thus, the scope of discovery (and the related expense) is generally much greater in litigation than in arbitration, and the restrictions may be even greater if specific limits on discovery are included in the arbitration provision. 

• Minority Investor Perspective: Broader Discovery Allows for a More Thorough Investigation of the Majority Owner’s Conduct and Financial Dealings

The minority investor may decide to require litigation as the dispute resolution method in order to ensure that sufficient discovery can be obtained to establish that the majority owner abused control over the company to obtain improper financial benefits. Litigation is the clear choice if the minority investor wants to be in a position to conduct thorough discovery regarding the majority owner’s conduct if a dispute between them later arises.

Given that litigation is so expensive, the minority investor may ultimately agree to accept arbitration to resolve disputes, but still include specific provisions in the BSA that will permit the investor to conduct the discovery necessary to ferret out fraud or other types of misconduct by the majority owner. For example, while it is common for arbitration provisions to limit the total number of depositions to just two or three and to restrict the number of document requests to 10 or 15, the minority investor may insist on obtaining a broader scope of discovery. In this regard, the investor may insist that the arbitration provision permit 30 or more document requests to be served, as well provide for the opportunity for each party to conduct five or six depositions. In this manner, the minority investor preserves the right to conduct enough discovery in the arbitration proceeding to be able to support future claims that are made against the majority owner.

Factor 3: Speed of Resolution and Cost

These final factors often provide the greatest consensus between the majority owner and the minority investor. Both parties typically want to resolve their disputes promptly and in a cost-effective manner. One variable, however, may be if the majority owner has substantially greater assets and the minority investor has limited resources. In this situation, the majority owner may believe the investor would be hard-pressed to engage in a drawn-out legal dispute, and the owner therefore may decide to select litigation as the dispute resolution mechanism. 

One important note here is that for the parties to achieve the prompt resolution they both desire, they need to specify in the arbitration provision that the final hearing will take place in a short timeframe, perhaps 90 days after all arbitrators have been selected. The arbitrators who are appointed will enforce this timetable in the contract, and it assures the parties that they will not become involved in a lengthy arbitration proceeding that drags on for months.

Conclusion

Business partners today can choose non-fatal ways to resolve their disputes. But before they select either litigation or arbitration as the dispute resolution process to include in a BSA or in the company’s governance documents, they need to consider how factors like privacy, the scope of permitted discovery. and the speed and expense of the resolution process may help them achieve their strategic goals. 

Majority owners who want to preserve confidentiality about the business and promptly resolve disputes with a minority investor are likely to conclude that arbitration proceedings meet their objectives. The selection of arbitration will avoid a long and public court battle that could expose the company’s sensitive business information and publicly reveal the investor’s claims. On the other side, minority investors may conclude that resolving disputes in litigation will provide them with broad access to discovery and a public forum for their claims, giving them some advantages and leverage in litigation that they would forego in an arbitration proceeding. 

The bottom line is that majority owners and minority investors need to decide how they want to resolve any potential future disputes between them at the outset — and long before they have conflicts that arise in their business relationship.