E-M8 Entrepreneurial Management for Eternal Mission

Understanding Mitigation of Risk Exposure

 

The foundational responsibility of the entrepreneurs and executives to generate a profit is secondary to their responsibility to protect the investors. Different investors may desire a different level of protection, but nevertheless it is a responsibility of the members of the management team to make sure that the level of the business risk is both kept to a minimum and is communicated to the stakeholders.

 

Understanding the inherent risks in doing business is the first step to mitigating them. The next steps are to identify specific acceptable risk levels; evaluate the various mitigation approaches; implement the approaches that will help achieve those goals; and develop a continued action plan for monitoring and managing the risk levels on the ongoing basis. We will discuss these secondary steps in the later chapters of the book. For now we will focus on understanding the risks that require mitigation.

 

With any activity there is an exposure to risk. The reason that any activity is a source of exposure is that we do not live in a vacuum, but rather have obligations to others. These obligations, otherwise known as duties or responsibilities, can arise from a number of sources and under varied circumstances. But any time we fail to carry out our obligations we breach our duty. As we breach our duty, even unintentionally, we can cause damage to those around us. If the damage that others have sustained is more then a minimal inconvenience, it is likely that the persons damaged, or somebody on their behalf, will seek to have us pay for this damage.

 

In business, a company or an individual always walks the tight rope between engaging in various activities to suit their purposes and not engaging due to the risks involved in that activity. Some level of risk is acceptable, so long is it a consciously taken, calculated risk, which could not be efficiently mitigated. It is however, unwise to build a business that creates more risk than profit, or to leave a risk that can be easily reduced, unmitigated.

 

Since duty comes from relationships it is worthwhile discussing some key relationships and how they are governed.

 

Contracts – Relationships with persons

 

The easiest and most foundational duty to understand is that of doing what we promised. This duty is the basis of contracts and contract law. It impacts just about any relationship that we have. Our interaction with partners and managers, employees and contractors, vendors and suppliers, landlords and tenants, buyers and sellers, clients and third parties, partners and competitors, investors and lenders is primarily driven by these principles.

 

Contracts affect every aspect of a business. Here are just some types of contracts, or promises that can give rise to a contract that commonly happen in business setting:

·                    Employment agreements

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  • Performance based schemes
  • Retirement and benefit plans
  • Employee workbooks
  • Non-compete
  • Non-disclosure

·                    Purchase, Lease and Resource Sharing

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  • Real Estate
  • Machinery and Tools
  • Intellectual Property such as brands, trademarks, copyrights, patents, client lists

·                    Service Contracts

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  • Consignment
  • Outsourcing
  • Promotions and advertising
  • Estimates and bids

·                    Sales and Purchase Agreements

·                    Payment and Collections

·                    Loans

·                    Investments

·                    Insurance

·                    Incorporations

·                    Voting agreements

·                    Commitments to stakeholders

·                    Other promises

 

The foundational rule of contracts is that there has to be an offer and an acceptance to form a contract. That means that if you promised somebody something and they agreed there is a good chance that a contract has been formed. Typically, contracts also require that there would be consideration, i.e. something of value, for the contract, but increasingly, reliance on the promise is being considered consideration enough. So, anything that you say and someone agrees with, can serve to expose you to the risks of the contract.

 

Fortunately, it is hard to prove who said what. So the courts came up with a standard where all contracts that cannot be performed in one year or involving substantial amount of money or Real Estate are required to be in writing.

 

It is always a good idea to write things down even if there is no requirement, so that later on it is easy to tell who agreed with whom and about what.  One of the simplest ways to mitigate the risk of others not doing what they promised is to get it in writing.

 

The contract law will do what it takes to insure that the person got the benefit of the promise which they received, but it rarely allows penalties beyond what was originally agreed. We will deal with contracts in a lot more detail, but for now let’s look at other sources of duty.

 

Torts – relationship with society

 

The second duty that we have arises out of responsibility to others to not cause harm to them. This is the basic principle of cohabitation in the society. And to understand the liabilities that can arise from the breach of this duty we can look to the law of torts.

 

The law of torts may impact our business in any of the same interactions that may be grounds for contracts, but also through anyone else who may be harmed by us, such as neighbors, clients of our clients, or even complete strangers.

 

The law of torts is primarily concerned with restoring the status quo. So, it does not care about the missed opportunities of those harmed. But, the law of torts also, depending on the degree of wrongfulness, seeks to punish the wrongdoer and often provides for financial penalties, known as punitive damages, above those that are necessary to restore the damage.

 

Criminal – relationship with the state

 

Our country provides us with care and protections under constitutional law in exchange for our allegiance. In turn, our allegiance is the source of our responsibility to our country. This responsibility is the focus of the criminal law. A duty to our country is to obey the spirit of the laws of our country and state, as well as local laws and international treaties in which our country has engaged. Even if our behavior did not hurt anyone, let’s say speeding, nevertheless we may be found guilty, since we violated the law. The offended party here is the state.

 

It is the role of the government to identify the responsibilities and punishments beyond those that can be properly administered within the realm of relationships within society. Since the government undertakes to regulate the various aspects of our life, there are many aspects of business activities that require special attention.

 

These areas include:

·            Employment Law

o       Employment conditions and compensation regulations

o       OSHA and Safety standards

o       Discrimination issues

o       Accommodation for Disabled

o       Enforceability of contracts

·            Environmental Law

·            Franchising and dealership laws

·            Landlord/Tenant Regulations

·            Marketing Regulations

·            Collection practices

·            Lending regulations and usury laws

·            Tax law

·            Corporate regulations

o       Securities Law

o       Incorporations

o       Bonds and Insurance regulation

 

With the criminal law, the stakes are much higher then with civil law (torts and contracts), since the crime have a stigma to it that is beyond the actual sentence, and the punishment may involve jail time and other restrictions upon freedoms. The activity that is criminal is usually not just condemned by the society, but also cannot be easily mitigated, since the use of organizational structures, such as corporations, will not allow the individual to limit their liability, nor can a person take out the insurance to shield themselves from the responsibility.

 

A business that succeeds in all other facets of operation, but operates illegally is no longer a business, but a crime family. While occasionally, it may be the appropriate course of action to defy the government, if for example, the government has failed of its essential function to take care of and protect its citizens; it is a dangerous course at best. It should never be the ordinary course of business to operate illegally.

 

Breach

 

Now that we have discussed the sources of duty / responsibility, we can focus on the ways in which we can breach these duties. There are four common ways in which we can be held responsible for a breach of a duty: intentional, reckless, negligent and strictly liable.

 

Intentional breach means, at the very least, that we were fairly certain that the damage would occur. Most serious offences and most serious punishments involve this type of behavior.

 

Reckless breach means, that there was indifference as to the occurrence of the damage, or taking unnecessary risks. The bulk of malpractice issues fall in to this category. It is not quite as bad as intending the damage, but it is not acceptable behavior, so like intentional breach, it is typically severely punished. In criminal law, just about every felony requires at least recklessness and often intention. In civil law, punitive damages are often awarded based on the finding of recklessness or intention.

 

Negligent behavior involves the failure to be as careful as the reasonable person would in the similar situation.  The reasonable person is a bit of an invention, since it is not any particular person, but composite idea. The reasonable person has at least average intelligence and at least average level of awareness of the situation around. The only discount from this expectation is for the children and physically disabled. The negligent behavior is not punished as severely, with the primary focus being of that of restoring the damage.

 

In a few instances, we can be held responsible even if our behavior was not negligent, under the concept of strict liability. Strict liability has been created to ease the prosecution of certain behaviors that society does not deem desirable no matter what the person is thinking. For example speeding and statutory rape are both punished even if they are done as a result of a reasonable accident. More often it is used as a means of public policy to have those who are more able to absorb the costs, bear it. Manufacturer and distributor are often found liable for problems caused by their products, no matter how unforeseeable and bizarre the damage seems. This is based on a belief that a company can better spread the cost over the other products that it sells than an individual who bought the product and suffered from it.

 

Mitigation

 

Finally, we can discuss how to mitigate our risk exposure.

 

Starting point is to protect the individual investors by forming a corporation or Limited Liability Company (LLC). It is the organization, not the individual that engages in business and so, unless the individual has done something intentionally or recklessly, it will be the organization not the individual that are held responsible for it. To benefit from this protection it is important to follow the protocol with regard to formal procedures and requirements, most importantly keeping the business and personal money separately.

 

To further protect the investors it is wise to limit their investment to a small portion of their overall wealth, or at least to a small portion of the income generated. The diversification of risks between the various types of investments is a good practice inside the firm, as well, having all of the money in one type of an asset, or serving just one type of client, may be necessary in the startup, but is not prudent in the long run.

 

The next step is to protect the organization from lawsuits for situations it cannot control. This is done by buying general business liability insurance and any other specialized insurance, such as malpractice, that is specific to the industry. There are many exclusions in a typical policy, but getting together with an insurance agent and learning as much as possible is a good place to start.

 

Legal compliance is the only way to protect from any known risks, such as actions based on theories of strict liability, recklessness or intentional behavior. Awareness is the first step to compliance. Since there is often a substantial cost to compliance it is important to be aware of the specific regulations requiring compliance and to build them in to the financial model of the business before the model is operational.

 

While being legally compliant is a good start, it is possible to take it further and be above reproach. When the organization holds itself to a higher standard than the one required, it creates a whole another level of protection, both by creating goodwill and making it harder for others to attack it. Even an occasional lapse of such an organization is less likely to be as devastating.

 

Finally, an organization can set a whole new standard, by striving for excellence. An organization that has embedded the pattern of excellence in the area of risk mitigation, is not only the least likely to fall below legal compliance, but can often achieve reduced compliance costs, by having the mitigation of exposure be part of the core strategy.

 

Conclusion

 

 Being profitable is not enough. The risks have to be minimized. The risks come from duties and duties come from relationships. Contract law looks at relationship based on agreement between persons. Tort law looks at the rest of the relationships between persons. Together contract and tort law are called civil law. Criminal law looks at the relationship of a person with their country.

The duties can be breached intentionally, recklessly, negligently or under theory of strict liability. The breach results in damages that are compensated.  An individual can reduce the responsibility to compensate damages by acting through an organization such as corporation or Limited Liability Company. An organization can further reduce the responsibility to compensate damages by carrying appropriate insurance, complying with laws, being above reproach or setting a higher moral standard.