Subsidiary governance is a growing challenge for the directors of both multinational organizations and domestic organizations with foreign assets. Although subsidiaries typically have boards of directors that are separate from the parent’s board, unmitigated or unidentified risks at a subsidiary level may expose the parent to financial and reputational harm. For these reasons, a parent’s board of directors has a general duty to oversee its subsidiaries’ operations. But how closely must a parent’s directors monitor a subsidiary’s activities? This article discusses directors’ traditional duty of oversight, and how several relatively recent cases could indicate a shift toward requiring directors to more actively oversee subsidiaries.
The duty of oversight
The director of a US corporation owes the corporation and its shareholders a duty of good faith, which generally is understood to include a duty to oversee the operations of the corporation’s subsidiaries. Traditionally, shareholders have had difficulty pursuing claims against individual directors for alleged breaches of the duty of oversight because shareholders must allege that a director acted in bad faith. Specifically, shareholders must plead facts sufficient to show that a director either knowingly failed to put in place reporting or information systems, or knowingly failed to monitor or oversee established reporting and information systems.
Actual knowledge and bad faith are much higher standards than negligence—so high, in fact, that a court once remarked that a breach of oversight claim was “possibly the most difficult theory in corporate law upon which a plaintiff might hope to win a judgment.” 1 However, a trio of recent cases from the Delaware Chancery Court may indicate a shift in the way courts view directors’ oversight duties with respect to foreign subsidiaries and assets. Specifically, these cases may indicate that directors will face personal liability if they are not meaningfully involved in overseeing important foreign subsidiaries or foreign-located assets.
In the first case, In re China Agritech Inc. Shareholder Derivative Litigation, 2 the Delaware Chancery Court refused to dismiss a shareholder derivative suit because the members of the audit committee faced a substantial risk of liability from failing to discharge their oversight duties. In that case, the company took several actions from 2009 to 2010 that ordinarily would require audit committee oversight. Specifically, the company purchased the remaining 10% stake in its otherwise wholly-owned subsidiary, conducted a public offering, disclosed a material weakness in its disclosure controls and procedures, claimed to have resolved the material weakness, terminated its independent auditor, hired a new auditor, and appointed a new head of the company’s internal audit department. However, in response to shareholders’ claims that the company engaged in fraud, the company was unable to produce minutes from a single meeting of the audit committee held during the period in question. The court noted that, due to the financial irregularities, the lack of documentary evidence regarding audit committee meetings supported a reasonable inference that the audit committee acted in bad faith.
In Rich v. Chong, 3 the Delaware Chancery Court declined to dismiss a suit against a company’s independent directors alleging that those directors failed to properly oversee the company’s assets, which were located solely in China. In that case, shareholders alleged various financial irregularities, including the fact that the chairman of the company verbally authorized a subsidiary to transfer approximately $134 million to a nonexistent business. Unlike the board in In re China Agritech, the Rich court found that the directors actually implemented some subsidiary oversight procedures, including holding regular meetings and establishing an audit committee. The court, however, found that the Rich directors’ actual oversight was “woefully inadequate” and that the controls were not “meaningful.” The court focused on the fact that the directors did not appear to establish “any regulation of the company’s operations in China,” which the court implied was unreasonable given the company’s substantial operations outside of the US.
Finally, in In re Puda Coal, 4 the Delaware Chancery Court refused to dismiss a shareholder derivative claim and made its most sweeping statements regarding directors’ obligations to oversee subsidiaries. The court’s general premise was that directors with substantial foreign subsidiaries or assets simply could not “sit in [their] home in the US and do a conference call four times a year and discharge [their] duty of loyalty.” The court appeared to subject directors’ duty of oversight to a reasonableness standard, “because you can’t watch everyone everywhere,” and implied that corporations with substantial or important foreign subsidiaries or assets should be held to a higher oversight standard. Specifically, the court determined that these directors must:
– Physically visit the foreign country where the corporation’s assets are located “an awful lot”;
– Have in place a system of controls to account for the company’s assets;
– Possess language skills “to navigate the environment in which the company is operating;” and
– Retain accountants and lawyers who are able to maintain the company’s reporting systems.
The facts underlying the decisions in Rich, China Agritech, and Puda Coal are certainly extreme. In all three cases, one could easily describe the directors’ alleged conduct as acting in bad faith. However, if the broad statements in Puda Coal become the majority view of courts, directors may need to carefully consider whether their current oversight practices meet a reasonableness standard—a standard that could impose higher oversight burdens on directors.
The Puda Coal court’s reasonableness standard appears to be a balancing test that is essentially designed to ensure that a director’s subsidiary oversight is appropriate under the circumstances. Thus, for example, periodic visits to a foreign location presumably may not be as high of a priority for a director of a financial services company as it may be for a director of a company that extracts natural resources. Unlike the bad faith standard, however, the reasonableness of a director’s actions could change over time without the director having actual knowledge of any “red flags” or other signs of wrongdoing at the subsidiary level. For example, it may be reasonable to delegate certain oversight responsibilities regarding a subsidiary that accounts for less than 1% of the company’s revenue. Such delegation may not be viewed as reasonable, however, if the subsidiary’s operations eventually grow to account for 25% of the company’s revenue. The reasonableness standard, therefore, would appear to require that the board consistently monitor subsidiaries to determine how much actual oversight the subsidiary requires.
The reasonableness standard also could be particularly challenging for multinationals with dozens, or even tens of dozens, of subsidiaries. While the Puda Coal court appeared to recognize the inherent limitations regarding a board’s ability to oversee subsidiaries, half of the factors cited by the court (e.g., physical presence and obtaining language skills) could be burdensome for large companies. Perhaps, in those cases, directors could comply with the reasonableness standard by putting into place strong and functioning reporting and information systems, and ensuring that those systems are closely monitored.
Even if the court’s statement in Puda Coal does not become the legal standard for directors’ oversight obligations, adhering to the reasonableness standard may be the best way for directors to ensure that the company avoids significant liabilities. Since the passage of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission’s (SEC) general focus on corporate governance has recently extended to the subsidiary governance practices of publicly traded companies. Over the last two years, the SEC has sharply increased its enforcement actions against public companies and their related subsidiaries, and many of these actions are related to alleged Foreign Corrupt Practices Act violations.5 The Chair of the SEC also has suggested that directors should consider voluntarily reporting to the SEC “serious, but non-material events,” including “a rogue employee in a small foreign subsidiary [that] has been bribing a foreign official in violation of the Foreign Corrupt Practices Act.”6 These actions and statements indicate that, regardless of the minimum required standard under state law, the SEC expects directors to more closely oversee corporate subsidiaries.
Cases from the Delaware Chancery Court may indicate a shift toward directors having increasing and more active oversight responsibilities regarding subsidiaries. But even if such cases are isolated or limited, directors should carefully consider whether their oversight of corporate subsidiaries represents best practices and whether those actions adequately protect the company from the severe financial and other consequences that could result from a rogue subsidiary’s actions.