The ABC’s of legal audits for (small) businesses
May, 2006
Thankfully for most of us, tax time has come and gone once again. Although the annual ritual of filing tax returns can bring with it, in some rare instances, the trepidation of being exposed to a time-consuming audit by the Internal Revenue Service (IRS), there is another kind of audit that many businesses should pursue: an audit of its legal operations.
In today's post-Enron world, public companies are held to new standards of corporate compliance, codified in the Sarbanes-Oxley Act of 2002. Smaller, private companies, however, can also benefit from establishing consistent corporate governance guidelines. By conducting an audit of its legal operations as part of its regular corporate governance practice, a business can develop a sense of accountability and transparency to its investors, shareholders and the general public that can have a beneficial and material impact on the company's value in even the most common transactions, such as financing and sales.
Many smaller companies are formed in the midst of a flurry of ideas and activity and easily lose sight of basic corporate formalities that, if not followed, could have serious consequences on the future of their business. For example, although an upstart business may believe that it has designed a unique portable safety wall that will help protect rescue crews at the scene of highway accidents, without an appropriate Confidentiality and Invention Assignment Agreement in place with its employees, the company could be embroiled in expensive litigation over the rights to the design and lose its ability to utilize that design altogether. And although the law generally shields directors from liability for the corporation's obligations, a director who approves the company's loan of money, without the approval of the shareholders, is personally liable for any losses to the corporation.
By taking the time now to review its business records, such as corporate minutes, standard contracts, insurance policies and the like, a company can substantially reduce its risk of unnecessary litigation and liability down the road. Here is a list of some items that a business will want to keep an eye out for in conducting its review.
1. Corporate Records
Are there minutes for all meetings of shareholders and directors? Keep in mind that the only action required to be taken by shareholders on a regular basis is the annual election of directors. LLCs do not need to conduct annual meetings unless required by its operating agreement.
Are all written consents of shareholders and directors included? Unless otherwise provided in the articles, shareholder action can be taken without formal meetings by written consent executed by a sufficient number of shareholders.
Have the bylaws been appropriately amended to reflect any changes in corporate governance? For example, bylaws generally can be changed either by the directors or shareholders. Once shares have been issued, however, only the shareholders can change the authorized number of directors stated in the bylaws.
2. Company Stock
Were all sales of stock made in compliance with applicable securities laws? Only after full compliance with state and federal securities laws are share certificates or securities actually executed and delivered to the issuees.
Has the company received appropriate consideration for each sale of stock? Although there are statutory limits on the type of consideration for which shares may be issued (prohibiting issuance of shares for future services or unsecured promissory notes), there are generally no limits on the amount of consideration for which shares may be issued.
Do the stock certificates have the appropriate legends? For example, if issued by a statutory close corporation, a certificate must contain a "conspicuous" legend on its face that recites specific language found in California Corporations Code § 418(c).
3. Contracts
Does the company have good form contracts in place? It is a good idea to make sure that a business' form contracts stay up to date with the ever evolving changes and requirements in the law.
Do the contracts contain appropriate forum and attorney's fees provisions? Unless specifically provided for in the contract or by statute, each party will have to bear their own attorney's fees in any subsequent dispute arising out of that agreement.
Do the contracts say that amendments to the contracts may only be made in writing? Remember that an amendment must satisfy any statutory requirements for enforceability of a contract, as well as any specific conditions stated in the contract.
4. Federal and State Filings
Has the company obtained its Employer Identification Number? Every corporation, regardless of whether it will have employees or not, must obtain a federal employer's identification number (EIN) from the IRS.
Has the company obtained any required local and state business licenses and permits? Cities and counties vary widely both in the extent to which they impose licensing requirements and in regard to the offices that handle the licensing function. Local officials should be contacted to determine all applicable licensing requirements.
Has the company qualified to do business in all states it is required to? Every state has laws requiring foreign corporations to qualify before doing business and imposing sanctions for failing to qualify. If your company intends to transact business in other states, inquire of the Secretary of State's office of each jurisdiction regarding the applicable local requirements.
5. Protecting Intellectual Property
Has the company obtained appropriate federal and state trademark registrations for its products and services? Owning a federal trademark registration provides several advantages, including a legal presumption of the registrant's ownership of the mark and the registrant's exclusive right to use the mark nationwide on or in connection with the goods and/or services listed in the registration.
Have employees, consultants and independent contractors signed appropriate Confidentiality and Invention Assignment Agreements? Holdover clauses (attempting to cover inventions made after termination of employment) are enforceable so long as they are reasonable as to time.
Is a trade secret protection program appropriate? Establishing procedures to protect the business' trade secrets, such as requiring employees to sign nondisclosure agreements and restricting access to trade secret documents, may be crucial to maintaining the protection of those secrets under California law.
6. Records Management
Does the company keep consistent and accurate records of its income and expenses? California law requires that adequate and correct books and records of account must be kept in writing or another form capable of being converted into a clearly legible tangible form.
Does the company keep track of all tax filings required? Under federal law, a person owning 1% or more of a corporation's outstanding stock may inspect the corporation's income tax return on file with the IRS.
Does the company keep track of any loans it disburses to its management and/or employees? A private company should review existing loans to officers and directors and the reasonableness of the terms of these loans and should establish company policy for any future loans to officers, directors, or employees. A public company is not allowed to disburse loans to its management.
7. Insurance
Does the company have policies of insurance that cover its different lines of business? Lines of insurance may include not only commercial general liability coverage and workers' compensation, but also coverage for commercial autos, real property, directors and officers liability, employment practices, environmental claims, etc.
Are the policy limits sufficient to cover any potential liability arising out of the company's growing business? As your business grows, make sure that your policy limits are sufficient to cover your potential exposure to additional liability and that you obtained the coverage you believe you purchased.
Does the company keep an accurate record of all its prior policies? Sometimes, injuries arising out of your business' activities may not be discovered until several years after the fact (e.g., a business' accidental leak of contaminants into the groundwater). So make sure that a copy of all prior policies are kept within the company's records.
8. Employment
Does the company have all needed forms from employees (W-2, W-4, I-9, etc.)? An employer must obtain a signed IRS Form W-4, Employee's Withholding Allowance Certificate, from each employee.
Does the company have a sexual harassment prevention program in place? For businesses that regularly employ at least 50 employees, employers must provide sexual harassment training and education to each supervisory employee once every two years, and to each new supervisory employee within six months of promotion.
Has the company prepared and distributed an employee handbook to its employees? Many companies now publish their employee handbooks on the company's intranet. This practice allows more frequent updates to keep pace with changes in the law and the company's business and to help ensure that the handbook appropriately reflects the company's current policies and procedures.
9. Website Compliance
Does the company's website contain a privacy policy and statement regarding the collection and use of personal information that conforms to existing California law? All web sites that collect personally identifiable information from California consumers must comply with the California Online Privacy Protection Act of 2003.
Does the company own the design and content of its website? When entering into a contract with a website developer, make sure that the developer assigns to the company all rights, title and interest to the content and designs within the website.
Does the company's website comply with laws pertaining to certain consumers, such as minors and disabled persons? For example, to ensure that your website complies with the Americans with Disabilities Act, create site navigation that works for individuals who can't use a mouse (e.g., keyboard shortcuts, tab order, etc.).
These are just a few of the many issues a small business should consider in auditing its operations. After this evaluation, the audit results can be reviewed with the company's legal counsel to address any concerns, questions or problems that arise. And like the annual rite of filing your tax returns, this audit should be conducted once a year to ensure that the company is up to date on its legal operations and that no surprises will derail the company's continued growth. Otherwise, a small business increases its risk of being embroiled in needless, costly litigation—something that can be even more painful than an IRS audit.