The Legal Audit: A Health-Check for Companies

December 6, 2012

The last few years have seen unprecedented levels of director and company scrutiny and investors and regulators have become far more cautious and far more a-tuned to the potential pitfalls of a badly managed businesses.

Set against this background, businesses are increasingly looking for ways to cut expenditure and reduce their exposure to risk. Time and time again, however, directors focus on their finances alone and the annual audit of accounts as a measure of risk, without examining the position of the wider business. To ensure a company is in the best position to weather the current economic storm, a company should perform a full “health-check” or, in other words, a “legal audit”.

In short, a legal audit is designed to ensure that your entire house is in order, not just your finances. A detailed examination of the key areas of your business will help identify dangers, areas of weakness and potential liabilities allowing you to formulate strategies to avoid or minimise such risks and ensure a smooth path through these difficult times. Not only can a legal audit unearth hidden issues before they impact the finances of the company but by identifying such issues early on it ensures that they can be managed in an efficient and less costly manner.

They are also an extremely good idea for companies looking for a suitable exit. By identifying problems in advance, it should cut down the pain of a potential purchaser's due diligence exercise.  

For the best results, a legal audit should be company specific, the scope of which should be discussed and agreed with management prior to commencement.

Typically, however, the following key areas would need to be examined:

Structure and Constitution

More often than not, a company’s constitution/shareholders agreement, once drafted, is left in a draw until the going gets tough or the company wants to pursue a new corporate initiative. This can prove a costly error.

With surprising regularity, small companies discover too late that when there is a disagreement on how to manage the company there is no agreed mechanism to find a solution. Not only do directors find themselves facing stalemate and deadlock at the very time that crucial decisions are needed for the survival of the business but any solution or settlement that can found is often costly and untimely at the precise moment the company needs to move quickly and preserve its finances.

A company should revisit their articles of association on a regular basis and, if control of the company is split between two or more shareholders, ensure a suitable a shareholders agreement is in place to govern any potential disputes.

Directors and their Duties

Throughout their period of office, directors must be aware of their obligations to the company under the Companies Act 2006. Never is this more important than when a company is facing financial difficulties.

In normal circumstances, when a company is in good financial health, the 2006 Act provides that the primary duty of directors is to act in a way which would be most likely to promote the success of the company with reference to the interests of its shareholders as a whole. As soon as a company starts to enter a period of financial difficulty, directors must also consider their potential liability for wrongful trading and the potential implications of granting preferences or approving transactions at an undervalue.

Companies should ensure that their directors are fully aware of their duties both in good times and bad and that their activities are sufficiently monitored to ensure nothing is missed.

Key Employees

It is not just good directors who will bring a business safely through the storm. It is surprising how often even quite large businesses are dependent on a very small number of key employees and never are those employees more vital than when a company is in difficulty. A legal audit is designed to identify such persons and examine their contracts of employment (often establishing whether they even exist in writing and have been properly executed).

In times of difficulty a good employee can be an invaluable asset and companies should be aware that the more important the employee the greater the poachable target. An examination of the contracts will not only ensure that the right people are being suitably rewarded but it will also check whether appropriate (and enforceable) restrictive covenants are in place to help prevent certain employees from being snatched by competitors.

Management

In difficult times the management of the business and all employees becomes increasingly important.

Regular reviews of reporting processes should be conducted to ensure that critical information is passed up to the board in a timely and accurate manner. It is often the workers on the ground who first notice when things are amiss and, when the going gets tough, it is vital that key management decisions are based on accurate and up to date information. Where companies have grown over a period of years it is not uncommon to find layer upon layer of management meaning that critical information passes through several hands before it reaches the decision makers, by which time it may be distorted or out of date.

Key Customers and Key Suppliers

As important as your employees may be, your business will flounder if it is unable to access customers and suppliers on the best possible terms. As well as ensuring that your standard terms enjoy sufficient legal protection, a review of existing arrangements can uncover new opportunities for savings or growth by identifying key terms for re-negotiation. It can also identify where a business has become overly dependent on one customer or supplier allowing the company to diversify before it becomes vulnerable: in difficult times it’s not just your company that is in danger, the knock-on effect of a key supplier or customer going under can be profound.

Finances

While your finances may enjoy the regular scrutiny of the annual audit, a legal audit can help identify new financing opportunities and key savings, as well checking that a company’s finances are readily accessible when most needed.

Many companies provide their working capital through overdraft facilities from their banks. Invariably such overdrafts are repayable on demand and are often the first facilities to be examined by any bank wanting to reduce its exposure. In the current climate, with bank finance particularly difficult to come by, an examination of existing facilities and security positions can identify opportunities by which to negotiate longer term loan facilities or release certain items of security thereby assisting in cash-flow.

Premises

Whether you run your business from a leasehold or freehold property, the associated overheads often constitute your largest outgoings. If you hold a leasehold, a legal audit can identify key areas for re-negotiation. During difficult times landlords are keen to hold onto good tenants and this can be used as a bargaining tool to fix your rent for a longer period, agree to the insertion of a break clause or even allow for sub-letting if the property is superfluous to your needs. If you hold the freehold the same analysis applies to any tenants you may have and the legal audit will also examine the terms of your mortgage ensuring you know exactly what you are paying thereby allowing you to explore the market fully informed.

Compliance

When a business is focused on staying afloat, compliance can often be overlooked until the regulator/creditors come knocking!

A legal audit will check that your company is update to date with all its corporate and regulatory filings and identify what policies or procedures should be implemented. This will ensure that compliance becomes second-nature and does not fall by the wayside. The last thing a company needs, when focused on keeping financial problems at bay, is a hefty fine.

In summary while the annual audit of accounts will give you a thorough picture of how your company performed in the previous year it will not provide you with a roadmap to a secure future. Far too many companies do not realise the potential danger their day-to-day activities and management styles can pose until it is too late.

Not only does a legal audit provide a full overview of potential liabilities but it can help remove those liabilities before the crystallise and identify ways to stream-line your business and reduce expenditure. While, by their nature, legal audits will focus on the “legal position” of your company they also provide a second set of business eyes which can spot company behaviour that has become entrenched over the years but which could prove costly in times of difficulty.


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Mary Elliott
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melliott@foxwilliams.com

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