Relations Between a Parent Company and its Subsidiaries

Question / Abstract

In a recent article published in the Company Law Review^[1], it was asserted that,

“There was no merit in imposing a more integrated regime on groups of companies which would take away flexibility and strike at the limited liability basis of company law.”

Further, the article continues,

“…No evidence of abuse of corporate status by parent companies.”

This paper will critically assess the foregoing statements in light of the present model of corporate group structure, the relationship between parent and subsidiary entities as well as the potential liability of a parent for the acts of its subsidiaries.

Introduction

Mitchell Caplan, the former Chief Executive Officer of the American financial giant ‘E*trade Financial Corporation’, once said ‘To succeed as a team is to hold all of the members accountable for their expertise.’^[2]

Certainly recent global occurrences, such as the unprecedented ‘crashes’ of the global financial institutions^[3] have taught us that all companies possess the true ability to positively or negatively affect the development and health of a country’s population.

One need only call to mind the destruction and economic loss left in the wake of the recent collapse of the global giant Lehman Brothers Holdings International, in September 2008. On the same day that the doomed Lehman Brothers Holdings International filed for Chapter 11 bankruptcy proceedings in the United Sates, the United Kingdom based subsidiary found itself with no choice other than to file for voluntary administration and close its United Kingdom doors on the same day as it did in the United States. As expressed by financial analysts,

‘Because the group managed its funding on a global basis, the UK trading operation found itself unable to meet its obligations when the flow of funds dried up’^[4]

It is estimated that the collpase of the empire would have resulted in the loss of five thousand (5 000) jobs within the United Kingdom alone^[5].

This paper will look at the former model of corporate group regulation alongside the present model while adding this author’s input into the debate about how tight should effective regulation really be.

The Beginning of the Principle – Separate Legal Personality

In 1867, the House of Lords was called upon to determine a case^[6] wherein a creditor of an insolvent company sought satisfaction of his debts from a shareholder of the insolvent company. The Court held that in such an instance, the creditor could only seek remedy from the company and not from any of the company’s individual shareholders.

In the 1897groundbreaking case of Salomon v. Salomon & Co. Limited^[7] the creator/ promoter of a leather selling business sold his interest to a limited company he established, the House of Lords held that the company, at the time of incorporation, became imbued with what was called ‘separate legal personality’ that made the company independent of its incorporators and shareholders. In the words of Lord Halsbury L.C. in the case of Salomon v. Salomon & Co. Limited,

‘…It seems to me impossible to dispute that once the company is legally incorporated, it must be treated like any other independent person with its rights and liabilities appropriate to itself …’

In the wake of this case, the principle has been upheld, that where a company has been legally incorporated, as outlined in the Companies Legislation, it becomes an artificial person, but a person nonetheless, having the sole control over its own assets and liabilities. Incorporation therefore, places a proverbial veil between the incorporated company and those who have incorporated or legally created it.

The principle of separate legal personality has been applied specifically to the situation of groups of companies. Templeman L.J. noted in the case of In Re Southard & Co Ltd.^[8] that, as concerns groups of companies, parent companies, other subsidiaries and shareholders of an indebted company, these persons are not to be held responsible for the liabilities of an indebted company within a group.

It is only where there is a reasonable belief that the separate legal personality is being used as a means of continuing fraud or the subsidiary is really an extension of the owner/creator/promoters, that the veil between the company and its creators /promoters /shareholders, that comes about because of incorporation, may be lifted.

In the case of Smith, Stone &Knight Limited v. Birmingham Corporation^[9] wherein the Birmingham Corporation expropriated land that had been used by a subsidiary of the claimant, the Court held that the questions that need be asked were: 1. Are the profits of the subsidiary being treated as that of the parent; 2. Are the persons conducting the business of the subsidiary appointed by the parent; 3. Is the parent the head and brains of the subsidiary’s operations; 4. Does the parent govern the ventures of the subsidiary and make all the decisions in any ventures of the subsidiary; 5. Does the subsidiary make its money through the skills and direction of the parent; 6. Is the parent in perpetual control of the subsidiary?

Where prima facie evidence can be shown to answer the above questions in the affirmative, then the courts may lift the veil.^[10]

One must bear in mind the judicial decision in the case of Adams v. Cape Industries PLC^[11] where Cape Industries PLC, the English parent company owned subsidiaries in South Africa that dealt with mining and the marketing of asbestos. The respondent decided to wind up its American subsidiary and created another to avoid the publicity, in the wake of the suits arising out of asbestos poisoning. The court held, that even where there were concerns about the ethics of the respondent’s decision, the court would nonetheless apply the principles of separate legal personality.

Running the Companies – Separation of Control from the Owners

Given the impact of the separate legal personality that comes with incorporation, the question that needs be asked is: Who is responsible for the running of the companies within the subsidiaries if they are all their own persons? The answer lies with the directors of each subsidiary.

Under section 282 of the Companies Act 1985^[12] as well as under section 154 of the Companies Act, 2006^[13] every public company must have at its helm at least two directors. For private companies, the number of required directors is set at one.

In discharging their duties, the law calls upon directors to exercise their duties with care, skill and diligence as well as exercising fiduciary duties of good faith. These obligations on directors are specified in sections 171 to 177 of the Companies Act, 2006.^[14] Among the duties that fall upon directors in the control of their companies is the duty to act in the best interest of the company, to exercise independent judgement and not to accept gifts from third parties.

The director of a company stands in the position of a fiduciary to his company. Indeed in section 175 (1) of the Companies Act 2006^[15]a director is placed under a duty to avoid conflicts of interest. Should there be a conflict of interest then the interests of the company are held to supersede that of the directors.^[16]

Despite the fact that directors are in control of the company and shareholders are considered distinct from the company through the concept of separate legal personality, shareholders still have the ability to exert control over the activities of their directors.

Section 112 of the Companies Act, 2006 requires companies to list as its members, subscribers to its Memorandum as well as persons who become subscribers thereafter. Of note is the fact that under section 136 of the Companies Act, 2006, holding companies and subsidiaries cannot ordinarily be members of each other.

The statutory powers of members are significant. Under sections 291 and 293 of the Companies Act 2006, the members of a company have the right to be sent proposed written resolutions, under section 303 they have the right to require the directors to call general meetings of the company with the right to vote at general and special meetings.

Individual members may even bring action against the directorship in special circumstances, such as where the directors have acted outside the scope of their powers.^[17]

Whereas the control of the company rests in the hands of the individual directors, the members are still able to have their say and exercise control in the running of the companies.

The Former Regime for Regulation of Groups of Companies

Coetzee J. (obiter dicta) in the suit of The Unisec Group Ltd. v. Sage Holdings Ltd.^[18] defined the corporate group by heeding that,

‘The group usually consists of one or more pyramids of interrelated companies in which all or the majority of the shares are held by others with the parent or holding company at the apex.’

The honourable judge incidentally further noted that,

‘Economic and administrative advantages flow from this arrangement on the one hand, but on the other hand it is clearly capable of abuse … the true financial state of the holding company can be effectively masked from the eyes of its shareholders and indeed distorted in the separate accounts of the companies in the group.’

The legislative definition of holding companies and subsidiaries is to be found in the Companies Act 1974^[19] at section 1, Companies Act 1985 at section 736^[20] and the Companies Act 1989 at section 144^[21]. All these Acts define holding and subsidiary companies using almost the same formulation of voting rights and control of board composition.

Using the provisions of the Companies Act, 1985^[22] and the Companies Act, 1989^[23], section 23^[24] and section 129(1)^[25] place a general prohibition against subsidiaries being members of their holding/parent companies. Moreover, under section 151^[26] a holding company and its subsidiaries are prevented from giving financial assistance to fund the acquisition of its shares.

At section 229^[27] and section 213(2)^[28] the responsibility for the compilation of the group accounts as well as the responsibility for ensuring that the group accounts are laid before the general meeting of the shareholders falls upon the parent company. Under sections 232 and 233^[29] as well as 213(2)^[30] the prepared accounts for the group must reflect any loans made by any of the members of the corporate group to any of its directors or connected persons. Under the provisions of section 323^[31] of the 1985 Act, a director of any of the companies within the corporate group is prevented from dealing in the share options pertaining to his company’s shares or the shares of any other member of the group including the holding company’s shares.

Judicial decisions have arisen to further clarify any unclear areas concerning the relationship of the various parts in the corporate group.

As stated by Pennycuick J. in the suit of Charterbridge Corporation v. Lloyds Bank Limited^[32] where the ability of the directors of one company to act to the detriment of the interests of their own company in favour of the interest of the group as a whole was challenged, the honourable judge held that,

‘Each company in the group is a separate legal entity … the directors of a particular company are not entitled to sacrifice the interests of that company to the interests of the group.’^[33]

Despite the relationship between the component companies within the structure of a corporate group and the legislative provisions that requires the production of group accounts, the limited liability status of each constituent company against the debts of the other members of the corporate group, is deeply entrenched in the law.

In the 1979 case of, In Re Southard & Co. Ltd.^[34] Lord Templeman, held that,

‘If one of the subsidiary companies turns out to be the runt of the litter and declines into insolvency to the dismay of its creditors, the parent company and the other subsidiary companies may prosper to the joy of the shareholders and without any liability for the debts of the insolvent subsidiary.’^[35]

It has been judicially noted^[36] and academically stated^[37] that the limited liability of one member of the corporate group for the debts of the others does not extend to instances where that company acts as the agent for the defaulting company, nor where the limited liability status is abused in order to commit fraud.

It is clear from the forgoing legislative provisions and the judicial pronouncements, the group structure is one that has been comprehensively regulated, especially in relation to the financial responsibilities and exposures to liability that obtain within the group.

The fact that there has been little significant change to the legislative framework between the years 1974 to 2006 may stand testament to the opinion that the structure of regulation that existed fulfilled the need for the balance between protectionism and free markets. But is that still true in today’s world?

The Present Regime for Regulation of Groups of Companies

The Companies Act 2006^[38] incorporates many of the regulatory mechanisms that were part of the regime in the former Companies Acts. It maintains for example the prohibitions against the subsidiaries being members of their holding companies^[39].

The Companies Act 2006 introduces some new regulatory provisions such as the provisions and exemptions from former accounting reporting where the subsidiaries are caught by the operation of the European Economic Area (EEA)^[40] as well as where it relates to inter group loans.^[41] Generally, however, the legislation maintains mostly the same regulatory mechanisms as its predecessors. The impact of the present regulatory regime is arguably best examined by looking at the lawsuits that have arisen recently.

In Re Genosyis Technology Management Ltd, Wallach v. Secretary of State for Trade and Industry^[42], the Chancery Court upheld the decision to disqualify directors who had not demonstrated appreciation for the concerns of their own organisation over that of the parent company.

In the suit of Millam v Print Factory (London) 1991 Ltd^[43] the Employment Appeal Tribunal upheld a decision to consider an employee transferred from the parent company to a subsidiary as an employee of the subsidiary since both parents and subsidiaries maintain separate legal personalities.

In the calculation of the consolidated group accounts, the European Court of Justice has ruled that companies may include the losses made by its subsidiaries in foreign jurisdictions, or another member state, in determining its taxable losses.^[44]

In the matter of MAN Nutzfahrzeuge AG v. Freightliner Ltd^[45], the Court of Appeal held ‘obiter dicta’ that auditors who had, without due diligence, conducted audits of a subsidiary company were not to be held liable for the losses that were incurred by the parent company in the sale of the subsidiary although the accounting company would have had a special duty of care to safeguard the parent company in undertaking the audit of the subsidiary.

Of international importance was the case of Barings PLC and Another v. Coopers and Lybrand and Others^[46] where in 1995, the Barings group of companies collapsed due to heavy financial losses from one of the group’s Singapore located subsidiaries. It was determined by the Board of Banking Supervision of the Bank of England that the cause of the fall was poor accounting and management of the subsidiary. The claimants brought action against the respondents who were the retained accountants and auditors for the group of companies. One of the questions that arose for determination was whether the holding company could have instituted the action. The Court determined that in preparing the accounts, the respondents would have had the claimants in mind in preparing the accounts and as such had a duty to them as well.

A curious situation arose in the case of MT Realisations Limited v. Digital Equipment Company Ltd.^[47] wherein a parent company appeared to have given financial assistance to its subsidiary when it transferred the sum of £8 million to its subsidiary in satisfaction of a debt that was owed to the subsidiary by a purchaser of the subsidiary’s shares. This accounting entry appeared to go against the legislative provisions. The Court of Appeal, in upholding the ruling of the lower court, held that the transfer of the sums was not the same as the giving of financial assistance, as the purchasing company had owed the debt to the subsidiary which itself had owed the debt to its parent. As such, the Court of Appeal ruled that this situation amounted to that of a secured creditor transaction.

Hence, the regulatory regime that obtains presently, in large part, follows the regimen of the former models.

The Abuse of Corporate Status

There have been publicly aired instances where companies in corporate groups have not always acted with the legal compliance and ethics that one would expect from such professional associations. There have been publicised instances, as noted by the honourable Coetzee J.^[48], that the corporate structure of groups has been used to cloud the true appreciation of the financial reality of the companies. In short, the sometimes-complex structure of the corporate groups has been abused.

Perhaps one of the most widely known instances of such abuse came in the case of WorldCom and its reported sixty-five subsidiaries.

It is believed that at the time of the collapse of the global giant in 2002, the parent company’s chief financial officer, Mr. Scott Sullivan as well as Mr. David Myers, WorldCom’s controller, had reported billions of dollars in capital expenditure throughout the group, that had really been unchecked operating costs. The pair further reported as income, reserve funds that had been hedged within the subsidiary companies. Through ‘creative’ accounting and an opaque network of subsidiaries, the pair was believed to have continued the accounting fraud for numerous years. When called upon to publicly answer the charges levied against the group, WorldCom’s directors admitted that they had been able to inflate the group’s profits by $ 9 Billion United States Dollars. As a direct result of the actions of the directorship of the parent company, the group collapsed in 2002, with the consequential loss of thousands of jobs and economic loss believed to have totalled billions of United States Dollars^[49].

The undisputed lesson of WorldCom is that whilst groups can offer synergies that can lead to more efficient business, one must be aware of the complexity and obscurity that comes with the collection of so many players on one business team.

Weighing in on the Pros and the Cons of Tighter Regulation

From the example cited on WorldCom and other famous cases of group collapses through mismanagement, such as the catastrophic fall of Enron in April 200, widely believed to have come out of accounting frauds in the group’s accounts, it is apparent that groups of companies are major players in the financial and economic landscape of the country, nay the world, amassing and utilising larger sums of money than many traditional single entity businesses.

The activities of these groups can affect larger volumes of people at one time, as their activities tend to spread over many geographical regions and throughout diverse business activities, as was demonstrated in the example of the fall of Lehman Brothers International where the folding of a parent company located on another continent almost simultaneously led to the loss of thousands of jobs in the United Kingdom. Such a loss would have likely had far-reaching effects on many areas of the country.

In the wake especially of the Enron and WorldCom collapses, there have been more attempts to tighten the reins on financial accounting and accountability within the United Kingdom. One example of tighter legislative requirements comes in the form of the Companies (Audit, Investigations and Community Enterprise) Act 2004 (Commencement) and Companies Act 1989 (Commencement No.18) Order 2004^[50] wherein power is given to the regulators, to require the production, collection and regulatory use of financial information by and on the groups of companies, to ensure regulatory compliance.

One must consider though, that if a regime of integrated regulation were to be introduced specifically for the regulation of corporate groups, this would mean, in all likelihood, that there would be increased operational costs, as subsidiaries and parents sought to satisfy the increased requirements for compliance. Increased operational costs do not usually lead to increased efficiency. Holding too tight a rein on the operation of groups could lead to the exodus of operating entities from the United Kingdom, in search of destinations offering a more favourable balance between regulation and business flexibility. In short, too complex or tight regulation could make it too difficult and costly for corporate groups to continue to operate in the United Kingdom.

Although it may be desirable to make related companies more accountable for the shortcomings of its brother entities, to walk down that path could lead to the blurring of the lines of separate legal personality that incorporation brings. If we were to take the arguments to its logical conclusion, then the requirement of joint or unlimited liability for the actions of grouped companies could mean unlimited liability for its shareholders. This goes against the very basis of incorporation and the very fabric of separate legal personality.

While it is not doubted that the sometimes-complex structure of groups lends itself more readily to abuse than simpler structures, general financial and oversight principles have been applied to all companies to safeguard against future abuses. Why then, in the face of such rigorous general regulation, is it necessary to isolate group structures as requiring further regulation?

This author cannot see any special risk that applies to group structures that the current matrix of regulations concerning companies does not address. Certainly the fact that largely the same structure of legislative regulation has been maintained all this time and the insistence of the Courts in preserving the separation between the entities in a corporate group is testament to the fact that the present model of group regulation has been tried, tested and found generally worthy. Indeed, the Companies Act 2006 was enacted after both the WorldCom and Enron disasters.

It perhaps does not make sense to encroach upon the present constitution of corporate groups to make the constituents more accountable to each other. Perhaps what is really needed is a determination of whether corporate groups are still viable in today’s world.

Adams v. Cape Industries PLC [1990] 1 Ch 433

Barings PLC and Another v. Coopers and Lybrand and Others (1996) 140 SJ LB 210

BBC News Channel, ‘Historians will refer to it as the crash of 2008 – the world’s worst financial crisis in almost 80 years’, http://news.bbc.co.uk/1/hi/business/7680103.stm

Charterbridge Corporation v. Lloyds Bank Limited [1970] 1 Ch. 62

Company Law Review, Modern Company Law for a Competitive Economy, Completing the Structure (2000)

Dickinson M., The Independent Newspaper, Monday September 15, 2008, ‘Prime UK Jobs at risk after Lehman Collapse’, www.independent.co.uk

Farrar J.H., Furey N., Hannigan B., Farrar’s Company Law, (Butterworth, 1988)

Gower L.C.B., Gower’s Principles of Modern Company Law, (Stevens, 1981)

Hahlo H. R., Farrar J.H., Hahlo’s Cases and Materials on Company Law, (Sweet &Maxwell, 1987)

Hoole v. Great Western Railway Company (1867) L.R. 3 Ch.App. 262

Industrial Equity Limited v. Blackburn (1977) C.L.R. 567

In Re Southard & Co. Ltd. [1979] 1 W.L.R. 1199

MAN Nutzfahrzeuge AG v. Freightliner Ltd. [2007] All E R 65

Marks & Spencer PLC. v. Halsey (Inspector of Taxes)(Case C-446/03) [2005] All E R 174

Millam v. Prit Factory (London) 1991 Ltd. [2006] All E R 87

Mills v. Mills (1938) 60 C.L.R. 150

MT Realisations Ltd. v. Digital Equipment Company Ltd. [2003] All E R 179

Oakes v. Turquand and Harding (1867) L.R. 2 H.L. 325

Re Augustus Barnett & Son Ltd. The Times, 7 Dec 1985, [1986] P.C.C. 167

Re Genosysis Technology Management Ltd, Wallach v. Secretary of State for Trade and Industry [2006] All E R 434

Salomon v. Salomon & Co. Limited [1897] A.C. 22

Sealy L., Worthington S., Cases and Materials in Company Law, (Oxford University Press, 2007)

Smith, Stone & Knigt Limited v. Birmingham Corporation [1939] 4 All E R 116

The Companies (Audit, Investigations and Community Enterprise) Act 2004 (Commencement) and Companies Act 1989 (Commencement No.18) Order 2004, S.I. No.3322 of 2004, ch.154

The Quotations Page, Mitchell Caplan Quotes, http://www.quotationspage.com/quotes/Mitchell_Caplan/

The Unisec Group Ltd. v. Sage Holdings Ltd. 1986 (3) S.A. 259

Velasquez M., Business Ethics Concepts and Cases, (6^th Ed., Pearson Prentice Hall), 28

Wolfson v. Strathclyde Regional Council [1978] S.C. 90

1

Footnotes

^[1] Company Law Review, Modern Company Law for a Competitive Economy, Completing the Structure (2000) **Para 10.20. > ***Para 10.58-10.59.