Wholly-owned subsidiaries might exist for a number of reasons, whether it be for quarantining assets and liabilities, satisfying foreign legal requirements, tax efficiencies or as a result of an acquisition.
A wholly-owned subsidiary is commonly viewed as an extension of the parent company and not treated as an individual company. As a result, subsidiary governance can be regarded as unimportant or overlooked altogether.
In addition, a parent company will often appoint its employees as the directors of a subsidiary. Directors of wholly-owned subsidiaries might adopt a relaxed approach in performing his or her duties on the basis that the parent company is the sole shareholder of the subsidiary.
However, directors of wholly-owned subsidiaries need to be mindful that their role is not perfunctory and carries with it important legal obligations.
While the obligations of a wholly-owned subsidiary and its directors will depend on the industry and jurisdiction in which the subsidiary operates, this note explores some of the responsibilities that apply to directors of a wholly-owned subsidiary, the potential liability of a parent company in relation to a subsidiary and the importance of establishing a subsidiary governance framework.
The subsidiary as a separate legal entity and the responsibilities of its directors
Although a subsidiary might be wholly-owned, the subsidiary is a separate and distinct legal entity from the parent company.
But what does this actually mean? Parent companies and directors of wholly-owned subsidiaries need to keep in mind the following:
- it is the role of the subsidiary’s directors, and not the parent company, to manage the affairs of a wholly-owned subsidiary. However, the parent entity (as the sole shareholder of a wholly-owned subsidiary) has the power to elect and remove the subsidiary’s board of directors;
- in making decisions affecting the subsidiary, the directors of the subsidiary are obliged to act in the best interests of the subsidiary - even where those interests conflict with those of the parent company or the broader corporate group. The obligation owed by a director of a wholly-owned subsidiary to act in the best interests of the subsidiary company takes precedence over the obligation of that director to act in the best interests of the parent company 1 ;
- the directors of a subsidiary are subject to the statutory and regulatory duties under applicable local laws. This means they should be prudent in carrying out their responsibilities as a director and not regard their role as merely a nominal position. The statutory obligations of the subsidiary should be well understood by both the subsidiary’s directors and the parent company; and
- any governance practices for the subsidiary need to be consistent with the purpose for which the subsidiary was established. The risk profile of a subsidiary with its own operating assets and employees is very different (and much higher) to that of a subsidiary that is only a holding company.
Does the parent company have potential liability in relation to the subsidiary?
Under Australian law, a parent company can be considered a shadow director of a subsidiary if it appoints its executives to the subsidiary’s board and expects those executives to exercise their powers in accordance with the instructions or wishes of the parent company.
If the wholly-owned subsidiary is a foreign entity, a similar concept of shadow directors may be recognised in the country in which the foreign subsidiary is incorporated.
This means that if the directors of a wholly-owned subsidiary are accustomed to acting on the instructions of the parent company, the parent company may be considered a “shadow director” of the subsidiary and essentially have the same obligations and liabilities as a director of the subsidiary, including liability for insolvent trading.
In light of the above, a parent company needs to carefully consider what degree of control it wishes to exercise over its wholly-owned subsidiary.
A subsidiary may be established with the specific intention of enabling a parent company to rely on the “corporate veil” to distance itself from potential legal liabilities that may arise in respect of a subsidiary company. In these circumstances, a parent company will look to demonstrate that the directors of the subsidiary operate independently and at arm’s length from the parent company.
However, it may be the case that the parent company does not intend to distance itself from the potential risks and legal liabilities of the subsidiary. Instead, it may seek to minimise the risk of liabilities arising in relation to the subsidiary and its assets through careful control and direction of the activities of the subsidiary. In these circumstances, the parent company needs to be aware that the corporate veil could be “pierced”, meaning that the parent company itself might be considered a shadow director with the same obligations and liabilities as a director of the subsidiary.
- Is it worthwhile implementing a subsidiary governance framework?
In light of the obligations of subsidiary directors and the potential liability of parent companies as outlined above, subsidiary governance frameworks are an important tool in facilitating risk management and ensuring compliance with applicable legal obligations. The additional benefits of a subsidiary governance framework can also include the following:
- defining the relationship between the parent and subsidiary
Clearly outlining the relationship between the parent company and the wholly-owned subsidiary helps to improve transparency both within and outside the organisation. The subsidiary governance framework should allow the subsidiary to operate independently without adversely affecting the interests of the parent company. Clear financial and operational delegations of authority from the parent company should also be articulated.
- aligning corporate governance practices of entities within the corporate group
Including key group-wide governance policies in the subsidiary governance framework will ensure that the subsidiary’s corporate practices are more closely aligned with the strategies of the parent company and assist in streamlining the business of the corporate group. However, in order to encourage engagement with, and effective implementation of, the framework, it is essential that any local differences, the subsidiary’s corporate culture and the reasons for the establishment of the subsidiary are taken into account.
- establishing a clear line of reporting between the subsidiary and the parent company
If a parent entity is a public company listed on ASX, for example, it will be subject to continuous disclosure obligations. Setting out procedures to improve the information flow between a parent and a wholly-owned subsidiary will assist a listed parent company in complying with its continuous disclosure and reporting requirements.
- clarifying the rights and responsibilities of the subsidiary’s board and management
The framework can include guidance and protocols on matters affecting the board and management including policies on conflicts of interest, board composition and procedures for board meetings. A comprehensive subsidiary governance framework will assist in educating and protecting officers and employees of the subsidiary in carrying out their respective responsibilities.
Neglecting legal obligations and corporate governance at the subsidiary level can expose both the directors of the subsidiary and the wider corporate group to serious risks. It is therefore essential that the directors of a wholly-owned subsidiary entity are diligent in carrying out their duties and the importance of implementing an effective subsidiary governance framework is not overlooked.