Contract Exceptions to Limited Liability

April 13, 2006

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If a small business owner hopes to limit liability for contracts and torts, he or she must have a basic understanding of the law of principal and agent, because agency law is one of the keys to understanding the exceptions to limited liability.

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.

A limited liability company (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, the small business owner must always ensure that he acts as an agent of the entity, and not in his personal capacity. Further, he must also always ensure that all other agents, including employees, act as representatives of the LLC or corporation, rather than as representatives of the owner personally (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).

With proper planning, the small business owner can accomplish these objectives and thereby preserve limited liability for contracts as well as torts.

The small business owner operating in the LLC or corporate form will still have unlimited, personal liability for a contract in these four situations:

the owner forms a contract before the LLC or corporation legally comes into existence (a pre-formation contract)
the owner fails to identify the principal (i.e., the LLC or corporation) in the contract
the owner identifies the principal, but fails to disclose that he represents the principal on the contract (his representational capacity)
the owner 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 (see the various discussions).

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

Also, by taking precautions against the entity unnecessarily incurring contract liability, he will protect his business's assets. Why rely on limited liability, when there can be no liability at all?