Litigation


What’s the point of a contract if I have to sue somebody to enforce it? Unfortunately, this is a question I have had to answer quite a few times over the last couple of years.  Imagine you want to enter into a business transaction with another person or business…we’ll call them the “Other Guy”…that’s a little easier than “party of the second part.”  Anyway, you sign a contract with the Other Guy and the contract has all the big words and seems to cover every possibility and you feel good about everything.  Then things don’t go as planned and the Other Guy fails to perform his part of the bargain.  Well the contract is pretty clear that the Other Guy has to perform right?  What’s the problem?

The problem is that a contract is not a gun.  You can’t waive a contract in someone’s face and make them do something they don’t want to do or can’t do.  Your primary recourse is to enforce the contract through the court system (i.e. you have to sue them).  Litigation is expensive and slow.  Even if you ultimately  prevail the cost of the process may greatly outweigh the potential contract benefits being enforced.  Further, even if you win a big judgment, you may not be able to collect if the Other Guy has no money.  Thus, in many cases even if the Other Guy is clearly breaching the contract, your most cost-effective option is to walk away.  I know some of you are thinking…where is the Corleone Family when you need them?

Now the prospect of a litigation roadblock doesn’t mean that you shouldn’t talk to an attorney if you believe you are being wronged.  You may decide to pursue the matter yourself in small claims court after a little coaching from an attorney.  There are other small and inexpensive steps short of litigation that an attorney may be able to help you with even if you have no intention of proceeding with a full law suit.  Sometimes all the Other Guy needs is a little push, and a demand letter from an attorney is enough to do the job.  I need to mention that if your contract has a provision allowing attorneys fees to be awarded if you prevail in litigation, that can often be useful leverage in obtaining cooperation from the Other Guy even when the contract dispute itself does not involve much money.  Again a review of all the facts  is important in deciding how to proceed in a contract dispute.

So what is the point of a contract?  A contract is designed to set the ground rules for a transaction and to address different conflicts that may arise and hopefully avoid surprises.  A contract does not guarantee that the Other Guy will perform.  Keep in mind that most people are honest and would not intentionally ignore or breach their obligations under a contract; however, many of them may simply find themselves in a position where they can’t perform.  They have made bad business decisions or suffered setbacks which make it financially impossible for them to live up to the terms of the contract.  Whenever you enter into a contract, you should consider things such as Who are you are doing business with? What is their experience and track record?  How likely is it that they may default? Do they have the resources to perform?  Don’t rely entirely on a contract to protect you.  Caveat emptor.

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Why am I still talking about lawsuits? Last month we reviewed the benefits of limited liability protection available in the form of a corporation or LLC.  But there is a little more to the story…..

Remember, business liability arises out of the operation of your business or ownership of property.  An LLC or corporation (a “business entity”) can help shield your personal assets from business liability.  But what if you have signed a personal guarantee?  If you need a business bank loan, you can count on the bank asking you (and maybe your spouse or business partners) to sign a personal guarantee in most cases.  The personal guarantee ensures that if the business is unable to repay the loan, then the bank can recover from your other financial  assets; this is basically an end run around the limited liability protection of the business entity.  Personal guarantees are also common in commercial office leases, equipment purchases or other commercial contract relationships with suppliers.  It is crucial for you to understand what you are signing and what exposure you have in these various business relationships.  You may have signed personal guarantees and not even realized it.  Be very careful when you sign any documents related to these types of transactions and make sure you are aware if you are undertaking personal liability.  Also be very careful how you sign on behalf of your business entity — you should always indicate your title (e.g., President, Manager, etc); that way it is clear you are signing only in your capacity as an officer for the company and not as an individual.

I also mentioned last time the importance of following corporate formalities in the operation of your business entity.  What I mean is that you can’t simply create an entity in name only.  You have to actually operate your business through the entity.  Again, use your entity name in all of your contract relationships.  Maintain bank accounts for the entity and handle all inflows and outflows of revenue through these accounts.  File your business annual reports with the Secretary of State each year.  Be consistent in your tax reporting; usually you need to prepare a separate tax return for your business entity.  Why are corporate formalities important?  You are trying to avoid an argument by a creditor that your business entity is simply a sham, and that the creditor should be allowed to collect against you individually.  This is known as “piercing the corporate veil.”  That’s all of the legal jargon I want to include on this, I think you get the point…pun intended.

Finally, consider options to protect against liability with insurance.  Professionals such as lawyers, CPAs, and doctors, carry professional liability insurance largely because they have personal liability exposure  for mistakes they make regardless of whether they operate through a business entity.  For other businesses which don’t involve typical professional liability, there is Errors and Omissions (“E & O”) insurance.  Most E & O policies are designed to cover liability arising out of your or your employees’ negligence — somebody made a big mistake and now the client is mad and has lost money.  If you are sued in this case, your insurance company helps defend you and ultimately pays for any claims that are successfully made against you (as long as they are covered by the policy).  The terms of the policy are very important so read it carefully.  In my experience,  many, if not most, businesses don’t carry E & O insurance, so don’t assume that is an absolutely necessity, but it may help you sleep better at night if you are worried about your exposure to this type of liability.

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What is the deal with limited liability protection? My apologies to Jerry Seinfeld, but I get that question from a lot of my business clients, particularly people starting up a new business.  There are some common misconceptions out there about what a corporation or limited liability company (LLC) can and can’t do to provide protection for you and your assets.

Let’s get one thing straight right away – limited liability protection is different from creditor protection.  If you transfer personal financial assets into your own LLC in order to “protect” the assets from your personal creditors, you are wasting your time.  If a creditor can get a judgment against you personally then that creditor can recover your ownership in the LLC and, effectively, you just lost those assets; not very protected.  I hope none of you has this type of problem, but if you do you need to be learning about creditor protection options which is a topic for another day.

For limited liability protection we are concerned about exposure to lawsuits or claims arising out of your business activity and property ownership, which I lump together under the term “business liability.”  For example, if your business has a fleet of automobiles, then one concern is exposure to liability from your employee’s automobile accident.  Or you may be worried about a tenant at your rental property falling through a hole in the floor because you didn’t get around to having the property checked for termites.  This actually happened to me as a tenant, seriously.  I decided not to sue my parents, which proved to be a good decision.  You may also be concerned about one of your customers suing you because something you did for them went wrong and cost them lots of money.  All of these issues involve business liability.  The point of limited liability protection is to limit that business liability to the assets associated with your business or property and to avoid exposing your personal financial assets (all of your wealth outside of the business) to those claims.

If your business is operated in the form of a corporation or LLC and if you follow the corporate formalities (e.g. keep your personal assets and bills completely separate from the business) then anyone making a claim against your business is limited in what they can recover.  They are free to sue your business entity and, if successful, recover from its assets, but that’s where the limitation kicks in.  They can’t go beyond that and collect from you individually.

Now here’s a very important point that clients never like to hear.  You may still be sued individually even if you operate through your business entity; lawyers like to take a “shotgun” approach.  Limited liability doesn’t protect you from being pulled into a lawsuit; however it is designed to help protect against ultimate recovery against your individual assets.  Also having a business entity may tend to discourage some lawsuits if they claimant knows that the business has very little in assets and if they doubt that they can succeed in suing you individually.  This is why your landlord for your office space will invariably require a personal guarantee from you; they don’t expect to be able to recover from your business.  Obviously if you sign a personal guarantee then at least for that obligation, your business entity is not providing liability protection.

OK I know some of you internet savvy people are saying, “What about malpractice insurance, errors and omissions insurance, or what about piercing the corporate veil or what are corporate formalities?”  All great questions and, as with any good TV season finale, you’ll have to wait til the next season.  Until then, get those floors checked for termites.

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