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Local difficulty

11 April 2017 by Jonathan Hayward

Subsidiary governance: Local difficulty - read more

Proper governance of subsidiaries can overcome jurisdictional problems

You cannot take the UK Corporate Governance Code and expect subsidiary boards simply to act as lower-level versions of the group board. Although they have some things in common, the particular characteristics of subsidiary governance are too significant to gloss over.

The principal difference, of course, is the role of the regulators in each separate jurisdiction. The fact is that, if it were not for the local regulators, many multinational groups would not have subsidiary governance at all. They would follow the model customarily found in corporates, where the group exercises control through the management structure, and the legal structure exists for purposes of statutory compliance – typically with board meetings as occasional rubber-stamping formalities.

Local regulators, especially those regulating financial services, do not like this model one little bit. Instead, they want the statutory board to have real authority over the business that relates to the local balance sheet. So, there is immediate potential for confusion, above all where the management structure is a matrix which means that no single executive owns the local balance sheet.

There is also potential for conflict between the local regulator, which would like a board to have complete authority – in effect, to act as a local bulwark against the possible rapacity or folly of a foreign owner – and the legitimate desire of a holding company to control its investment.

Neither of these potentially conflicting forces are going to go away. It is necessary to make the best of the situation and find a way to make local governance a useful component of group governance. The key to doing this is to define a role for the local board which meets the interests of the regulators and the group, and then to ensure the local board is properly equipped to fulfil that role.

Useful role for subsidiary governance

Thoughtful groups recognise that subsidiary boards can be assets. The more far-reaching and more complex the group structure, the greater the challenge of managing the risks. Managing the problems of growth, exerting consistent standards, understanding behavioural norms, responding to multiple regulators – it’s easy to put together a long list of issues and risks that need to be managed.

Part of the parent company’s risk response needs to involve embedding sound governance across complex group structures to complement management control and to give those at the centre greater confidence that the group is under control. This leads to a two-way flow that all parties benefit from maintaining.

“Subsidiary boards do not have the right to abandon the group strategy and go off in a completely different direction ”

The key to having the win-win in local board governance – useful to the group, satisfactory to the regulator – is to start by explicitly recognising that the local board is there because the local regulator requires it.

But what exactly does the local regulator want? More often than not, the answer, is that the board should make a positive contribution to local management of prudential and conduct risk. If this is done in a constructive fashion, then the board should be able to serve the interests of the parent group. Doing it constructively means recognising there are some areas where subsidiary boards do not have the authority of stand-alone boards.

For example, subsidiary boards do not have the right to abandon the group strategy and go off in a completely different direction. They do, however, have not just the right, but the responsibility, to push back against the group strategy if they think it is either too risky – for example, in putting too much pressure to grow the local balance sheet – or could be improved, for example, by investing more to take advantage of local opportunities.

Similarly, the local board cannot just ignore the group risk appetite, but it can request a lower appetite locally if it believes the group appetite is too high for the local business to sustain. We say ‘request’ because that is more diplomatic than ‘require’. The upshot should be the same, but it is always better for a local board to explain to the group why it is in everyone’s interest to adjust things. Apart from anything else, it is not in the group’s interest for the subsidiary to get a section 166 on its board governance, and the local board will be doing everyone a favour if it cultivates its powers of persuasion and earns the respect of head office.

The starting point is to have a clearly defined role for the local board that is centred on risk management, positions the board as a valuable part of the overall group governance, and sets out where the board’s authority and responsibility intersect with that of the parent.

One size does not fit all

However well integrated the group, differences abound. Subsidiary governance cannot be driven just by a policy statement and compliance checklist from head office. It needs the flexibility to allow for local variations in factors such as: management capability, local politics, regulatory regimes, cultural norms, the quality of advisors and auditors, escalation practices, the fit in the matrix, and control attitudes.

Effective subsidiary board governance

The influences on effectiveness will vary, but here are some things to look for:

Objectives

A precise statement on the role of the subsidiary board or committee, communicated clearly and understood consistently, with specific guidance on the level of autonomy and the flexibility granted to the subsidiary body.

Independence

Clarity over the participation of group executives on the subsidiary board and their role as quasi-independent non-executives. Genuinely independent directors with influence should be involved when sitting with ‘group non-executives’.

Discussion and dynamics

The subsidiary board should have non-executive directors who understand the business and its risks, and have sufficient time to undertake the non-executive director role properly. They should be willing to challenge management and to follow through, with the ability to question ‘received wisdom’.

“Subsidiary governance bodies should have the ability to influence local strategy”
Strategy

The group should set out its strategy clearly, communicating what it expects from the local business. The subsidiary governance bodies should have the ability to influence local strategy, especially where there is concern over the implications.

Risk appetite and capital

How useful is the group risk appetite by the time it reaches the subsidiary? The local board should ensure stress testing takes rigorous account of actual and potential circumstances in the local market.

Risk and risk management

The local board should have a clear view of the subsidiary-level risk profile and how it is affected by, and how it affects, risk exposures and management from other parts of the group. The local board’s ability to influence internal audit and risk management, if these are group functions, should also be assessed.

Escalation

There should be a definition of when and how the local board should escalate significant issues, and the group’s obligation to respond. There should also be clarity over how the board’s escalation works in relation to the subsidiary executive team and in matrix structures.

Group functions

There may be a local dependence on group services and this could influence the way the subsidiary is controlled and managed. How the local board assesses and manages the risks of outsourcing to group functions is important.

Information

The quality and usefulness of reporting to the local board, especially where the statutory and management organisation structures differ. The integration of subsidiary enterprise resource planning systems into global structures and how this affects local information flow and management reporting.

Systems

The level of support provided by the group in supporting the operation of information systems covering transactional and data/management information systems. How the local board gets comfort over local IT-related risk exposures and security standards.

People and pay

The board’s ability to form a view on the calibre of local management – and how far it can influence appointments – and its ability to influence local remuneration policy and awards, given the possible effect on risk, retention and ethics.

Culture and behaviour

How the local board assesses culture and ethics and its effect on management, risk-taking, control, reporting and whistleblowing. How the local board helps make the group aware of cultural differences that affect group oversight, risk-taking and control.

Anxious parents

Parent companies, particularly those from oversees, are sometimes concerned that a strong subsidiary board might become too independent and steer the local business in an unwelcome direction. It is important to explain that UK boards have a fiduciary duty to shareholders, and – unlike in a listed company – there is a direct relationship which enables the shareholder to spell out exactly what its objectives and standards are.

The board of a subsidiary company is required to promote the success of the company in the interests of the shareholder and with reference to other stakeholders, not to strike out on an independent course. Where there is only a single shareholder, the local board can understand what the parent’s definition of ‘success’ is, and that is what it should promote. The significant qualification to this is that the best interests of the shareholder include keeping the firm out of regulatory trouble, which means the board might sometimes have to resist proposals that sail too close to the wind.

An overseas parent should have no concerns about a UK board becoming too independent and challenging, so long as it makes clear what its interests are. If the board fails to act in those interests, the shareholder can replace directors at any time. This would, however, be unwise if the only reason were that the board had regulatory concerns which the shareholder wished to override, as it would lead to a tricky conversation with the regulator.

The role of company secretary

For company secretaries to make a success of subsidiary governance we suggest starting from a high level and then working down into the detail. It is important to apply common sense and acknowledge the competing pressures. And remember, none of this should be done in isolation by the company secretary, who must talk to people throughout the business to understand what will work best.

“If governance is driven by the management line, the secretary needs to work out how this forms part of the governance framework”

The company secretary must first identify governance objectives and opportunities and assess where he or she sits – or want to sit – on the subsidiary governance spectrum. If there are board structures involved, the secretary needs to be clear what their role is. It will make a difference if the subsidiary board has full autonomy rather than its governance being through the management line of control. If governance is driven by the management line, the secretary needs to work out how this forms part of the governance framework, rather than just part of the operational framework, and what it is providing as a source of assurance. The secretary must also work out how the various governance bodies – non-executive and executive – fit together.

The ‘story’ on how governance works in the organisation needs to be put together, with a clear practical statement of the role of the subsidiary board and management within the group’s governance structure. In doing so, company secretaries should think through the practical consequences from different angles and activities, that is, ‘what needs to get done’. The secretary must work out who does what – it is not all about what the subsidiary has to do – but also what the group has to do and how the group has to work with the subsidiary.

Finally, move onto the detail – the terms of reference, processes, information and appointments –and make sure that the subsidiary board structures are effective and can be relied upon.

Jonathan Hayward is a Partner at Independent Audit Limited

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