Heavy Duty: More Liability Traps for Business Owners

Forewarned is forearmed

Unless you were daydreaming during history class, in high school you learned that the birth of modern limited liability business entities, namely corporations, was a key factor in the Industrial Revolution and America’s emergence as a world economic leader. An investment of capital that risks only that capital, not the investor’s other assets, has been at the heart of capitalism ever since. This is especially true, but often challenging, in human-owned businesses where the people who invest the capital are often investing blood, sweat and tears as business management, too.

Typically, the law splits management of a corporation into two functions: the officers (President, Secretary, Chief Cook and Bottle Washer, etc.), who run the day-to-day operations, and the Board of Directors, which supervises the officers and keeps a long term view in mind. Yes, I know that if public company Boards of Directors really did that, we wouldn’t be in our current economic pickle, but that’s not today’s subject; my concern is that people in private companies don’t keep track of the hats they wear (owner, officer and/or director) and the consequences that go with wearing them.

Officers and directors are fiduciaries and as such they have certain special responsibilities to their company. The existence of these duties and the personal liability that comes with their violation can put a huge hole in the wall separating the risk of the business from an owner’s other assets. I’m not going to get into the specifics of these duties (and you don’t want to read a bunch of legalese) so I will give you two words: care and loyalty. To flesh it out just a bit, be careful in exercising your responsibilities and don’t put personal interests above the company’s.

With that summary, you are ready to begin an important conversation with your co-owners and your company’s legal counsel about the following four ideas:

  • Limit your duties?
  • Be especially careful around the edges.
  • Don’t let your LLC fool you.
  • Check indemnification rights and consider D&O insurance.

Fiduciary duties and personal liability for violating them can usually be limited by agreement among the owners of a business. You may or may not want to do this; in general, however, my clients like to set limits. In a corporation, this is accomplished in a public document – the Articles or Certificate of Incorporation. Colorado, for example, allows a simple statement included in the Articles to eliminate personal fiduciary liability in all but a few situations. The trouble is most private business owners aren’t aware that they have fiduciary duties, let alone that the duties can be limited. I asked a paralegal in my office to conduct an unscientific survey of 20 recently-formed corporations – 10 formed by lawyers for clients, 10 formed by the business owner(s) – and found that in the corporations formed by lawyers, 8 of the 10 limited fiduciary duties. However, none of the corporations formed by their owners contained any limitation. Enough said?

Good human-owned business practices conducted in ordinary circumstances rarely risk violating fiduciary duties. The stuff that makes it to court and into case law often involves either a practice so questionable or circumstances so unusual that you might well ask, “What were they thinking?” My answer: they probably weren’t. So you won’t let that happen to you. Actions when the company is in financial stress and anything that is or appears to be a conflict of interest are clear examples of situations where careful consideration of duties is required. In today’s economy, business owners struggling to save their business may actually be creating personal liability to the business creditors. In Colorado that may be true even despite legislation to end fiduciary duties to creditors.

The vocabulary of this post has, so far, been all corporate. Many human-owned businesses in recent years have chosen to be limited liability companies rather than corporations, and the owners may have been lulled into a false sense of security by business books and blogs touting, among other advantages of the LLC form of business, the ability to limit or even eliminate fiduciary duties. That ability might exist in your state, but chances are that the exercise of that right requires explicit language in the governing documents of the LLC. Since my informal survey showed that owners of corporations have a poor track record in limiting duties, I suspect LLC owners fare no better with their private operating agreements. I encourage you to review your operating agreement with your attorney. He or she can help you limit, eliminate or expand duties as appropriate for your ownership group and explain what duties may apply regardless, such as Colorado’s common law duty to creditors.

Your primary goals should be to understand and then carry out the duties that apply to you as an officer, director and/or manager of your business, but you should also be ready in case that is not enough. There are two fail-safes that you need to look at in the last step of your analysis. First is Directors and Officers insurance, commonly called D&O. No doubt you have purchased insurance to cover certain business risks; you can also purchase D&O to insure the actions of the business fiduciaries. If you already have D&O, check with your agent and confirm the term and scope of your existing policy’s coverage. Otherwise, ask your agent about adding D&O and the price and terms of a new policy. Unless you are in the financial services sector, chances are D&O insurance should be available and reasonably priced, but like all things in business or life, you get what you pay for.

Indemnification is the second, final step to consider. Indemnification means the business will be responsible for paying, or at least reimbursing, damages (including those all important attorney’s fees) incurred in connection with the exercise of your duties to the business, subject of course to some legal limitations. Your lawyer can explain to you the indemnification requirements currently applicable to your business and whether and how those rights can be either expanded or contracted to suit the needs of the business and its fiduciaries. Indemnification, as a practical matter, may be of limited utility if you are the sole owner of the business, but in private businesses with more than one owner, indemnification rights deserve your attention.

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