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A Family Business “Legal” Audit

By August 1, 1996July 12th, 2023Management and Leadership6 min read

In all likelihood, you know of family businesses that have suffered through painful internal struggles or have endured embarrassing revelations. The consequences can range from public humiliation to catastrophic sanctions from federal regulators that can cripple or devastate a business.

The possibilities for such painful situations seem to be growing at an alarming rate. Family businesses have special issues that may increase the likelihood for such events. Issues such as association with fraudulent charities, lawsuits related to outside board members, unanticipated exposure to bad investments, or inadvertent violation of SEC insider or reporting requirements are a few areas where peril may strike an unsuspecting family business.

Family businesses may avoid agonizing situations by annually auditing their internal workings. In our litigious, regulation-bound climate, owners of family businesses that ignore regular scrutiny do so at their own peril.

Many family-owned businesses enjoy a more casual, less bureaucratic environment than most large public organizations. For this reason it is important for family principals and senior management to develop practices that promote good controls.

Just like a financial audit, a legal audit of your family business should fit the organization’s businesses and structure. Here is a starting point to alert family businesses to a list of issues other than those relating to wills, trusts, and tax planning that are usually considered critical to the ongoing business enterprise.


> A good place to begin a legal audit is to consider the structure of the day to day activities. Consider whether the structure is as effective and efficient as it might be? Does the staff have the optimal mix of generalists and specialists? Is the office staff and administrative structure efficient and designed around your current business? Is the method for allocating overhead and direct costs to family members fair? In your decision making, do you evaluate immediate priorities against competing priorities to achieve a workable balance?

> If your records contain sensitive information, do you have strict policies of confidentiality and records access that apply to both outsiders and family members? Does confidentiality extend to your disposal of records and everyday office trash? And what about special services for family members? Do the services of the office extend to non-family members? Should you address conflicts that develop over business work versus personal services for family members?

> Have you reviewed the requirements of the combined involvement of family members in such things as political contributions, investment holdings, reporting rules, welfare or benefit plan compliance tests? Does everyone understand who has legal control in the business? Have you planned for likely changes or possible future control contests within the business?

> Do you know your weaknesses? Have you made formal plans for management succession or continuity? Have you carefully considered if your business could benefit from independent directors or an advisory board to broaden your perspective?


> Have you been specific about lines of authority and clearly documented the boundaries between family advisory councils and legal boards? In legal matters, are you frequently caught off guard? Do you routinely document contracts, and do you know when you must have a written agreement?

> Do employees feel free to bring up potential or current problems or do they hide bad news? Do they share your values and ethical framework? Does your employee compensation structure align with your interests by balancing conservatism and risk-taking? In oversight issues, do principals in the company adequately monitor the work of non-principals? Is someone designated to maintain general oversight of the business?


> Do you carefully scrutinize the reputation and every day business practices for all businesses and non-profit organizations before agreeing to serve on their boards? For your own protection, have you reviewed indemnification and director’s liability insurance protection? Do you attend board meetings and actively monitor the organizations for which you serve as a board member? Do you know the risks of being a figurehead?

> Do you have systems in place to avoid leaks of confidential company information to those closest to you? Do you comply with SEC reporting requirements? Are you aware of trading by family members that may violate insider trading rules or restrictions imposed by SEC rule 144? Do you routinely evaluate board positions that you, family members, or key staff hold for possible conflicts or access to sensitive information about your competitors?


> Do you actively identify and try to insulate your business against risks? Have you reviewed your indemnification policies or agreements to know when they might negate efforts to establish corporate liability veils? Do you carefully review the details of even “small” investments to be sure your risk is limited to your investment, and do you know the uninsured exposures of your company as well as the coverage limits of your insurance policies? Do you know your “worst case scenario?”


> Do you have an organized process for making investment decisions? Is your style to carefully identify investment opportunities on your own, or do you respond to advice from others? Do you honestly know how to analyze investment opportunities?

> If you are an early investor, are you aware of the risks of others viewing you as a sponsor or relying on your decision as an endorsement? If you use multiple investment managers, are their efforts coordinated so that they do not exceed risk levels, cancel strategies, or unwittingly exceed legal limits on particular holdings? Do you place limits and actively monitor discretionary investment managers?

> Are you aware of and understand potential environmental liability risks to your business? Do you have an investment vehicle for small family trusts and entities to pool resources or to meet qualified investment requirements? When you invest in private placements, do you carefully evaluate your cash call possibilities and your representations and indemnification obligations in subscription documents? Do you carefully monitor ongoing transfer or other restrictions?


> Do you consider securities law compliance issues if you put others in your investments? If you or someone in your office manages funds from a very broad extended family or from third parties, have you checked to be sure your business does not need to be licensed as an investment advisor, securities broker, or real estate agent?


> Keeping professional services coordinated is vital. Lawyers, accountants, insurance agents, and investment advisors/consultants should coordinate with each other to avoid duplication. Have your professional advisors gotten to know you well enough to give you correct advice? Does the expertise of your advisors and their firms match your needs? Do your advisors give you the balance you need between the broad overview and areas that require specialization?

> When seeking advice from your advisors on legal, tax, or financial questions, do you understand the degree of certainty behind the answer? Are you willing for them to give you objective advice or does your manner and attitude discourage it?

> Are the fees you pay commensurate with the quality of professional services you receive or need? Do you choose advisors for their abilities and cost or because they are friends or relatives?

Tom Hurtekant, J.D. is an attorney with Brown McCarroll & Oaks Hartline. His practice includes family-owned and closely held businesses.