04 September 2018 by Kariem Abdellatif
In the face of fragmented international regulation, companies must bolster governance frameworks to combat subsidiary risk
An ongoing theme since the financial crisis has been the growth in new regulations around the world. One estimate suggests there was a 492% increase in international regulatory requirements between 2008 and 2015.
The networks that supply multinationals are intertwined across multiple jurisdictions. Yet increasing and changing regulation will not stop businesses from operating internationally – deal-making will continue and companies must be aware of the potential problems that arise when working across such global frameworks. These changes will inevitably bring disruption, and new processes, procedures and systems will all need to be updated accordingly to meet it.
The major risk as regulatory complexity increases is the likelihood of mistakes. Mistakes can be costly and may bring substantial financial repercussions, as well as reputational damage. Last year the Financial Conduct Authority (FCA) total fines came to over £229 million in the UK – a tenfold increase on 2016 – firm evidence that the regulators are not afraid to punish compliance failures.
“Errors in subsidiary governance are virtually inevitable for companies of a certain size”
Indeed, there is a view that errors in subsidiary governance are virtually inevitable for companies of a certain size. With so many moving parts needing to be monitored by a company’s governance framework, the likelihood of errors will naturally increase.
As multinationals have to take into account numerous geographies, jurisdictions and an array of service partners, this increases their exposure to risk.
One such vulnerable area is performing due diligence on new acquisitions – the utmost caution should be taken in uncovering exactly what is being bought.
For example, when acquiring a portfolio of entities that includes companies in foreign jurisdictions, it is essential that your due diligence takes into account local rules and regulations; from financial statements, to the details of annual meetings and who holds which company directorships.
It can be extremely difficult to get genuine visibility of entities located in other jurisdictions. Those in charge of corporate governance can be in for a nasty surprise when encountering companies that have not been liquidated – effectively taking on so-called ‘zombie entities’ in cross-jurisdiction acquisitions.
For example, in one outlier case, a routine corporate health check uncovered that a multinational had acquired a portfolio containing a delinquent entity domiciled in Trinidad, which had not filed a company statement for a decade. Furthermore, as the directors of the entity could no longer be located, the only options were to dissolve the entity voluntarily by paying a fine of $165,000 or to wait for Trinidad’s registry to dissolve the entity of its own accord.
“Those in charge of corporate governance can be in for a nasty surprise when encountering companies that have not been liquidated, taking on 'zombie entities'”
As the multinational was unwilling to pay the fine, the entity in question is still dormant, despite having filed no returns since 2005.
Of course, the fines threatened will differ from jurisdiction to jurisdiction, but this example illustrates the potential gravity of the consequences of poorly managed entities.
Extreme cases like this may be more common than we think. A global governance report from 2013 by one of the big-four audit firms suggests that the average major client company had over 90 subsidiaries worldwide and that around a third of their multinationals did not spend sufficient time overseeing the risks of subsidiary governance.
Given there are around 8,000 subsidiaries overseen by the FTSE 100, we suspect that there may be thousands of entities in operation without proper oversight, visibility or governance, with this figure only likely to increase.
There are a number of practical measures that can be taken to avoid serious subsidiary governance issues, with the following three elements an integral part:
Firstly, companies of all sizes must implement a framework around existing governance rules and regulations and how they apply to the entities. Responsibility for the maintenance of this framework must ultimately lie with the company’s secretarial/governance function.
With so many potential regulatory complications, those tasked with ensuring corporate governance compliance should have clearly-assigned roles and frameworks to cover and this extends to local service providers.
Good record-keeping and cross-refencing are vital. If incomplete, missing or incorrect records become known in the due diligence stage, there is already a problem. Mistakes unearthed at an earlier stage will be far less costly.
The second tip is to ensure this information is updated and maintained when existing rules change or new jurisdictions are introduced.
The main difficulty here is when companies lack a cohesive approach to subsidiary governance, an issue which is far from uncommon. There are likely to be external service providers, lawyers, company management and audit firms involved, with local firms tending to lean towards local service providers. However, this can weaken a centralized framework.
In an effort to cut costs and remain profitable, some companies will try to keep operations streamlined. This is all well and good, but they must make sure that oversight is not sacrificed when overheads are reduced.
Full visibility of an entity’s governance is an essential part of the process and something that should not be overlooked.
Finally, transparency and accountability must work across all processes, and in both directions.
For example, how do you know that the documentation you are producing in an overseas jurisdiction is still valid – and are the deadlines you are working to correct?
This ultimately comes down to the framework. Although it is vital to integrate local service providers into the workflow in order to check the validity of any governance-related documentation, it is just as important that the central governance functions have full visibilities of these local service providers. Think of this as ‘double entry book-keeping’ – it needs to be compliant and tied off at both ends.
“Even with the greatest will in the world, subsidiary governance can still be undermined by human error”
Best practice in governance is to ensure full visibility at the central function level and this means having a full oversight of all local service providers and partners, minimizing the dangers caused by the complexity of multiple jurisdictions.
Even with the greatest will in the world, subsidiary governance can still be undermined by human error. However, proper utilisation of entity management technology can help mitigate this kind of risk.
New software can help good governance and streamline the three core components of entity management: frameworks, accountability and transparency. The integration of these processes into a single dashboard that can automatically update end-to-end will certainly reduce the risk of human error. The added visibility and the ability to track changes will ultimately allow for a more joined-up approach and improve the day-to-day maintenance of subsidiary governance.
Centralising these solutions under one roof via new technology will be a step forward for any company working across multiple jurisdictions and help it to stay compliant with challenging regulatory complexity. Subsidiary governance cannot be afforded to be treated as an ancillary service and requires a specialist approach.
There is an increasing recognition that governance needs to be brought front and centre as a corporate concern, and luckily technology is keeping pace to help avoid any future subsidiary governance horror stories.