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Legal framework analysis: Parent company and subsidiaries

An Analysis Of The Legal Framework Governing The 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]

Mr. Caplan’s statement resounds emphatically in the world of corporate groups.

Certainly recent global occurrences, such as the unprecedented ‘crashes’ of the global financial institutions[3] have taught us that all companies possess the incontrovertible ability to positively or negatively affect the development and health of a country’s populace. Imagine then the potentially catastrophic effects that the collapse of corporate groups could engender or the havoc that could be wreaked by poor governance within these groups.

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 recourse than to file for voluntary administration. As theorised 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 an guaged five thousand (5 000) jobs within the United Kingdom alone[5].

Legislators, jurists and legal academics have sought to navigate the fine line that lays between good regulation and intrusion into the affairs of groups of companies. It would seem however, that the goal posts might be shifting, as the stated regime for regulation of these entities has evolved.

This paper will juxtapose the former model of corporate group regulation with its present incarnation whilst adding this author’s analysis of the brewing controversy surrounding how tight should effective regulation really be.

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.[6] 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 are to be found in the Companies Act 1974[7] at section 1, Companies Act 1985 at section 736[8] and the Companies Act 1989 at section 144[9]. 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[10] and the Companies Act, 1989[11] as demonstrative of the regulation espoused in the former regulatory regime, section 23[12] and section 129(1)[13] places a general prohibition against subsidiaries being members of their holding/parent companies. Moreover, under section 151[14] a holding company and its subsidiaries are precluded from rendering financial assistance to fund the acquisition of its shares.

At section 229[15] and section 213(2)[16] the responsibility for the compilation of the group accounts and the concomitant responsibility for ensuring that such is laid before the general meeting of the shareholders falls upon the parent company. Under sections 232 and 233[17] as well as 213(2)[18] 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[19] of the 1985 Act, a director of any of the companies within the corporate group is prevented from dealing in the share options appurtenant to his company’s shares or the shares of any other member of the group including the holding company’s shares.

The schedules to these pieces of legislation include further directives for the handling of the holding and subsidiary accounts such as the form and required content of the group special category accounts where the company upon whose accounts the report is compiled is either a holding or a subsidiary company[20]

Legal dicta have arisen to further clarify any areas of ambiguity concerning the relationship of the component parts in the corporate group.

As opined by Pennycuick J. in the suit of Charterbridge Corporation v. Lloyds Bank Limited[21] 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.’[22]

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

In the 1979 case of, In Re Southard & Co. Ltd.[23] Lord Templeman, (referring to the judgement of the Australian court in the case of Industrial Equity Limited v. Blackburn[24] which upheld that the intention of the companies’ legislation was never to impose joint liability for group debts), espoused 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.[25]

It has been judicially noted[26] and academically stated[27] 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 used as a means of perpetrating fraud.

It is clear from the forgoing exemplar legislative provisions and the judicial pronouncements made to buttress the application and understanding of the legislation, the group structure is one that has been arguably comprehensively regulated, especially in relation to the financial responsibilities and exposures to liability that obtain between them.

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

The Present Regime for Regulation of Groups of Companies

The Companies Act 2006[28] incorporates many of the regulatory mechanisms that marked the regime of the former Companies Acts. It maintains for example the prohibitions against the subsidiaries being members of their holding companies[29].

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)[30] as well as pertaining to inter group loans.[31] Generally, however, the legislation maintains the same regulatory mechanisms as its predecessors. The impact of the present regulatory regime is arguably best examined by analysis of the suits that have arisen recently.

In Re Genosyis Technology Management Ltd, Wallach v. Secretary of State for Trade and Industry[32], a case mirroring that of the Charterbridge Corporation v. Lloyds Bank Limited[33], 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[34] 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 jurisdictions another member state outside its domicile in determining its taxable losses.[35]

In the matter of MAN Nutzfahrzeuge AG v. Freightliner Ltd[36], 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.

A curious and arguably instructive situation arose in the case of MT Realisations Limited v. Digital Equipment Company Ltd.[37] wherein a parent company appeared to have rendered 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 affront the legislative provisions. The Court of Appeal, in upholding the ruling of the lower court, held that the transfer of the sums was not tantamount to the rendering 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 averred to by the honourable Coetzee J.[38] 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 perpetrated 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[39].

The undisputed lesson of WorldCom is that whilst groups can offer synergies that can lead to more efficient business, one must be wary of the complexity and obscurity that necessarily comes with the intertwining of many players.

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 2001, 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 diverse geographical regions and throughout myriad business activities. As was amply 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 repercussions on many facets of the country.

In the wake especially of the Enron and WorldCom collapses, there have been more concerted 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[40] wherein power is given for the production, collection and use of financial information to ensure regulatory compliance.

If a regime of integrated regulation were to be introduced specifically for the regulation of corporate groups, this would translate, in all likelihood, into increased operational costs, as subsidiaries and parents sought to satisfy the increased requirements for compliance. Increased operational costs do not lend themselves readily to increased efficiency. Holding too tight a rein on the operation of groups could lead to the exodus of operating entities within the United Kingdom territorial borders, in search of destinations offering a more favourable balance between regulation and business flexibility.

Whereas it may be desirable to make related companies more accountable for the shortcomings of its brethren to safeguard the interests of stakeholders, 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 on shareholder interests. This affronts the very basis of incorporation.

While it is not doubted that the sometimes-complex structure of groups lends itself to abuse, 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 discern any special risk that appertains to group structures that the current matrix of regulations concerning companies does not address. Certainly the preponderance of largely the same structure of legislative regulation and the insistence of the Courts to preserve the sanctity of the separation between the entities 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 is time for the jurists to give special thought to the eternal words of Jeffrey Veen[41],

‘Good design [regulatory design] can’t fix broken business models.’

It is perhaps oxymoronic to encroach upon the present constitution of corporate groups to make the constituents more accountable to each other. Perhaps what is needed is a determination of whether corporate groups are still viable in today’s world.

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)

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

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

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

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

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

Veen J., Designing the Friendly Skies, June 2006, The Quotations Page http://www.quotationspage.com/quotes/

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

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.

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

[3] So named by the 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

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

[5] Dickinson M., (n.4)

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

[7] Companies Act, 1974, Chapter 30, section 1

[8] Companies Act, 1985, Chapter 6, section 736

[9] Companies Act, 1989, Chapter 40, section 144

[10] Companies Act, 1985, (n.8)

[11] Companies Act, 1989, (n.9)

[12] Companies Act, 1985, (n.8), section 23

[13] Companies Act, 1989, (n.9) section 129 (1)

[14] Companies Act, 1985, (n.8), section 151

[15] Companies Act, 1985, (n.8), section 229

[16] Companies Act, 1989, (n.9), section 213 (2)

[17] Companies Act, 1985, (n.8), section 232, section 233

[18] Companies Act, 1989, (n.9), section 213 (2)

[19] Companies Act, 1985, (n.8), section 323

[20] Companies Act, 1985, (n.8), schedule 9, Part II

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

[22] Charterbridge Corporation v. Lloyds Bank Limited, (n.21), p.74

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

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

[25] In Re Southard & Co. Ltd , (n.23), p.1202

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

[27] Gower, L.C.B., Modern Company Law, (4th Ed., London), 118

[28] Companies Act 2006, Ch. 46

[29] Companies Act, 2006, (n.28), section 136

[30] Companies Act, 2006, (n.28), section 400

[31] Companies Act, 2006, (n.28), section 208

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

[33] Charterbridge Corporation v. Lloyds Bank Limited, (n.21)

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

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

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

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

[38] The Unisec Group Ltd. v. Sage Holdings Ltd., (n.6)

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

[40] 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

[41] Veen J., Designing the Friendly Skies, June 2006,


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