Source: https://www.lawteacher.net/free-law-essays/company-law/law-parent-company-and-subsidiaries.php
Timestamp: 2019-04-21 20:18:48+00:00

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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.
Certainly recent global occurrences, such as the unprecedented ‘crashes’ of the global financial institutions have taught us that all companies possess the true ability to positively or negatively affect the development and health of a country’s population.
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.
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.
In 1867, the House of Lords was called upon to determine a case 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 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. 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 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.
One must bear in mind the judicial decision in the case of Adams v. Cape Industries PLC 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.
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 as well as under section 154 of the Companies Act, 2006 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. 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 2006a 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.
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.
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 legislative definition of holding companies and subsidiaries is to be found in the Companies Act 1974 at section 1, Companies Act 1985 at section 736 and the Companies Act 1989 at section 144. 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 and the Companies Act, 1989, section 23 and section 129(1) place a general prohibition against subsidiaries being members of their holding/parent companies. Moreover, under section 151 a holding company and its subsidiaries are prevented from giving financial assistance to fund the acquisition of its shares.
At section 229 and section 213(2) 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 as well as 213(2) 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 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.
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.
It has been judicially noted and academically stated 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 Companies Act 2006 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.
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) as well as where it relates to inter group loans. 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, 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 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.
In the matter of MAN Nutzfahrzeuge AG v. Freightliner Ltd, 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 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. 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.
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., 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.
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.
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 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.
 Company Law Review, Modern Company Law for a Competitive Economy, Completing the Structure (2000) **Para 10.20. > ***Para 10.58-10.59.
"Relations Between A Parent Company and Its Subsidiaries." LawTeacher.net. 11 2013. All Answers Ltd. 04 2019 <https://www.lawteacher.net/free-law-essays/company-law/law-parent-company-and-subsidiaries.php?vref=1>.
"Relations Between A Parent Company and Its Subsidiaries." LawTeacher. LawTeacher.net, November 2013. Web. 21 April 2019. <https://www.lawteacher.net/free-law-essays/company-law/law-parent-company-and-subsidiaries.php?vref=1>.
LawTeacher. November 2013. Relations Between A Parent Company and Its Subsidiaries. [online]. Available from: https://www.lawteacher.net/free-law-essays/company-law/law-parent-company-and-subsidiaries.php?vref=1 [Accessed 21 April 2019].
LawTeacher. Relations Between A Parent Company and Its Subsidiaries [Internet]. November 2013. [Accessed 21 April 2019]; Available from: https://www.lawteacher.net/free-law-essays/company-law/law-parent-company-and-subsidiaries.php?vref=1.

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