One of the most important elements of the control environment is any business is the establishment and use of formal policies and procedures for reviewing and approving contractual arrangements with third parties that will create legal rights and obligations for the company.
Ideally some sort of contract review and signature authority policy will be put in place very early in the company’s existence since contracts of various types will be needed from the time that the company first opens its doors. Many times all of the contracts under consideration during the start-up phase will be discussed by all of the founders because it easy to do so in light of their close proximity and the absence of layers of management personnel when the company is still small. The problems begin to arise, however, when founders and other senior managers start to assume more responsibility for particular areas of the business and the input from other founders and managers becomes more limited due to the lack of time, problems with communication and the fact that the other persons are themselves preoccupied with their own projects.
While the senior managers in a particular functional or business area presumably have the most skill and experience with respect to contracts that they initiate it is nonetheless important to have some independent review of the business case for the contract and the potential risks to the company of assuming the legal and operational obligations included in the contract. For example, all functional areas that might be involved in fulfilling the company’s duties under the contract should be consulted in advance to verify that they will be able to perform as anticipated. Contract review is also necessary to avoid conflicts with commitments that someone else in the company may have already made with other parties. Finally, contract review is needed to be sure that independent parties are reviewing the terms of each proposed transaction and that persons initiating a contract do not have some “vested interest” in the selection and use of the contract partner.
Procedures for contract review and signature authority should accomplish at least two main purposes—establish the process for the review and approval of proposed contracts by various departments (e.g., legal, finance and other departments involved in the fulfillment of obligations created under the contract) and identifying which persons within the company have the authority to approved specified transactions or activities and thus execute a proposed contract on behalf of the company. Ideally the contract review process will also provide an opportunity for evaluating the proposed contract in the context of the company’s overall business strategy. This can and should occur through the creation of a business case for each proposed contractual arrangement (or at least those contracts that are “material” in light of the company’s business) that describes the key rewards and risks associated with the contract, explains why the contract is important to the company’s business plan, establishes performance milestones, and suggests procedures for monitoring performance under the contract after it is executed. The business case process forces the initiating party to think through each proposed contract and become an informed internal champion for the relationship and also serves as an important information and communication tool for senior management to the extent that they are being kept in the loop as to the specific activities and tactics that are being used to further the company strategy that has been established at the top of the hierarchy.
The content in this post has been adapted from material that will appear in Business Counsel Update (Summer 2008) and is presented with permission of Thomson/West. Copyright 2008 Thomson/West. For more information or to order call 1-800-762-5272.