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The Legal Audit: A Reality Check for Entrepreneurial Companies

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

The development of a business model and the achievement of the business objectives necessary to enable that model to be effective means that an advisory team must be put into place to help the entrepreneur keep plans on track. These outside advisors should perform periodic reality checks to test and adjust the validity of the business model. As a corporate lawyer, I am aware that these "business model reality tests" typically take the form of a legal audit.

In a legal audit, the company's management team meets with corporate counsel in order to discuss strategic plans and objectives, review key documents and records, and analyze and identify current and projected legal needs of the company. The legal audit also lays the groundwork for the establishment of an ongoing legal compliance and prevention program in order to ensure that the company's goals, structure and ongoing operations are consistent with the latest developments in business and corporate law. Finally, the legal audit helps managers identify the legal issues triggered by changes in strategies, goals or objectives and allows planning for the legal tasks that must be accomplished as a result of the issues identified.

Issues in a Legal Audit

A comprehensive legal audit will examine a wide range of issues which may be as mundane as whether or not the company is qualified to do business in foreign jurisdictions or as complex as an analysis of the company's executive compensation and retirement plans in order to ensure consistency with current tax and employment law regulations. The topics that must be addressed include: choice and structure of the entity; recent acts of the board of directors and documentation (or lack thereof) relating to those decisions; protection of intellectual property; forms and methods of distribution and marketing; pending and threatened litigation; estate planning; insurance coverage; hiring and firing practices; employment agreements; securities law compliance; antitrust and related trade regulations; product liability and environmental law; and a review of sales and collection practices. Naturally, the extent and complexity of the legal audit will vary depending on the size and stage of growth of the company, the type of business (such as service vs. manufacturing), the number of shareholders and employees, the extent to which the company does business in a "regulated industry," and a host of other factors.

A legal audit may be performed on a periodic basis as part of an ongoing compliance program or may be performed in connection with a specific event, such as a financial audit, or in connection with a specific transaction, such as an acquisition or securities offering. There are also specialized legal audits in specific areas, such as tax; labor and employment; estate planning/asset protection; government contracts; franchising compliance; and environmental law. The mechanics of the legal audit and a sample questionnaire are listed below.

Mechanics of a Legal Audit

  • The Preliminary Questionnaire. The legal audit should begin with a comprehensive questionnaire for the company's management team to review and address prior to the arrival of the team of attorneys who are to conduct the legal audit. In the case of smaller companies, a simple checklist of issues or a formal agenda will be more than sufficient to prepare for the initial conference.
  • The Initial Conference. Once the documents and related materials requested in the questionnaire have been assembled and problem areas preliminarily identified, a meeting should be scheduled between audit counsel and the designated officers of the company who are well-versed in the various aspects of its operations. Related members of the management team, such as the outside accountant and other professionals who play key advisory roles, should be present during at least the portion of the audit that relates to their area of expertise. This initial series of conferences is an information-gathering exercise designed to familiarize the legal auditor with the most current information about all aspects of the company. In addition to these conferences with key personnel, the audit team should perform some on-site observations of the day-to-day operations of the company. The legal audit team should also review the current financial statements of the company and spend some time with the company's accounting firm.
  • Implementation of the Post-Audit Recommendations. Once the legal audit team has issued its post-audit evaluation to the management team, the entrepreneur can implement the recommendations of the report. What he or she does will vary, depending on the growth planned by the company, as well as the specific findings of the report. At a minimum, the entrepreneur should schedule meetings with key personnel to review and discuss the post-audit recommendations; prepare internal memos to educate the "rank-and-file" employees; conduct employee seminars to educate employees about proper procedures and compliance; and in certain cases, develop handbooks and operations manuals for continued and readily available guidance for the company's staff. If significant problems are discovered during the audit, counsel should be careful about what is included in the final written report in order to avoid potential adverse consequences down the road under the federal or state rules of evidence. In addition, the company can establish a "tickler system" for periodic reporting and key dates/deadlines, as well as a time set for the next legal audit.

Risks of Not Complying

The failure to have an independent legal audit performed by qualified legal counsel can have a significant adverse impact on the company and its founders. The risks of non-compliance with these many laws and regulations include:

  • Failure to keep proper books and records or mixing personal assets with business assets could lead to the ability by third parties to "pierce the corporate veil," thereby removing the limited liability protection of a corporation or LLC, or even to litigation among co-owners.
  • Failure to obtain all proper permits and licenses could lead to fines, penalties, and, in some cases, even closure of the business by governmental agencies.
  • Failure to comply with certain laws and regulations may lead to problems under federal law with agencies such as the IRS, the EEOC, the EPA, and even the SEC.
  • Failure to have employment applications, personnel handbooks and general employment policies reviewed periodically could give rise to governmental and civil liability.
  • Failure by the directors of the company to keep accurate records and minutes of its decision-making procedures, such as proving that directors are exercising informed judgment, could subject the company and its board to liability to its shareholders and investors.
  • Failure to monitor the company's reporting requirements may put the company into default with lenders or investors.

The process of going through a legal audit isn't easy, but the risks associated with avoiding the issue are too high for any company to bear. Doing so is not only necessary, but beneficial. It is the entrepreneurial company's reality check.

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