Protecting Your Business from Lawsuit Risk
Understanding the many forms that risk can take and how to avoid them will go a long way.
Protecting Your Business from Lawsuit Risk By Ray Chodos
Risk management is of great importance to business operators; yet, it is poorly understood by most. It is possible to lose your business and most major assets to just one legal liability judgment.
Much of the exposure businesses face is not intuitive. To manage risk, one needs to understand it in its many forms. These include legal structure, employment law, product liability, contract risk, partnership and succession risk and insurance claim denial risk.
This article seeks to raise the awareness of owners about lawsuit risk and encourage them to allocate thought, time and resources to becoming savvy about risk exposures and take steps to mitigate risk and control losses. Naturally, all business risk cannot be eliminated in the competitive environment in which we operate.
What is asset insulation planning?
Asset protection planning is the process of organizing a business’ ownership and affairs to insulate them from loss by reason of potential future fiscal calamity. The aim of asset insulation planning is for the organization to become unattractive to litigation by removing the financial gain (as much as is practical) that drives most plaintiffs’ lawsuits and their counsels.
Businesses are a favorite target of litigators as many seek to settle cases (even weak ones) rather than defend themselves and run the risk of attracting negative publicity, large legal costs and loss of valuable time in litigation that can span several years. Over 50 percent of all civil lawsuits target small businesses annually. Seventy-five percent of those lawsuits are thought to be frivolous. But 90 percent of business owners settle them simply to avoid higher court costs and embarrassment. This pattern of behavior, unfortunately, fosters even more lawsuits.
How large a problem is business litigation? Consider the following data:
- Each year, some $200 billion is involuntarily redistributed to claimants by U.S. Courts.
- There are 15 million civil lawsuits filed annually in the US, costing litigants $251 billion in legal fees and associated costs.
- The U.S. exceeds every nation in litigation cases and costs.
- 80% of the world’s lawyers reside in the U.S. (1,316,000 lawyers). Many nations utilize the "English Rule" of "loser pays costs and expenses of the winner" designed to discourage frivolous litigation. The U.S. does not do so.
- Many nations disallow contingency based legal representation—the U.S. does not. This practice, while allowing the poorest of plaintiffs to file a complaint, also enables frivolous suits as the plaintiff has little to lose. Seasoned, quality attorneys will predictably eschew low-merited contingency compensated cases.
NERA Economic Consulting (NERA), a global firm of experts, performed a study of litigation’s impact on small businesses. Their findings are as follows:
- The tort liability price tag for small businesses in America in 2008 was $105.4 billion.
- Small businesses bore 81% of business tort liability costs, but took in only 22% of revenue.
- Small businesses paid $35.6 billion of their tort costs out of pocket as opposed to through insurance.
In a 2007 Harris poll of business owners/managers, respondents indicated they were concerned about frivolous or unfair lawsuits and 62% said they make business decisions to avoid lawsuits.
These decisions had the following effects:
- 61% said they made their products and services more expensive.
- 45% said they made a product or service unavailable to customers.
- 23% said the business decisions forced them to cut employee benefits.
- 11% said the decisions forced them to lay off employees.
More than a third of these respondents had a lawsuit filed against them in the prior ten years. These suits had the following effects:
- 73% said business suffered because litigation was very time-consuming.
- 4% said business suffered because litigation was very expensive.
- 61% said they felt more constrained in making business decisions generally.
- 45% said they changed business practices in ways that do not benefit their customer.
In spite of the litigious environment in which they operate, many small-business owners are poorly versed in these critical matters. This is because in most small businesses (closely held), management wears many hats due to cost containment.
In addition, there are usually no HR departments, general counsels (in-house legal), risk management (insurance related) or external board members. Accounting and tax compliance services are often provided by a local external CPA firm as needed.
Owners and operators of small businesses should enhance their knowledge of legal liability risks
Legal services are also often provided by a local general practice attorney on a reactive basis as issues arise. Risk transfer (insurance) products are generally sold by individuals who may have little expertise in business risk management beyond the policies they sell. Also, most of these external providers do not work collaboratively to further the interest of the business owner and many do not even know one another.
Business owners also have to face litigation from their employees. While employee lawsuits tend not to go to trial, for those that do the damages can be substantial. The median judgment is approximately $200,000, which is in addition to the cost of defense. About 25% of these cases result in a judgment of $500,000 or more.
Commercial insurance is usually not enough to protect the business owner. This coverage is the foundation of risk management for perils that are insurable. However, many of life’s most serious risks are not insurable or have exclusions and limitations. These include co-owner disputes, divorce, punitive damage awards, wage-related employment practices and environmental risks.
Owners and operators of small businesses should enhance their knowledge of legal liability risks. Generally, they can be held liable for the products/services they sell, the staff they employ, contracts they are a party to—regardless of whether they are directly involved in an event or not. Even when they are not aware of what an employee is doing, there is the potential for liability.
Owners should thoughtfully examine all aspects of risks relating to what their companies are doing. They should ask themselves the following questions:
- What could go wrong?
- How severe of an impact could this have on the business?
- What changes can I make to mitigate risk and control damages?
- Do my employees understand risk and our vulnerability to claims?
- Are my business practices ethical and defensible if challenged?
Once the owners have gone through this analysis, it is wise to bring in outside risk management specialists to suggest changes that can be made to insulate the business and major assets of the owners based on the recognized exposures.
Good planning often divides business activities and assets into distinct entities. An insurance coverage specialist can be engaged to issue a written report about the efficacy of the coverages and any overlap or insurable areas that are not addressed. An employment practices specialist can review the employee handbook, hiring and termination practices as well as the employment practices insurance policy.
Owner awareness and use of specialists to insulate what may be the owner’s single largest asset are necessary if owners wish to properly protect their businesses. The cost of a single defense against a claim will likely exceed the cost of proper planning—not to mention aggravation and time lost after the fact, even if the owner wins.
Ray Chodos is the managing member of the Wealth Preservation, LLC™ in Greenwich, Connecticut. He can be reached at chodos@WealthPreserve.com.
This article appeared in Advisor Today.