ComplianceFinanceLegalTax & AccountingNovember 15, 2020

Take steps to limit liability for contracts

Even if you organize your business as an LLC or corporation, you can find yourself personally liable on a business contract if you enter into a contract before your business is legally formed, fail to act as an agent, or personally guarantee performance on a contract.

To avoid day-to-day liability risks when running a small business, merely creating a limited liability company (LLC) or a corporation is not a sufficient asset protection strategy. The business entity must be structured and funded properly to limit exposure to liability.

However, even properly structuring and funding the LLC or corporation is not sufficient, because some assets remain vulnerable within the business entity itself. The LLC or corporation must be operated properly, in ways that preserve limited liability granted by law.

Significant exceptions to limited liability exist, in terms of both contract and tort liability. When an exception applies, limited liability is lost and the owners of the business have unlimited, personal liability for the business's debts. Yet, most times, with proper planning, these exceptions successfully can be avoided. The first step is understanding the nature of contract law.

Warning

The unfortunate truth is that most small business owners operate their business blissfully unaware that they have a tremendous exposure to liability through contracts or torts (acts or actions whose outcome produces a lawsuit or settlement forcing payment of monetary damages). Perhaps they are under the illusion that the LLC or corporation they formed will protect them from liability. Of course, reality sets in when a financial disaster strikes, such as a major lawsuit. By this time, it usually is too late to take corrective measures.

 

By avoiding the exceptions to limited liability for contacts and torts, the small business owner will preserve his legally guaranteed protections, thus securing his personal assets outside of the business. Further, the small business owner can take actions to limit this limited liability, and thus protect the business's assets as well. A careful understanding and application of authority under contract law, and the pitfalls that can result from contracts and torts, will go a long way toward ensuring maximum asset protection for you and your business.

Authority can be actual, applied, or apparent

In order to limit liability for contracts, you need a basic understanding of contract law. An agent of the business (for example, you or your employees) must have actual authority to form a contract for a principal of the business.

Express authority. Ideally the authority being the entity will be express authority--permission from the principal (owner) given verbally or in writing. Obviously, written authority is preferable, as it is difficult to substantiate verbal authority. In a corporation, common sources of written express authority include bylaws and resolutions from directors' meetings. In a limited liability company (LLC), common sources include an operating agreement and resolutions from managers' meetings (or members' meetings, in a member-managed LLC).

Implied authority. Actual authority also may be implied. This means that someone who is considered to automatically have all the authority necessary to carry out the express authority even though there is no express delegation of this authority. For example, if an agent representing a Connecticut company is expressly authorized to sign a contract in California, and he must travel there to accomplish this, he is also (most likely) impliedly authorized to contract for travel and lodging, as an agent of the company, because this is necessary if he is to accomplish his express authority and sign the contract in California.

Clearly, implied authority can present problems, because it is neither in writing nor verbal. It is simply understood. Remember, though, that implied authority stems from express authority. By specifically addressing express authority, problems with implied authority can be avoided.

Apparent authority. While caution should be exercised with both actual and implied authority, the biggest problem for the small business owner is apparent authority. If apparent authority exists, an agent or employee can bind the business to a contract, even though the agent or employee has no actual right to act for the business. Apparent authority can represent a significant source of liability for the business.

If it reasonably appears to a creditor that an agent has authority to represent a principal on a contract, then the principal is legally bound to the contract, based on the apparent authority theory. This is true even though the agent had no actual authority at all to represent the principal. 

This is frequently a problem when an employee is fired or the scope of his authority is curtailed, and creditors of the business are not properly notified of this fact. Clearly, this can especially be a problem when the agent had significant authority (e.g., an officer in a corporation, a manager in an LLC or an employee such as a purchasing agent).

Apparent authority creates significant risk exposure

The issue of authority under contract law is not always clean-cut. In most situations, express or implied authority is granted to an agent of the business. But sometimes apparent authority muddles the picture. In most cases, apparent authority arises when there has been what is termed a "past course of dealing" with a creditor.

In this situation, the agent, who was acting with actual authority at the time, has on many prior occasions contracted with this particular creditor on behalf of the principal. In each of these cases, a bill was sent to the principal, and the bill was paid. Subsequently, the employee's authority is revoked or curtailed.

It is easy to see that, because of the past course of dealing, the creditor can reasonably believe that the agent is still authorized to represent the principal, if the creditor is not notified otherwise. Thus, if the agent subsequently forms a contract with the creditor, while representing that he is acting for the principal, the principal is liable on the contract because of apparent authority. In short, an employee may be fired, or a partner may withdraw from a business, and still bind the business to contracts.

If your business is structured properly, the limited liability company (LLC) or corporation will be the principal held liable--provided, of course, that you have properly taken the precautions to separate the owner from the business's liabilities.

Notice of revocation of apparent authority. By eliminating apparent authority, you can protect your investment in the business. The key to this is one word: notice. If apparent authority is to be eliminated, notice that the agent no longer has authority to act for the business must be provided to creditors.

There are two types of notice:

  • actual individual notice
  • constructive notice

 

Warning

When notifying creditors to terminate apparent authority by letter or newspaper advertisement, the small business owner must be careful to avoid saying anything regarding the agent that might be actionable as defamation. No explanation should normally be given. A simple report that John Jones no longer is an employee or agent (or partner) of the company is appropriate.

 

Actual individual notice. The law requires that the principal provide actual individual notice to all creditors with whom the business and the agent have established a past course of dealing. It also requires that the principal prove the creditor actually received the notice.

A telephone call, for its immediacy, and a letter should satisfy this requirement. The business owner should always document the date and time of telephone calls, and the name of the individual who took the message.

Where immediacy is not an important issue, the business owner may want to bypass the telephone call. A copy of the letter should be retained. Moreover, if a serious question of possible wrongdoing by an agent exists or exposure to liability is particularly high for some other reason, a certified letter, return receipt requested, is recommended.

Constructive notice. Of course, it is not possible to make a telephone call or send a letter to a creditor with whom the business has not yet established a relationship. Here, the law provides that constructive notice is sufficient. This type of notice is best represented by a newspaper advertisement, in a newspaper that circulates in all the areas the company has done business. Here, there is no requirement that the principal prove the notice was actually received.

Note that constructive notice is ineffective against creditors with whom the principal and agent have a past course of dealing (unless the principal is able to prove the creditor actually read the advertisement, which is usually impossible).

The best course is for the small business owner to use both actual individual notice to known creditors and constructive notice to cover all future potential creditors.

Make sure to act as agent not principal

An agent is a representative of the principal. As a general rule, whatever the principal could do himself, he can instead hire an agent to do on his behalf. The employer/employee relationship represents an example of a principal and an agent.

An LLC or corporation is recognized as a "person" or separate entity from the owners. However, the LLC or corporation can accomplish nothing at all on its own--the LLC or corporation obviously is inanimate. More importantly, because the LLC and corporation are, in fact, inanimate, they must always act through agents. In the LLC, these agents will primarily be the managers in a manager-managed LLC, or all of the members in a member-managed LLC. In a corporation, these agents will primarily be the officers and the directors. However, in both cases, employees also are agents who act on behalf of the entity.

In striving to preserve limited liability, you must always ensure that you act as an agent of your entity, and not in your personal capacity. Further, you must also always ensure that all other agents, including employees, act as representatives of the LLC or corporation, rather than as your personal representatives (i.e., that the principal on whose behalf an agent acts is the entity--the LLC or corporation--and not the small business owner personally).

Nikki Nelson
Customer Service Manager
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