In an ideal world there would be no such thing as subsidiary governance. But even in the real world, subsidiary governance is often more the exception than the rule. Or at least it has been.
But the world is changing. Where traditional corporate governance addressed concerns from the perspective of the parent entity, the focus is shifting to subsidiary level governance. The question in relation to this is how prepared businesses are to evaluate existing corporate governance policies and, where necessary, to make adjustments to align with developing leading practices. This will not necessarily be an easy task, but it will better position them to manage corporate risks and to generate operational efficiencies.
The importance of corporate governance became particularly clear at the turn of the century in the wake of several major corporate failures. While governments woke up to the need for better regulation, this was typically directed at the parent companies of listed multinationals. This is somewhat surprising given how many of these major governance failures occurred at the subsidiary level. However, pressure has been building from various quarters of the globe to recalibrate the rules to take into account more than just the parent company’s perspective. After years of inattention, the matter of subsidiaries and the way they are managed, is beginning to be taken a lot more seriously.
As supply chains increasingly integrate and groups combine worldwide, group headquarters’ risk are becoming, in these ways, further and further distanced from the companies that carry out the day-to-day business. At the same time, legal entities are multiplying and corporate structures are becoming more complex. As a result, establishing and maintaining a clear picture of a group’s legal entities, their business function and risk profile is becoming increasingly difficult. And things will not get any easier as economic disrupters such as the threat of trade wars from the US, Brexit in the EU and the OECD’s global anti-tax avoidance initiatives start playing out around the world.
We are also seeing regulators not only issuing new rules, but also taking a harder line with existing ones, together with an increasing number of stakeholders that are demanding more transparency and accountability. This has translated into higher risks and increased associated costs of corporate governance failure. It has also reinforced the need for robust corporate governance frameworks at every level.
And corporate governance failure is not just a question of direct financial cost for the entities concerned. It is about lower stock prices or downgraded corporate debt ratings for the group. It is also about damaged reputation and reputation that can take years to recover from, if at all. It is exposing the parent company to civil claims triggered by subsidiary actions. And it includes the risk of personal liability, including criminal penalties, for corporate managers.
Why people matter
Most multinationals we speak with recognize the value of centralized systems as part of a group’s corporate governance framework. Indeed, we are regularly called upon to help businesses optimize or replace their entity management platforms, or to bring in new process management software to track compliance and to police deadlines. It is a fact of life that technology is playing an increasingly important role in corporate governance, for example, by automating repetitive tasks, using data analytics to identify risks and trends, and helping to limit human error. But that does not mean that businesses can ignore the human element. People will still be needed to make decisions, even if many routine decisions are completed using automated tools. In fact, the more business processes are being automated, the more critical the human element becomes. This is true for parent companies but also for subsidiaries. Having a corporate governance framework in place does not of itself secure good governance. It is how management—at all levels—interacts with that framework.
There are many theories as to how subsidiary boards should be structured. However, in practice there are two basic approaches: on the one hand, a centralized model and on the other hand, a decentralized model. Under both models a balance is needed between control from the top and freedom at the bottom. The difference is largely one of where that balance lies.
- A centralized model is characterized by a strong parent company board with largely passive subsidiary level boards focused on regulatory compliance and day to day decision making and reporting. This results in more direct control and a clearer division of responsibilities, but risks fettering local initiative, stifling motivation and slowing down decision making. Under such a model, clear and relevant information flows back to the parent as an essential part of the governance framework, in particular if local conditions are to be properly taken into account.
- A decentralized model means empowering subsidiary boards so that they have the freedom to develop their business in a way that makes sense from a local perspective, without unnecessary or irrelevant interference from the parent. This results in a more agile, pro-active board that can respond quickly to local conditions. The challenge here is to ensure that subsidiaries take into account group governance policies and feedback sufficient information to enable their activity to be monitored and, where necessary, corrections made.
Which model should be chosen depends on various factors such as the size and composition of the group and its constituent entities, including its business sector, the functions performed by the various entities, and the maturity of the group’s existing corporate governance model. In fact, it is not necessarily a question of choosing between one or the other model, but a question of which elements are appropriate for the given group. The result should be a model tailored to the group’s actual circumstances. Finding the right balance may not be easy but can make the difference between success and failure.
Problems can arise where too much control is concentrated at the level of the parent. In extreme cases this could lead to courts ‘piercing the corporate veil’ and holding parent companies liable for the wrongdoings of their subsidiaries. In one recent decision, a UK court considered it arguable that a duty of care was owed by the UK parent company of a foreign subsidiary accused of causing pollution and environmental damage: one of the factors taken into account was a ‘sustainability report’ that stressed that the oversight of all subsidiaries rested with the parent board.
An over-dominant parent board can also have adverse tax implications. Depending on the jurisdiction concerned, the tax residence of a company may be strongly influenced by where the key decisions regarding its business are taken, often referred to as a company’s ‘mind and management’. If such decisions are taken by the parent board without regard for the subsidiary’s own management, this could cause the company being deemed resident – and taxable – in the parent jurisdiction.
But just as too much control can lead to problems, so too cannot enough oversight. This is true not only for the general well-being and efficiency of the subsidiary’s business but also from the point of view of legal liability.
Designing the right subsidiary board model on its own is not enough. Like governance frameworks generally, a subsidiary governance framework will not work unless it is properly embedded in the organisation. That requires buy-in at all levels, which means not only that it needs to be properly communicated but that it is seen to be applied in practice. Our experience shows that a well thought out subsidiary board framework can easily be undermined if management at the headquarter location prefers to talk directly with local management rather than respecting board mandates or other governance mechanisms. As the UK case mentioned above illustrates, having a governance policy in place but poorly implemented is not merely inefficient; it can be worse than having no policy at all.
Finding the right the mix
There is no magic bullet for what makes a good subsidiary board: the composition, size and structure of a subsidiary board is very much a function of the group to which it belongs and the role it plays within that group. Of course, much of what applies to parent company boards applies to subsidiary boards. This is particularly true as regards the importance of diversity. A mix of skills, personal strengths, experience and background, as well as gender optimizes the ability of a board to make informed and balanced decisions. “Group think” should be avoided at all costs.
Diversity also implies independence. While this also applies to parent company boards, it is a particular issue for subsidiary boards that need to maintain an appropriate degree of independence from the parent. So long as the interests of the parent and the subsidiary coincide the latter is of little concern. While this is often the case, our experience shows that conflicts can and do arise. A board that is not strong enough to meet such challenges is handicapped. That interests can diverge where there are minority shareholders is self-evident. But conflicts can arise for other reasons. These can include decisions on business strategy, for example involving reorganizations, closures or product development, decisions on board appointments, or even on the level of inter-company charges. Conflicts can also be triggered as a result of diverging interests between a parent company and other stakeholders such as customers, suppliers, investors, employees and regulators. We are seeing corporate governance codes in various jurisdictions starting to reflect these diverse stakeholders, so this is an aspect that deserves particular attention.
But to be clear, building independence into a subsidiary board is not just about being able to handle conflicts. It is also about generating a healthy challenge. For example, proposing adjustments to group risk and business policies or to ethics codes, to reflect local business conditions or regulations. Independence can be built in in various ways. Again, the choices depend on the group’s facts and circumstances. While appointing parent company representatives to subsidiary boards is one option, this has practical limitations, in particular for large groups with perhaps several hundreds of subsidiaries. Alternatives include drawing on officers from other subsidiaries or business divisions or appointing fully external board members. All options come with pros and cons, so need to be carefully assessed. For example, a subsidiary board that consists largely of directors who are resident in other jurisdictions may have implications for the tax residence of the subsidiary. Some jurisdictions even require a degree of local residence for legal regulatory purposes or, like the Netherlands, for certain tax purposes. Local resident board members are often able to provide valuable specific insights and intelligence. Advisory boards may also be considered as may be external professional support services.
Corporate subsidiary governance does not stop with designing the right model or finding the right people. It’s much more than this. It’s about optimizing communication lines and ensuring the right information gets to where it is needed. It’s about giving support and taking adequate precautions to guard against personal liability risks. And it’s about getting the logistics in place that work for the organisation.
- Information should flow
- Wherever a subsidiary is positioned on the corporate governance continuum, quick and efficient information flows are essential. For example, to downstream group governance policies to decentralized subsidiaries, or to upstream local insights to a centralized group management. More and more businesses are recognizing the importance of this, particularly as regards local insights, and we are seeing more demands on our network of local multi-disciplinary specialists for their local expertise, particularly by organisations with an underdeveloped local presence.
- Sound induction and training
- While a succession policy is important, it is equally important to have processes in place to ensure new subsidiary board members are familiarized with new local culture and practices and, if brought in from outside, the values, policies and business operations of the organisation. Training and a sound induction program are central to this, where appropriate supported by external professional tools.
- Personal liability protection
- With subsidiary boards’ duties and responsibilities on the increase, the risks of getting things wrong are multiplying. These risks are compounded by new regulations and an increasingly firmer stance taken on enforcement. This can result not just in financial penalties but, in serious cases, even in criminal sanctions. Bribery is also being taken a lot more seriously in many jurisdictions, with potential sentences of up to 30 years imprisonment a deterrent in some countries under their legislation. A well thought out subsidiary governance framework will address these risks by providing relevant and updated information as well as mechanisms to protect against personal liability, such as insurance, and indemnification and retroactive authorization policies.
- Have the right technology and logistics in place
Businesses are embracing technology to support their subsidiary governance frameworks in numerous ways. These naturally include legal entity management, documentation and compliance functions, but also deal with more everyday matters such as meeting logistics or creating audit trails for training purposes. But technology is not a solution unless it is embedded in a governance framework. For example, in some organisations meetings just happen. In organisations with a sound governance framework all aspects are addressed such as who organizes them, their content and purpose, frequency, and their (virtual) location. The latter can be relevant not just from a practical perspective but, for example, also for potential tax residence implications or environmental governance (carbon footprint) implications. Not having the necessary administrative infrastructure in place does not have to be a problem, and we know some businesses even prefer to outsource this kind of operation to specialists.