Maintaining Distinct Corporate Identities
A major function of a subsidiary is to shield the parent company from liabilities incurred from the subsidiary’s operations. This enables businesses to isolate risk exposure to the amount of capital investment the parent has made in the subsidiary. The legal concept is that each corporation has a unique identity and parents should not be de facto held liable for subsidiary liabilities (similar to how the parents of natural persons are not held usually liable for the activities of their children).
However, litigants suing a subsidiary often claim that the parent is also responsible for the subsidiary’s actions. This is often claimed because the parent tends to have deeper pockets to pay a judgement. Asserting that a parent is liable for the actions of its subsidiary is called piercing the corporate veil.
Increasingly courts are allowing claims to pierce the corporate veil to permit claims against corporate parents to proceed. For example, in February 2021, the English Supreme Court allowed a claim against Royal Dutch Shell Plc (the U.K. domiciled parent) to proceed for alleged acts of englience of a Nigerian subsidiary.
In most circumstances, courts are hesitant to pierce the corporate veil. However, courts will disregard unique corporate identity if the parent company demonstrates domination over the subsidiary to the extent that the subsidiary shows no distinct mind separate from the parent and that an injustice will likely result to plaintiff if the corporate veil is not pierced (the injustice is typically the subsidiary lacking the funds to pay a judgement).
Domination by Parent Company
Courts will use a variety of factors to determine whether a parent company dominates the subsidiary. In general, they are evaluating whether the subsidiary has a distinct mind and if the parent has created the subsidiary for the sole purpose of avoiding liability. Below are some, but not all, the factors courts consider:
- Does the parent company own all of the stock in the subsidiary?
- Is the subsidiary inadequately capitalized?
- Are the subsidiary’s corporate actions properly documented and follow statutory procedures (e.x., annual shareholder and director meetings, documenting stock issuances and asset transfers, and recording board meeting minutes and resolutions)?
- Does the subsidiary make loans to the parent company that are not documented or on non-market terms?
- Do the parent company and subsidiary share corporate officers and directors?
- Does the subsidiary share offices/facilities, employees, bank accounts, and telephone numbers with the parent company?
- Does the parent company pay the salaries of the subsidiary’s employees or make human resources decisions for the subsidiary?
- Are there intercompany agreements that document shared administration services at market rates (finance, legal, insurance policies, etc.)?
- Does the parent accept payments intended for the subsidiary?
- Does the parent company use the subsidiary’s property as its own?
- Does the subsidiary guarantee the debts of the parent company or any of the parent company’s other subsidiaries?
- Do the subsidiary’s contracts contain cross-default provisions with contracts entered into by the parent company or any of its other subsidiaries?
Many of these factors are common among companies with subsidiaries and no single factor alone typically supports disregarding distinct corporate identity. For example, appointing officers and directors common to both the parent and the subsidiary is standard practice for efficient business operations.
Best Practices to Prove Corporate Identity and Avoid Veil Piercing
Below are best practices that legal departments can take to demonstrate evidence that a subsidiary has a distinct corporate identity. Taken together, these will reduce the risk of a court piercing the corporate veil of a subsidiary to access the parent company’s assets to satisfy a judgement.
- Securing separate insurance policies for each subsidiary sufficient to pay out most court judgement. If the plaintiff can collect a judgment from the subsidiary’s insurer, courts are less likely to permit a plaintiff to reach the assets of a parent company.
- Properly capitalize each subsidiary to meet statutory capitalization requirements and have a reasonable amount of funds to operate its business activities. This avoids an argument that the subsidiary is “thinly capitalized” and does not have a distinct identity.
- Maintaining an arms-length position on all intercompany transactions with the subsidiary, particularly for loans and credit arrangements.
- Maintaining a corporate finance operation (debt and equity) that is appropriate for the type of business the subsidiary operates.
- The subsidiary should hire and fire its own employees and pay their salaries from the subsidiary’s own funds.
- Avoid references to the subsidiary as a division or department of the parent company.
- Maintain distinct bank accounts, credits cards, and other financial services for the subsidiary.
- Ensure that the subsidiary’s corporate actions are properly documented and follow statutory procedures (e.x., annual shareholder and director meetings).
- Documenting the reasons for the subsidiary’s capital structure and its levels of equity and debt
- Holding separate meetings of each subsidiary’s board of directors or having each board sign its own unanimous written consents (avoid omnibus resolutions).
- Filing separate tax returns and corporate annual reports.
It is important for companies to implement these best practices of corporate subsidiary management to produce evidence of the distinct corporate identity of the subsidiary. Failure to do so may result in parent assets being collectable to satisfy judgments of a successful plaintiff claim made against a subsidiary.
The data and documentation that supports these best practices is typically centralized in a legal entity management system that allows monitoring and reporting of data for specific subsidiaries.