There are many reasons why our clients form entities – governance, succession planning, tax efficiency, asset segregation, etc. – but the most common reason is to protect themselves from the personal liability of running a business. A properly formed and operated entity acts as a wall between the various risks of the business and the personal assets of its owners. However, the entity should not be the only line of defense against these risks, and too often owners overlook the fact that the business’s assets are still exposed to these risks.

What is Liability?

Liability, as discussed in this article, is any potential claim against the business’s assets. A lawsuit is the most easily understood, but the rarest, type of liability faced by a business. More commonly, a business will be exposed to customer complaints, product warranty claims, employee and workplace disputes, contract claims, auto accidents, and workplace injuries, among others. All of these items are either actual, or potential, liabilities, and need to be properly managed by the business. Without preparation, any of these events could turn into a “bet the company” lawsuit.

The Onion Model of Liability Protection

Liabilities can be managed through layered levels of protection, like the layers of an onion. While some events that give rise to liability cannot be anticipated, most of them can be either prevented or mitigated through the following layered levels of protection. Note that this is not an exhaustive list, and there may be additional tools available based on the specific type of business.

Employee Training. Proper employee training for both co-employee and customer/vendor interactions can help businesses avoid a wide variety of issues before they turn into larger problems. For example, sexual harassment training can prevent many instances of workplace sexual harassment that would otherwise expose an employer to liability. Clearly defined policies and procedures that set expectations for behavior and ensure that certain mission-critical tasks get done, are equally important.

Customer Relations. A good program of customer relations will stop many customer claims, even when the business is at fault. This could include return policies, warranties, service-level agreements, and other ways of redressing issues. Other than these legal documents, good interpersonal training of employees and a healthy relationship with customers goes a long way in preventing problems from escalating.

Customer and Vendor Agreements. The phrase “good fences make good neighbors” is just as applicable to the relationship between a business and its customers and vendors. A well-drafted agreement, that clearly specifies the rights and responsibilities of all parties, can prevent disputes and confusion from turning into larger, or more formal, claims. This can be in the form of a master service agreement, a purchase order, or a terms and conditions.

Employment Agreements and Handbooks. The relationship between a business and its employees is just as important as its relationship with customers, and the employee/employer relationship is even more likely to expose the business to liabilities. Strong policies and agreements with employees will similarly prevent small issues from turning into larger problems for the business.

Comprehensive Insurance Coverage. A standard general commercial liability policy is intended to cover claims against the business that are outside of the scope of a warranty, return policy, or service-level agreement. It also steps in when unexpected events, such as a slip-and-fall, occur on the business’s premises. We recommend working closely with an insurance agent in order to get the right policies for your business, which may include property coverage, automobile insurance, professional errors and omissions, etc.

Entity Structure. The ultimate fallback for any liability that exceeds the business’s resources is the fact that the entity separates the business’s debts from the owner’s assets. However, walking away from a business liability is easier in theory than in practice. This approach means that all of the business’s assets – such as equipment, inventory, employees, leased space, contract rights, etc. – must be wound down and liquidated in order to pay as much of the debt owed as possible. The wind-down can be either informal or conducted through the bankruptcy process (depending on the specific circumstances), but it can be very time consuming and expensive to wind down a business in this manner. This is why the business entity is the last layer of the onion: it protects the owners, but at the cost of losing the entire operating business.

ABOUT THE AUTHOR: Kieran B. Wheeler is a shareholder at Rapp & Krock, PC in the Business Transactions group advising clients on corporate governance matters as well as mergers and acquisitions and other business transactions.

DISCLAIMER

Rapp & Krock, PC presents the information in this article for general education purposes only. Although this article discusses legal issues, it is not legal advice. The law and the content of any linked website may have changed since this article was written, and Rapp & Krock, PC makes no warranty or guarantee about the continuing accuracy of the information presented. Use of this article does not create an attorney-client relationship, and Rapp & Krock, PC does not represent you unless and until we are expressly retained in writing.

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