Ensuring the Appropriate Governance of Subsidiaries
By David Chew
The Business Times, 14 November 2016
Subsidiary companies are a fact of life for corporations as they expand their scope, operations and geographical coverage.
Subsidiaries are separate legal entities, created for good business reasons such as limiting the risk and exposure of the parent organization, taking advantage of tax incentives, and facilitating the management of the business at the local or regional level.
By nature of being separate legal entities, subsidiary companies have their own boards and structure. This adds another layer of governance and management to a group corporate structure.
As subsidiaries grow, they will significantly impact the risk environment and bottom line of the group of companies. Their proper oversight and governance can thus be critical.
The Singapore Code of Corporate Governance does not explicitly address the issue of subsidiary governance. However, this is something that conglomerates should explicitly ensure, especially when the perspectives of parent and subsidiary boards can be very different.
Parent board’s perspective
A 2013 Deloitte survey of the practices of global companies on the governance of subsidiaries found that most parent companies and their boards view the whole group as one organization. They tend to treat their subsidiaries as no different from that of a business division within the parent organization and do not differentiate decision-making based on the legal subsidiary structure.
Parent companies seek to exercise appropriate control and influence over subsidiaries in a number of ways, depending upon the ownership structure and jurisdictional requirements.
They may nominate or appoint directors or employees of the holding company to the subsidiary boards. They may identify a senior executive in the holding company to develop and roll out subsidiary-level policies and procedures. The group’s internal audit function may then assess compliance of the subsidiary policies and procedures and report back to the holding company’s board.
That said, there are instances where the parent would not be able to impose all of their governance practices on their subsidiaries due to differences in legal and regulatory requirements, business cultures, and other practices.
Acquired subsidiaries with embedded cultures require substantial time and effort before the new parent may impose its culture and governance practices onto the subsidiaries.
If a subsidiary is not wholly-owned, the holding company has to deal with sometimes competing interests or priorities of the joint venture partner or co-owner in the management and operations of the subsidiaries concerned.
Subsidiary board’s perspective
Regardless of the degree of ownership or control over the subsidiary, when it comes to governance, it is useful for the parent to bear in mind that subsidiary boards have their own fiduciary responsibilities.
The directors of a company are required to act in the best interests of that company, in an independent and objective manner. And there will be times when the interests of the subsidiary are at odds with that of the parent company.
Therein lies the dilemma for the board of a subsidiary. How much autonomy can it have when it is wholly or substantively owned by another corporation? How does it prevent the interests of a holding company taking precedence over those of the subsidiary, especially when there are other shareholders?
The dilemma is particularly acute for the directors who are nominees of the parent company. Nominee directors have principal-agent or employer-employee relationships via their appointers, and thus owe obligations that are governed by agency or contract law.
Yet, these nominee directors have the same fiduciary duties owed to the subsidiary as the other directors. They thus face a greater inherent risk of breaching those fiduciary duties when they act in line with their appointers’ instructions in a way that may not be in the best interest of the subsidiary.
Group governance framework
The 2009 edition of the King Report on Governance (known as “King III”) recommended that a governance framework be agreed between the group and its subsidiary boards. The draft King IV report of 2016 which is currently undergoing public consultation, has gone further to allocate responsibility for the implementation of a group governance framework to the holding company’s board.
Such a governance framework should address areas such as:
- the delineation of the rights and role of the holding company,
delegation of responsibilities by the subsidiary board to a board
committee of the parent without abdicating accountability,
- the extent of governance and operational policies across the group,
- engagement by the holding companies with the subsidiary boards before electing directors to the subsidiary boards,
- duties and protection (including indemnities) for nominee directors, and
- procedures to handle a breach of legal duty in relation of use of information obtained as a director.
A leading practice is for parent organizations to categorize the importance of each of their subsidiaries, based on factors such as its investment in the subsidiary, its strategic importance, the risk it poses to the group, and other factors including the maturity of the subsidiary’s governance practices. The holding company could then establish the appropriate governance structures and practices for each subsidiary.
Every organization with subsidiaries will need to determine its own unique framework and practices to govern both the parent and its subsidiaries. Regardless of how it is structured, it is essential that boards at both levels remain focused on their fiduciary duties to act in the best interests of their organizations.
David Chew is a member of the Corporate Governance Guidebooks Committee of the Singapore Institute of Directors.