Take Steps to Limit Liability for Contracts

Filed under Asset Protection Strategies. Fact checked on May 24, 2012.

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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, Implied 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).

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Mistakes Lead to Personal Liability

If you operate your business as an LLC or corporation, you will still have unlimited, personal liability for a contract in these four situations:

  • you entered into a contract before the LLC or corporation legally came into existence (a pre-formation contract);
  • you fail to identify the principal (i.e., the LLC or corporation) in the contract;
  • you identify the principal, but fail to disclose that you represent the principal on the contract (your representational capacity); and
  • you personally guarantees the entity's contract.

The first three exceptions can be avoided in all cases by using careful business sense. The last exception can be avoided in many cases. In addition, many other precautions can be taken so that the entity does not unnecessarily incur contract liability.

By avoiding the four exceptions, you will enjoy limited liability for any contract entered into on behalf of the business. Thus, the most you can lose on any business contract will be your investment in the business (i.e., the business's assets--to the extent these assets are left vulnerable). Personal assets are protected.

Pre-formation Contracts Create Personal Liability

One of the contract exceptions to limited liability involves a pre-formation contract (i.e., a contract formed by the owner before his LLC or corporation legally came into existence). An individual can act as an agent only if there is a principal. With a pre-formation contract, there is no principal, as the entity has yet to legally come into existence. Thus, with a pre-formation contract, the owner is acting in his personal capacity. Accordingly, he has unlimited, personal liability on the contract.

The way to avoid this outcome is simple: Avoid entering into any contracts until after the LLC or corporation legally comes into existence. Each entity is created formally under state law, by filing articles of organization with the state along with the appropriate fee. The state will approve the articles and send back a written acknowledgment indicating the date the entity came into existence. Only after this date can the owner act as an agent for the entity.

Unfortunately, many small business owners enter into business contracts first and then form the business entity. It is easy to understand how this can happen. As the owner surveys the market for his business, many times contracts are signed to lease space, buy equipment and furniture, hire employees, etc. Somewhere in the middle or at the end of this process, the entity is formed. However, the owner should only make inquiries about the costs of leasing space, purchasing equipment and furniture, hiring employees, etc., and not execute any contracts until after the entity is formed.

If you mistakenly sign a pre-formation contract, the owner has two choices:

  • You should first attempt to have the creditor sign a novation, which will release the owner from personal liability, and substitute the LLC or corporation in his place.
  • Failing this, you should carefully consider an indemnification agreement from the LLC or corporation.

Novations and Indemnification Can Restore Limited Liability

Even though entering into a pre-formation contract can create an exception to limited liability, all is not lost. It is possible for a creditor to release the owner from liability on a pre-formation contract through an agreement termed a novation.

Do not confuse a novation with an indemnification agreement, where the business makes itself liable for a contract in addition to an owner personally. In a novation, the creditor on the contact signs the release. This is the key to the novation. Only the creditor, and not the owner's entity, can release the owner from liability.

A novation signed by the creditor releases the owner from liability and substitutes the entity in his place. Technically, a novation can take place only after the entity is formed. If there is a pre-formation contract, the owner can approach the creditor and request that the creditor sign a novation, releasing the owner from personal liability and substituting the entity in his place. However, with a newly formed entity that is not exactly overflowing with vulnerable assets, the owner should not usually expect a positive response.

Novations clauses included in pre-formation contracts. The owner, in anticipation of forming his business entity, can insert a clause in a pre-formation contract wherein the creditor agrees to a novation upon the creation of the entity. Clearly, this is the approach that should be taken. This may occur when the owner discovers an unusual bargain that he would like to capitalize on during the exploratory stage of his business formation. Once again, however, the creditor would have to be willing to sign off on this clause. (If the entity is not actually created, as sometimes happens with new businesses, the owner will retain personal liability on the contract.)

Example

In one case, an individual, in anticipation of creating a corporation, signed a contract with a large accounting firm for $10,000 of accounting and tax services for the prospective business. Though the corporation was legally created only one month later, the owner had unlimited, personal liability on the contract, because the principal (i.e., the corporation) did not exist at the time the contract was formed. In addition, the owner argued that he should have no personal liability because the accounting firm knew he intended to create the corporation. However, the court ruled against the owner, because he did not insert a novation clause in the pre-formation contract.

Indemnification Agreements Can Shield Owner

Often, when the business entity comes being legally it will adopt the contract and release the owner from personal liability on the contract. Unfortunately, this "release" does not actually release the owner from liability. This type of agreement, commonly called an indemnification agreement, makes the entity liable on the contract in addition to the owner personally.

This agreement allows the owner to seek reimbursement from the LLC or corporation, in the event the owner is called on personally to honor the contract. However, this agreement has disadvantages: this agreement does not actually release the owner from personal liability as it is not signed by the creditor, and the agreement will make the LLC or corporation liable on the contract and, thus, expose the business's assets to liability, in addition to the owner's personal assets.

In a small business with a single owner, you may actually be better off if he does not use an indemnification agreement. Why now make the business also liable on the contract and expose the business's assets to liability, in addition to the owner's personal assets? However, this type of agreement may have some value, especially in a larger business with multiple owners. 

While the agreement does not release the owner from liability, it does mean that, if the owner is called on to personally honor the contract, the owner then can seek reimbursement from the business. In a larger, more complex business, this advantage probably outweighs the cost of exposing the business's assets to liability, at least from the perspective of the individual owner in question. 

Always Execute Contracts As an Agent

Make sure that you always sign a contract as an agent of your business, not as a principal or owner. The following examples illustrate how to sign correctly.

Example (1) John Smith is the owner of ABC, LLC. He is entering into a contract with XYZ Supplies, Inc. Smith should execute the contract as follows:

Heading should read:

Parties to the contract:

Seller: XYZ Supply, Inc
Buyer: ABC, LLC

Signature lines should read:

Signed: ABC, LLC
By: John Smith, Manager
John Smith, Manager

It is customary to print a name under a signature (if the name is not printed elsewhere in the contract) so that the party's name can be clearly identified.

If the name of the entity appears at the top of the contract, it would be acceptable to omit repeating the name of the principal a second time above John's signature, as follows:

Signed: By: John Smith, Manager

John Smith, Manager

Example (2). If XYZ Supplies, Inc. insists on a personal guarantee from Smith, the contract will look like this:

Heading should read:

Parties to the contract:

Seller: XYZ Supply, Inc
Buyer: ABC, LLC

Signature lines should read:

Signed: ABC, LLC
By: John Smith, Manager
John Smith, Manager

"The undersigned hereby personally agrees to perform all of the obligations in this contract."
Signed: John Smith
John Smith

The second signature makes Smith personally liable on the contract. Usually, language regarding the personal guarantee will appear before the second signature. This language may make the owner primarily liable, along with his entity, so that the creditor can call on either immediately to pay the debt.

Or, the language may make the owner a surety, or guarantor, who agrees to pay the debt only if it is not first paid by the entity: "The undersigned hereby personally agrees to perform all of the obligations in this contract in the event ABC, LLC does not perform these obligations."

With a one-owner business, the two alternatives will probably produce no difference in outcome. However, with a multiple-owner business, the individual owner usually will prefer to act as a surety, rather than a co-primary party.

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