The subsidiary governance challenge

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Gabe Shawn Varges Bio PictureGabe Shawn Varges – Senior Partner at HCM International AG

 

 

 

In recent years, and particularly since the financial crisis, many companies have been working to upgrade their corporate governance. This has been driven in part by foresighted initiatives at some companies and industry groups, but mainly by external pressures from shareholders, stock exchanges and regulators.[1]  

One area where bank and insurer regulators have been increasing their focus is so-called ‘group supervision’.[2] The regulator’s goal is to have a more complete view of a group or conglomerate as a whole, not only financially but also in terms of the company’s governance and its ability to identify and manage its enterprise-wide risks. 

But as companies react to these pressures, are they directing their energies primarily at enhancing the parent company’s board and making other adjustments at the centre? Or are they also giving sufficient scrutiny to their legal ‘subsidiary structure’ and the ‘individual governance of each subsidiary’?[3]

This question is as relevant for large multinational groups as it is for companies of any size with multiple legal entities. For regardless of size, a company could suffer financial or reputational damage from the governance and related weaknesses of a single subsidiary, no matter how small.   

Here are seven key questions that a group board should consider in addressing the ‘subsidiary governance’ challenge.

  1. Why do we have the number of subsidiaries that we do?

A company creates subsidiaries for different reasons. Sometimes it does so because local law or regulation requires a separate legal entity for the licensing or operation of the business. Other time it’s because it is legally advisable for limiting legal, financial or tax liability. Google’s recent corporate restructuring, which included new subsidiaries under a new parent company umbrella, is an example of the sometimes complex reasons why subsidiaries are created.    

Yet, particularly in a larger company or one that has grown by acquisitions, it is not uncommon for the company to discover one day that it has subsidiaries in the dozens, hundreds or even thousands, without really understanding how the number grew so large.

In many cases the growth took place by accretion. Subsidiaries were added over time by different people in different parts of the company without coordination or without a sound assessment of the value or possible complications of each addition. For example, not enough reflection may have been given to the governance implications of having yet another legal entity, including any need for the entity to have its own board of directors.

A first order of business for a group board in such a situation is to consider establishing a ‘subsidiary pre-screening process’. Under such process no new subsidiary may be created unless all the pros and cons have been carefully reviewed, including from a group perspective, and approval obtained from the boards of the entities affected as well as from the group board. 

  1. How is each subsidiary’s existence essential for our group’s mission and business strategy?

Once a process is in place to prevent non-essential new subsidiaries, the next step is for the board to oversee a review of existing subsidiaries to determine if any lack a compelling raison d’être. Verifying the justification for each subsidiary allows for categorisation into those that are:

■  Required to retain a licence or meet any other fundamental legal requirement

■  Vital for carrying out the company’s basic mission or its long-term goals

■  Instrumental for meeting important current strategic goals

Any subsidiaries not meeting these criteria would need to be further vetted. Those found not to be indispensable should be recommended for winding down. 

  1. Does our subsidiary structure add unnecessary complexity or cost? Does it make our group opaque?

Another angle to consider is complexity. Is the number or the interrelationship of the subsidiaries such that it makes your group difficult to understand or manage? Do you have too many layers? Could it open up your group to the charge of opaqueness? 

It is significant that in its revised governance principles, the Basel Committee on Bank Supervision (BCBS) gives increased attention to this issue.[4] It urges group boards to understand their group’s corporate structure and avoid intransparent or unduly complex arrangements. Such arrangements may not only create concerns for regulators and shareholders but make it more difficult for the group board to provide proper oversight.[5] 

“As regulators focus more on group supervision, today’s group boards need to provide stewardship on the governance ‘underneath’ as well as on the governance at the top of the group”

Cost is another important element. Large or complex corporate structures can add to a company’s cost base. Besides the legal and other fees involved in creating each legal entity, there are considerable maintenance and operational expenses over time. In any review, it is helpful to estimate the direct and indirect costs of each subsidiary. This includes management time and the time of those that serve on the subsidiary’s board of directors.

  1. Who should serve on the boards of our subsidiaries?

Depending on the type of legal entity and the jurisdiction in question, the subsidiary may or may not require a separate board of directors. And where it does, there may be a choice of having executive members, non-executive members or a combination of both.

Where such choice exists, the decision has typically been made or led by management. Group boards have tended to delve little into the composition or operation of subsidiary boards. They have focused instead on their own composition and way of working. 

The result is that essential governance decisions, such as whether to have at least some independent members on the board of a subsidiary where optional, have not always been made with sufficient involvement or leadership from the group board.

As regulators increase their focus on group supervision, today’s group boards need to adjust. They need to provide stewardship on the governance ‘underneath’ as well as on the governance at the top of the group. This includes forming a view on what kind of boards the subsidiaries should have and who should serve on them. The answer can directly affect how well the business is supervised in important parts of the company.      

Having assumed this larger group governance role, a group board may encounter differences of opinion with management.

■  Management may see benefit in having the seats of subsidiary boards occupied entirely by executives from within the group where legally possible[6]

■  The group board may feel that having some external independent members adds to checks-and-balances

For material subsidiaries, it is also essential to consider the relevant regulator’s expectations on board composition. Even when allowing executive members from the group on a subsidiary board, for example, the regulator may require such board members to have no direct connection to the local subsidiary so as to increase independence from local management. Or the regulator may prefer independent board members for important subsidiaries or subsidiaries that have recently experienced financial or compliance difficulties.

  1. Should our group board members serve on our subsidiary boards?

While needing to play a more active role in enterprise-wide governance, group board members should reflect carefully before serving on the board of a subsidiary.

Possible cost and time efficiencies need to be weighed against any possible loss of the healthy governance distance that the group board should enjoy vis-à-vis the operative subsidiaries. 

At the same time, there may be limited instances when such double service does not give rise to major governance difficulties.[7] This could be the case where the major business of the group is carried out in a separate subsidiary, making it critical to have direct group-wide direction and oversight at such level.

  1. What expectations should we have of board members in our subsidiaries?

The foremost expectation is to meet what local law requires of board members. Even well-governed groups have run into significant issues when a subsidiary has taken actions – on its own or under group instruction – that failed to fully reflect local legal or regulatory considerations.  

A second fundamental expectation is that those subsidiary board members who are also executives within the group fully understand the difference in duties when acting as a board member versus as a member of management. 

The above is no easy task. In serving on a subsidiary board, a group executive may have difficulty switching hats and seeing matters from the perspective of the subsidiary. Such tension may arise in areas such as transfer pricing, local retention of profits versus upstreaming of dividends, dealing with matters protected by local confidentiality obligations and responding to local regulator demands when these clash with group interests. 

An increasing number of groups are recognising the benefit of setting minimum standards for the boards and board members of group subsidiaries.[8] These may include expectations on matters such as:

■  Board size

■  Board member competencies

■  Resources available to the board

■  Board compensation[9]

■  Length of service

■  Ability for the board to meet without management presence

■  Service on other boards

■  Quality of board minutes and resolutions

■   Onboarding and ongoing training of board members [10]

The group standards may also include specific measures to address the tension between local and group interests. For example, they may specifically require local boards to ensure management is responsive and timely in dealing with local regulators. Or they may instruct the local board to always review and approve group policies before local adoption to avoid any local legal challenge.[11]

As long as group subsidiary governance standards do not clash with local obligations, they are not problematic. In some instances the group may choose to go above local requirements, such as with respect to the number of times the subsidiary board should meet or the types of issues on which the board should provide special oversight. The group standards may also set a higher bar on personal conduct of board members, such as with regard to conflicts of interest or the acceptance of gifts.

  1. How can subsidiary governance best be advanced going forward?

Undertaking the types of steps described above can help drive the right governance throughout the subsidiaries of a group. 

But the starting point is not a legal policy prepared by the company secretary or law department. Instead, it is the fundamental reflections by the group board on how governance relates to the group mission, strategy and culture. The primary motivation from this perspective is not what law or regulation requires on governance, but rather the question, “How could smart governance – also at the subsidiary level – help us in advancing and managing our group?”

“The starting point is not a legal policy but a reflection on how governance relates to the group mission, strategy and culture”

Once viewed from this angle, the indispensable leadership role of the group board on subsidiary governance becomes clearer. This is true whether the group favours a more centralised or decentralised approach, or something in between. 

For example, being decentralised does not mean allowing lax local board practices. Most group boards recognise the benefit of having both a reliable group view and a reliable solo view of the main entities, regardless of the degree of centralisation of the group.

In addition, since a group board ultimately relies on the quality of governance underneath it, it should be inherently interested in who serves on local boards and how well they perform. This is particularly important since group consolidation could make it harder to spot individual subsidiary risks, including risks that could potentially cause group contagion or group reputational harm.  

The above considerations, as well as the inherent tensions involved in addressing subsidiary governance, have been well recognised by the BCBS in formulating the 2015 revisions to its governance principles.[12]

The BCBS revisions provide that in operating the group structure the group board should be cognisant of the key risks and issues affecting the group as a whole and its subsidiaries. To accomplish this, the group board should define an appropriate subsidiary board and management structure and provide adequate oversight over subsidiaries. And it should do this while respecting the independent legal and governance responsibilities that might apply to the subsidiary boards.  Not an easy balancing task, but one that is clearly now on the lap of group boards. 

 

About The Author:

Gabe Shawn Varges is Senior Partner at HCM, an international consulting firm which advises boards of directors, senior management, and control functions of companies in a variety of industries on strategic aspects of compensation, governance, and compliance. HCM is a partner firm in the Global Governance and Executive Compensation Network, a strategic alliance of leading independent international firms focused in these areas. A former senior regulatory official and corporate executive, Mr. Varges has also served on various professional boards and is former President of the Association of Corporate Counsel in Europe. He is a graduate of Harvard University and lectures at the University of St. Gallen Executive School. He is the author, among other publications, of “Governing Remuneration”

 

Footnotes:1One example is the Group of 30, a private non-profit financial services industry group, whose research and publications have had impact on the international discourse on various important topics. See, for example, Group of 30’s Toward Effective Governance of Financial Institutions, 2012. 2At the international level, the work of the Financial Stability Board, the Joint Forum, the Basel Committee on Bank Supervision and the International Association of Insurance Supervisors has each added to the attention given by national regulators to groups and conglomerates. See, for example, the Joint Forum’s Principles for the Supervision of Financial Conglomerates, 2012; FSB, Thematic Review on Risk Governance, 2013; IAIS, Issues Paper, Approaches to Group Corporate Governance, 2014; IAIS, Common Framework for the Supervision of Internationally Active Insurance Groups (in development and currently due for adoption in 2018). 3 This article focuses on the legal entity structure in a group, not its functional organisation with business units and divisions. The latter may or may not align with the legal entity structure. Reconciling both is another challenge for companies and their boards. For the sake of convenience, the term ‘subsidiary’ is used here to refer to a separate legal entity within a group, even when its ownership or legal relationship to the parent or group company may be indirect or otherwise differ from a direct subsidiary. 4See, BCBS, Corporate Governance Principles for Banks, 2015 (Principle 5, Governance of Group Structures). The 2010 version of the principles also touched on corporate structures but less from the context of groups and group governance. 5For regulators, the most recent concern about corporate structures regards systemically important financial institutions. The concern is that complex structures impede orderly resolution planning. See, FSB, Key Attributes of Effective Resolution Regimes for Financial Institutions, 2014. 6This practice is followed sometimes for practical reasons (so as to not have to hire external board members) but other times to increase management control. Occupying subsidiary boards with group executives is also seen as a way of giving promising executives more exposure to the different parts of the businesses. 7The assumption here is double service by an independent group board member who also serves as an independent board member of a subsidiary. Having an executive member of the group board also serve on a group subsidiary could raise more governance complications. 8In setting such standards it makes sense in most instances to make allowances for material and less material subsidiaries, still taking into account the local legal and regulatory requirements. 9See, e.g., G.S. Varges, Governing Remuneration in S. Emmenegger, Corporate Governance, 2011, and Financial Stability Board Links Executive Compensation and Conduct, in Ethical Boardroom, https://ethicalboardroom.com/committees/financial-stability-board-links-executive-compensation-and-conduct/. 10A leading training practice is to have the group and subsidiary board members meet periodically in joint training sessions. In addition to transmitting group expectations, such fora can permit board members to get better acquainted with each other and exchange ideas on the challenges and good practices for carrying out their duties. 11Proper setting of group standards becomes more complex in respect of subsidiaries that are not consolidated in the group’s financials or over which the group otherwise does not have majority control. This includes joint ventures and other equity participations where nonetheless the group’s reputation may be on the line. 12See footnote 5.