Thursday, June 18, 2009

Common Legal Mistakes Businesses Make and How to Avoid Them, Part I

Most small and many medium-sized businesses make common mistakes that could be easily avoided with little cost and just a small amount of effort. However, businesses make the same mistakes over and over. This article, which is based on Georgia law, will identify nine common legal mistakes and the steps businesses can take to avoid them. Although this article will help you identify and understand some key points, be sure to consult with a lawyer from your jurisdiction regarding the law in your jurisdiction, and also about the particular factual circumstances that affect your business. This article is based on a presentation the author recently gave to a business.

Mistake No. 1: Failure to follow the prime directive. What is the prime directive? It is a nearly universal rule regarding legal issues and can be stated as follows: It is almost always cheaper to address a legal issue on the front end (such as by preparing a proper contract) than to address it on the back end (such as through litigation). Many business people know that they should pay more attention to legal issues, but they instead choose to ignore the issues, or try to get by with home made solutions. In litigating cases for over twenty-five years, I cannot even hazard a guess as to how many times litigation could have been avoided if an issue had just been addressed before there was a dispute. If you take away anything from this article, remember the prime directive.

Mistake No. 2: Failing to Protect Limited Liability. Most business people know that they should form a corporation or a limited liability company ("LLC") for their business, and know that doing so offers protection for their personal assets. It is true that the "corporate veil" will protect personal assets from many types of liability (do not forget, however, to also have a good liability insurance program). However, many business people are not aware that, in certain circumstances, courts will "pierce the corporate veil," meaning they will look through the corporate liability shell and subject shareholders and others to personal liability. This arises when a court determines that the corporation or LLC has been used for "fraud."However, from a business person's standpoint, a better explanation is that the veil may be pierced when the business is not properly maintained as a separate legal entity.

Courts look for particular indicia in considering whether to pierce the corporate veil, including (1) using the corporation to pay personal debts and obligations, (2) not maintaining separate personal and company bank accounts, (3) not maintaining proper corporate records, such as annual shareholder meeting minutes or unanimous consent resolutions (this happens all the time), (4) not documenting shareholder loans to the company, (5) not maintaining proper accounting records, (6) signing company documents (letters, etc.) in a personal, rather than a business capacity (i.e., not signing as an officer of a corporation), and (7) not using the full corporate name in doing business (i.e., not using "Inc." or "LLC" on letterhead, business cards, purchase orders, and business forms). I am not suggesting that failing to do any one of these things will result in piercing the corporate veil. In fact, piercing the corporate veil is somewhat difficult. However, the point is that there is no need to incur that risk. Proper observance of these formalities may also be important to potential investors or potential merger and acquisition partners.

Mistake No. 3: Not Understanding the Consequences of Sales Talk. Most business people understand a warranty to be a written undertaking, either in a contract or provided with a product, that says what the manufacturer or seller will do if there is a problem with a product. It is true that such documents are warranties. However, the law goes further. Statements your sales people make in the sales process may also create warranties.

Lawyers love sales people because sales people have helped put a lot of lawyers' children through college! Here is how the problem can arise: Sales people are typically trained to think of themselves as consultants. Sales people may make recommendations, they may make very specific statements regarding the capabilities of the product, and may even prepare customized "pay back" reports or other written reports regarding the benefits of the product for the customer. Although this approach is undoubtedly effective in creating sales, it can result in unintended express warranties.

Under the Uniform Commercial Code ("UCC"), any affirmation of fact regarding the goods that becomes part of the basis for the bargain can create an express warranty. Descriptions and samples of the product that become part of the basis for the bargain can also create express warranties. There is probably no way to avoid this risk completely. However, there are some common sense steps that can be taken to lower the risk without lowering sales. First, if a sales person is creating a payback analysis or similar document, any statements regarding performance should be described as an "estimate" or "illustrative," and that actual experience may vary. Of course, it is also very important to have data and experience backing up any estimates! Second, every effort should be make to have the customer sign off on a written contract or terms and conditions that state that the only warranty is the written warranty stated in the contract or the terms, and that the contract or terms supersede all prior discussions, negotiations, and agreements. It is best to have an experienced lawyer both review your sales techniques and prepare a standard contract or terms and conditions.

Mistake No. 4: Not Disclaiming Implied Warranties. The UCC provides for implied warranties that apply to any sale by a merchant. The implied warranty of merchantability provides, in essence, that goods will be of fair and average quality and would pass without objection in the trade. The implied warranty of fitness for a particular purpose comes into play when a seller has reason to know that a buyer is acquiring goods for a particular purpose, and is relying on the seller's expertise to furnish suitable goods. If these circumstances come into play (which they often can, given the tendency of sales people to act as consultants), then there is an implied warranty that the goods are suitable for the purpose.

Implied warranties can create a lot of problems for sellers. Implied warranties come into play only when there is a dispute. Further, implied warranties are very vaguely described in the UCC. This means, as a practical matter, that what an implied warranty "really" means will be revealed only by the plaintiff's lawyer after there is a dispute. Based on many years of experience, there are few creatures more creative than a plaintiff's lawyer!

Fortunately, however, the UCC also generally allows implied warranties to be disclaimed. This can be easily done, but there are some "magic words" that need to be used. It is best to have a proper disclaimer in your written contract or terms and conditions. It is again a good idea for counsel to prepare or review the contract or the terms and conditions. Please note that there are additional issues if you are selling consumer goods, so be sure your lawyer addresses those issues as well.

Mistake No. 5: Not Protecting Trade Secrets and Confidential Information. Many business people think of "intellectual property" as patents, copyrights, and trademarks. It is true that patents, copyrights and trademarks are important forms of intellectual property. However, particularly for small and medium-sized businesses, the most important forms of intellectual property are often trade secrets and confidential information. However, many small businesses also do not take adequate steps to protect them.

What is a trade secret? Under Georgia law, many types of information may qualify as a trade secret, including business plans, secret formulas, computer programs, customer lists, and other information. The Georgia Trade Secrets Act lists many types of information that may quality, and the list is not intended to be exhaustive. Generally, information must meet three elements to qualify as a trade secret: (1) it must not be generally known (i.e., it must be a secret), (2) it must derive actual or potential economic value from not being known, and (3) it must be subject to reasonable efforts to maintain its secrecy.

Other confidential information may not quite rise to the level of a trade secret, but may be information that a business wants to keep from competitors. The line between a trade secret and other confidential information is a gray one, but both trade secrets and other confidential information should be protected. Unfortunately, many businesses do not protect trade secrets and confidential information adequately.

What steps should be taken? First, employees, consultants, actual and potential suppliers, actual and potential customers, and perhaps others having access to trade secrets or confidential information should be subject to non-disclosure agreements ("NDAs"). NDAs are also known as confidentiality agreements. It is very important that NDAs be crafted for particular circumstances, because "one size does not not fit all." In addition, it is important to put other safeguards in place, such as limiting the disclosure of trade secrets and confidential information to those who truly need to have access, maintaining hard copy documents under lock and key, and using password protection for electronically stored information. There are many other steps that might be taken. Trade secrets, confidential information and NDAs are very important subjects.

More information is available on a three-part podcast series that can be accessed on our law firm's website. However, in putting a program in place, and especially in drafting NDAs, it is very important to involve counsel, because there are many issues that are not readily apparent to an untrained person.

This concludes Part I of this article. In Part II, we will cover additional issues.

John L. Watkins is a business litigator and business lawyer for Chorey, Taylor & Feil, A Professional Corporation, a business litigation and business law firm in Atlanta. John represents businesses of all sizes, and has written and spoken frequently on helping domestic and international business people understand and navigate the legal system. After practicing with a large law firm for over twenty years. John joined Chorey, Taylor & Feil in 2007 because of its high quality, smaller size (20 lawyers), and ability to provide more responsive and higher touch service to its clients. John practices primarily in the field of business litigation, handling cases involving trade secrets, insurance coverage, shareholder and corporate disputes, commercial contracts, construction disputes, product liability, and other commercial matters. John also negotiates, drafts and reviews sales contracts, non-disclosure agreements and other contracts. John is active in the international business and legal community, and represents a number of international companies or their U.S. subsidiaries. He is also a registered mediator. John graduated first in his class from the University of Georgia Law School in 1982. John is rated AV by the Martindale-Hubbell Law Directory, its highest rating, and is rated 10.0 by the AVVO website, its highest rating. John was named in 2008 and 2009 to the list of Georgia Super Lawyers in the field of business litigation published by Atlanta Magazine and the Journal of Law and Politics. More information can be found at the firm's website,

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