Subway, McDonald’s and the importance of adequate insurance for franchises

It is common practice for business owners to protect their investments and assets with a number of insurance policies. This is especially the case for franchise owners who have large fit-out costs at the commencement of trading. It is compulsory to have insurance cover for building, contents, public liability and workers compensation. It has also long been a practice of insurance brokers to suggest to their clients that life insurance should be sufficient to at least cover the extent of the client's debt so that in the event of his or her death close relatives are not encumbered with the responsibility of outstanding debts.

It has been in my lifetime that insurance companies have introduced policies to protect their clients’ income. I remember the relief I felt when I realised that with a simple monthly premium I could keep my family functioning on 75 percent of my income in the event that I became temporarily incapacitated for work. Then there is trauma insurance. It has become attractive for a number of people who want the comfort of knowing that in the event of a trauma, such as a heart attack, any large out-of-pocket expenses will be covered.

So we have all been taught and come to believe that inadequate insurance cover can result in heavy loss of business assets as well as turn our personal lives upside-down. Therefore, most people still believe that as long as they have in place the correct insurance policies for the correct amounts, they are safe. However, that is no longer the case. In recent years it has become an increasing practice of insurance companies to deny claims on their policies. One of the main reasons for denying such claims is the allegation that the person who holds the insurance policy has been negligent in the exercise of his or her responsibilities.

Denial of claims by insurance companies have resulted in massive punitive damages being awarded against unprotected businesses and individuals. It is frighteningly easy to have negligence proved at law. Take a look at these cases:

1. Magnetic Island golf owners sued $2.6 million for a social day golf accident. The golfer was found to be negligent.

2. Customer sues Subway outlet for slipping on soft drink spilled by another customer.

3. Payout to customer of McDonald’s for spilt hot coffee.

It is important to understand that negligence proved against an employer can easily be on the grounds that he or she was responsible to prevent the negligence, even though he or she may not have been present at the time nor aware that the act of negligence occurred. If an employee is responsible for the negligence then in the event of litigation to secure compensation it is the owner who is sued and the only recourse for the owner is to cross-sue the employee who may have no assets or be a family member or a friend.

As disturbing as these possibilities might be, it is also important to take into account that New South Wales is the second most litigious state in the world per head of population, after California in the US. Queensland has the distinction of being the fifth most litigious community after Florida and Texas, which rank third and fourth. Even more disturbing is the recent emergence of television advertisements on behalf of legal firms that unashamedly advertise free interviews to assess the strength of plaintiff cases and make a number of suggestions to viewers just in case they don’t realise that they can sue other people for almost any mistake at all.

Incorporation in a proprietary limited company offers limited protection. It can protect the assets held in the personal name of the directors. For example, if an employer has no public liability cover or insufficient cover. In such a circumstance a successful claim by a plaintiff against the employer for a non-negligent act will still expose the assets of a corporation to loss, but not assets in the personal name of directors. However, in the event that the employer (i.e. the proprietary limited company) is found to be negligent, the assets held in the personal name of the directors are at risk if the assets of the corporation are insufficient to cover a successful litigation.

Many lawsuits are frivolous but cause huge stress to employers, and may still require an out-of-court settlement. Indeed, consider the following.

Two investors, Jones and Smith meet for lunch every Friday at a club. They enjoy discussing business, investments and retirement plans. But on this particular occasion they discuss some expected problems.

One day at his business, Jones was surprised to see a nervous looking stranger show up in the lobby. The stranger asked, “Are you Mr Jones, the owner of the business?”

“Yes, that’s me, and who are you?” Jones responded.

“Process server,” he said, shoving some papers into Jones’ hands. Then he turned briskly and walked away.

“What the…?” Jones wondered. Upon opening the document, his heart fell.

A customer was suing him for negligence because she had slipped and fell outside his property. Finally he got to the end of the complaint and saw the amount he was being sued for: $1 million in actual damages and an additional $2 million in punitive damages – far more than his net worth.

“But I’ve got liability insurance,” he remembered. “I’ll just let them worry about this.” So he promptly overnighted the complaint to his liability insurance company.

The next week, an attorney from the insurance company met with him. They sat down and reviewed the case. The attorney reassured Jones that he had not been guilty of negligence.

“So it looks like I’ve got nothing to worry about?” Jones assumed.

“We should settle this out of court,” the attorney advised.

“What? Why should someone get a penny when I wasn’t negligent?” Jones asked.

“Unfortunately, whether you broke the law is somewhat irrelevant. If this goes to trial, the plaintiff’s attorney will pit the poor plaintiff against the rich business owner. Judges sometimes fall for this trick of the poor versus the rich. The story will make the news. Your reputation in the community could be damaged. Customers could stop coming to your business. You’ll have to spend days away from your business while appearing in court.”

“I never considered all that. How much do you think it will take to settle this out of court?” asked Jones.

“About $100,000 to $200,000.”

“Well, you can spend your money however you want. That’s why I’ve been paying all these insurance premiums.” Jones presumed.

“Not exactly,” said the attorney. “Your policy has a $50,000 excess. The first 50 grand comes out of your pocket. We’ll kick in the difference. But, if they refuse to settle out of court, remember your policy is for only $1 million. You’re still liable for the remaining balance.”

“And what will a claim do to my future liability insurance premiums?” Jones asked.

“Plan on your insurance premiums increasing by about 50 percent.”

“So, what you’re telling me is that I can buy off this ridiculous lawsuit for $50,000 out of my pocket plus increased insurance premiums for the rest of my life, or I can risk losing my customers and my reputation in the community. I feel like I’m being threatened with legal extortion.”

“Sorry, but that’s how the litigation game works in Australia,” explained the attorney.

As it happened, Jones decided not to settle out of court. Before the trial, he was required to hand over to the plaintiff copies of his tax returns, bank accounts, business records, superannuation, leases, credit cards, and loan applications.

Four years later, when his case finally came to trial, the judge’s gavel came down and he pronounced the verdict – “guilty”.

Jones had to postpone his retirement plans. Jones’ friend from the club, Smith, had a similar problem. His wife was named in a lawsuit after she caused an automobile accident resulting in an injury. The lawsuit was for $2.5 million, far more than her insurance coverage, or net worth.

The plaintiff’s attorney met with the Smith’s attorney to discuss a possible out-of-court settlement. The Smith’s attorney started the conversation: “Before you waste your time here, there is something I need to tell you about my clients. The Smiths don’t own any assets. They are penniless.”

The plaintiff’s attorney sat back in his chair and said, “Well, we’ll see about that.”

“You can ‘see’ as much as you like,” said the Smith’s attorney. “Their assets are mortgaged to 100 percent of their value – they’re penniless.”

The plaintiff’s attorney looked a little ruffled. “Well what about their investments, stocks, rental properties and business?” he questioned.

“Sorry,” said Smith’s attorney. “They don’t own those, they are all held in trusts that are controlled by one-dollar companies, not Mr and Mrs Smith.”

After verifying what he was told, the plaintiff’s attorney advised his client that he could not afford to take on this case on a contingency fee basis because the Smiths had no available assets. The complaint was dropped.

How likely are you to be a target? If you own a business it is probable that you will be sued in your lifetime. The question in Australia is no longer if your assets will be attacked, the question is when.

The structure utilises a trustee company and two trusts, which are known as the asset trust and service trust. The asset trust owns the hard assets from the fit-out, cars, office equipment and the like, and leases them to the service trust. The service trust is the entity that employs staff, including the owner of the business, and conducts the activity of the business. For example, trading accounts would be in the name of the service trust. If an employer is sued, it is the service trust that is the target of litigation. However, the service trust does not own any hard assets. The asset trust owns the hard assets but it is a different entity and not responsible for what happens in the service trust. Therefore, since the service trust has no assets of its own it is unlikely that any litigation will proceed against the service trust.

Barristers do not waste their time. At the same time, it remains a possibility that a plaintiff may resort to litigation in order to access the income stream coming into the service trust. There are a few ways this might be handled but at least the hard assets of the business are protected.

The transfer or ‘rolling over’ of existing business assets into the above structure is normally an inexpensive exercise, as long as stamp duty on real estate is not involved. Even then there are asset protection strategies available to reduce this cost. Our company, for example, engages legal and financial advice from trained professionals who are expert in the field. This advice is directed specifically at the needs for which the asset protection is requested. The cost of the illustrated structure is $5,250. This includes GST and all advice given. It is a one-off cost to protect your assets – unlike other insurance strategies that require the payment of regular premiums.

In summary, even with enough insurance cover a business owner remains at risk of losing the assets if an employee is found to be negligent in the course of exercising his or her responsibilities. It must be emphasised, however, that insurance policies are still necessary, as there will be a number of legitimate claims that such policies will cover.

The bottom line is that franchise owners need no longer fear that their whole investment is at risk if an insurance company denies a claim on an existing policy.

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