Three Steps of a Corporate Entity Lifecycle

Purpose of Subsidiaries and Legal Considerations

A subsidiary is an independent company that is more than 50% owned by another company or corporation. The subsidiary acts on its own behalf and has its own board, but the parent company’s participation helps spread the risk and limits investor loss.

The benefits of having subsidiary corporations are substantial:

  • They are separate legal entities that contract on their own behalf and are solely liable for their own obligations, debts, and assets
  • They meet local legal and regulatory requirements by being the entity in the location, saving the parent company from having to maintain an agent in a remote office
  • They provide on-site management of assets, reducing the need for oversight by equity owners
  • Subsidiaries protect corporate separateness (i.e. “the corporate veil) when managed properly

The parent company’s duties towards the subsidiary are to provide advice and counsel where needed, but not to interfere in the daily management of the subsidiary’s affairs. For instance, the parent company should provide assistance with dividend management, corporate document filing for the subsidiary, and maintain a document repository for all subsidiaries and joint ventures.

Piercing the Corporate Veil

When a parent or subsidiary finds itself in legal trouble, the courts will collect all entities under the parent company’s name and disregard any claim of corporate separateness. This is known as “piercing the corporate veil.” In legal terms, it means that the parent company becomes liable for the actions of the subsidiaries, whether they were directly responsible or not.

Related to “piercing the veil” is the “alter ego.” If a member of the board, an officer, or the entire parent company is determined to be using the subsidiary as a personal piggy bank or a straw company for their own benefit, penalties can range from severe monetary fines, regulatory sanctions, dissolution of the company, and even prison time.

The key to avoiding both corporate veil issues and alter ego questions is transparency and good data management. The subsidiary cannot appear to be dominated by the parent company. Some tips to avoid this include:

  • Keep all records of the parent and subsidiary separate
  • Ensure the subsidiary board has direct oversight of the subsidiary
  • Do not commingle parent and subsidiary assets.
  • Ensure the subsidiary has adequate capital
  • Carefully monitor all intercompany loans, service agreements, and other transactions
  • Avoid overlap in officers, directors, and management personnel where possible

If the company finds itself being audited or examined for possible regulatory violations, the best defense is a record of corporate filings, what used to be called a paper trail. As long as the attorneys can show the regulators that everything was done according to state and federal requirements, the company and its subsidiaries should be in the clear.

Lifecycle of a Subsidiary: Formation

A subsidiary begins life as a separate entity that is either created or taken over by the parent company. If a subsidiary is wholly owned by the parent company, then it has no minority stockholders, but otherwise acts as an independent company. Subsidiaries must follow the corporate formation laws in their locations regarding governance structure, filing annual reports, and shareholder agreements.

For instance, corporations must file Articles of Incorporation that include the location of their physical office, the names and numbers of directors and officers, and the rules governing shareholder meetings. A Limited Liability Corporation (LLC) must file its management style, officer titles and duties, and powers and authorities of the managers.

Non-U.S. subsidiaries must meet the requirements for the nation in which they reside, and the parent company must meet the requirements for doing business overseas. Companies doing business with subsidiaries outside the U.S. should take great care to vet their potential acquisitions thoroughly, since they may be liable for any acts of terrorism, weapons violations, and other crimes, even if they are unaware of the scope of their subsidiary’s acts.

Lifecycle of a Subsidiary: Maintenance 

Once a subsidiary has been created and started, the parent company’s duties are to keep it running smoothly. The parent company needs to balance good governance and oversight with staying on the sidelines as much as possible to avoid any appearance of “alter ego.”

Most subsidiaries will have their own boards and CEOs, but it is in the parent company’s interest to have a say in who will sit on the boards, and to have at least one member of the parent company present in the board for maintenance purposes. Any board members will be determined by the allowable size of the board, any conflicts of interest, and the ability of the parent company’s board members to relocate to the subsidiary location.

The assigned director or directors need to adhere to two basic rules while serving on the subsidiary board:

  • Standard of Care. The director must be reasonably informed on all business affairs before making any corporate decision that will affect the subsidiary, shareholders, or the parent company. The primary duty is to avoid harm and promote the wellbeing of the company.
  • Standard of Loyalty. The director must act in good faith and in a manner reasonably believed to be in the best interests of the corporation, the subsidiary, and the shareholders.

The director must rely on corporate records for the analysis before any decision. A robust database that is accessible at all times is essential for the directors and managers of a subsidiary. They need to have the most accurate information so their guidance can best assist the subsidiary and the parent company.

Lifecycle of a Subsidiary: Dissolution

If it becomes necessary to dissolve a subsidiary and return it to its original state as an independent corporation, or else terminate the company’s existence, there are a number of steps that must be taken to ensure a clean break for the parent company and the shareholders and officers of the subsidiary.

The shareholders must be notified according to the state or national law where the subsidiary is incorporated, and consent obtained for the dissolution. The directors must also consent and formally resign from their offices. Tax reports and a final annual report must be sent to the relevant offices. Stock certificates and outstanding options must be canceled.

The final winding-down of a subsidiary corporation can take months or years, so the parent company should be prepared for a flurry of documentation. The entire lifecycle of a subsidiary is filled with a need for a solid data management system, and corporations should have a good management solution.

Athennian has the robust database system that can support multiple corporations in multiple locations. When it’s time to start diversifying, you’ll need an entity management system that can serve as a secure and reliable central source of truth. Request a demo today.

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