Incorporation? Shmincorporation!

Since Aaron & Sanders is in the business of (among other things) helping start-ups get started up, one of the most frequent questions Tara and I get is whether it was worthwhile to incorporate or form some similar corporate entity, such as an LLC. The short answer is it depends on (1) whether you will need to be entering in any scary contracts (i.e., if you breach it, will you be personally devastated?), and (2) how many owners would there be (a single owner is about ten times easier and cheaper to form than two owners, then it get more complex and expensive from there).

It’s well known that corporate entities “protect” the owners somehow, but there is often some confusion about what the owners are protected from. Corporate entities protect against contract liability only, and even then, only if you are clear it’s your company and not you who is forming the contract.* And, only if you have been treating your corporate entity as something separate and apart from you (otherwise, the contract creditor can “pierce the corporate veil” and reach your personal assets).

* I.e., In the part where it says who the parties are, make sure it says the legal name of your company, and when you sign it, make sure you sign as an officer of your company, not as yourself. Note that in cases of great disparity of bargaining power, the more powerful party will sometimes force the less powerful party’s owner to personally guarantee his or her company’s performance under the contract. In that case, the corporate entity does the owner absolutely no good at all.

Corporate entities don’t protect against what lawyers call “torts,” which encompass all the other non-criminal bad* things you can do. If you step on your neighbor’s lawn, you’ve committed the tort of trespass; if you accidentally back your car into your neighbor’s car, you’ve committed the tort of negligence; if you smack your neighbor in a drunken rage (or even just poke him), you’ve committed the tort of battery.

* Many of which don’t even seem that “bad”, really.

Further, if you tell your employee to do any of these things (and your employee was bound to obey), you might also be a “tortfeasor.”

The human beings who commit torts are always potentially liable for the tort. The question is whether the human being’s employer is also liable. The question is, thus, sort of the reverse of the question involved in a contract action. In a contract action, the entity is liable, but the question is whether we can make the human beings behind the company liable.

And that question turns on whether the human being was acting on his or her employer’s behalf when the tort was committed. If you cut across someone’s yard, or hit someone’s car, on your way to delivering a package for your employer, you’ve probably made your employer liable.* You are also still liable, but since your employer has a lot more money than you, no one will seriously be looking at your to satisfy the judgment (though you might remain a defendant in the lawsuit).

* By contrast, if you stop at a diner for lunch on the way back and get in a fist-fight, your employer is probably not liable for the battery you committed.

Significantly, violations of intellectual-property laws are torts, so the same human-being/employer distinction is at play. The difference is that the person committing an IP tort is usually someone in management. If you instruct someone to copy the software, use that trademark, or build that product, you could find yourself a co-defendant with your company.

Fortunately, since there’s a rule against double-counting (i.e., the plaintiff can’t recover damage from you if it can recover from your employer, and vice-versa), employees of large companies have little to worry about. So long as your employer can pay, you have little to fear about being forced to satisfy a large judgment.

Unfortunately, this is not the case with small companies and especially with start-ups. Indeed, it almost the reverse. Usually, owners of start-ups have more assets than their companies. If that’s the case, plaintiffs with a non-contract beef will be looking to your personal assets to satisfy a judgement against your company.

Incorporal Corporation

This brings us to this alarming recent decision: Universal Furniture Int’l, Inc. v. Frankel. In that case, the plaintiff furniture maker sued Frankel’s company, Collezione Europa USA, Inc., for copyright infringement. Collezione was in the business of selling “knock-offs” of others’ furniture designs. It was careful not to copy too closely, but not careful enough. It infringed Universal Furniture’s copyrights and trademarks and got rung up with a $11 million* judgment.

* Based on disgorgement of profits. Ouch.

Collezione filed for bankruptcy, which made it nearly impossible for Universal Furniture to collect the judgment. So Universal Furniture went after Frankel, who owned Collezione with his brother, in a separate lawsuit. Frankel argued that Universal Furniture would have to prove the copyright and trademark infringement all over again since he was not a defendant in the first lawsuit.

The court disagreed and held, essentially, that Universal Furniture didn’t have to prove anything new, except Frankel’s personal role in the infringement. Since the company was fairly small, and the design decisions went through the owners, that wasn’t hard. Beyond that, all findings from the previous lawsuit carried over to the new lawsuit under a principle known as “collateral estoppel.” It’s a somewhat unusual application of the principle, but warranted in this case because Frankel pretty much was Collezione. He knew what was going on in the lawsuit, and had every opportunity to protect his rights. In legal-speak, his interests lined up nearly perfectly with Collezione, and it would be a waste to judicial resources to try everything again.

The scary takeaway is that Frankel is not very different from many owners of small businesses. They can’t claim ignorance of what their business is doing, and their interests will nearly always “align” with their companies’.

It might hard to generate much sympathy for Frankel, since he had to know the risks his business was running. But remember that bad intent isn’t necessary to prove violation of most IP laws. One can violate copyright, trademark and patent laws purely by accident.

To put it in stark terms: Your LLC isn’t going to protect you against liability for IP infringement (which can be pretty huge). All you can do is (1) be very careful, and (2) hope that your adversary isn’t as vindictive as Universal Furniture apparently was.

Thanks for reading!