Monday, February 25, 2013

Company structures and their impact on contracts.

A large company will normally consist of one parent company and a number of individual subsidiary companies. Subsidiary companies may be wholly owned by the parent company or the parent may have only a majority or controlling interest in the subsidiary. Each subsidiary is a separate legal entity from both the parent company and other subsidiaries. Each subsidiary has their own board of directors. Each may issue stock in that subsidiary company’s location stock market. Subsidiaries are created for a number of different reasons. The primary reason is the management of potential liability. You see unless the parent company becomes party to a contract between their subsidiary and a third party such as a supplier or customer, the parent company will not be liable for the actions or inaction of the subsidiary and that is how they manage potential liability. The need to manage potential liability can be for a number of reasons. For example, in many countries to have a subsidiary in that country that sells to the local market there may be a requirement of a certain percentage of local ownership. When that happens, a parent company that may only have fifty-one percent ownership in that subsidiary does not want to be 100% liable for the acts or inaction of the subsidiary.

Another reason for the separation of the entities is taxes. If a parent company becomes too involved in the management of the subsidiary, from a tax perspective they could be looked upon as a single entity. In that case the profits made by that subsidiary could be subject to taxation by the tax officials of the parent company’s headquarters location. In these days of offshore use of tax havens to manage taxes there needs to be what’s called arms length transactions that keep the entities separate.

Companies may create different subsidiaries for high-risk activities. They may have separate subsidiaries that sell to government that have to comply with governmental requirements. They may have subsidiaries set up to perform or sell services to other subsidiaries. For example, you could have a real estate subsidiary that leases the property, You could have a subsidiary that purchases and sells insurance. If a common function can be performed in one location and sold to other subsidiaries, it may
be a subsidiary.

In a large multinational corporation you may each country may have their own sales subsidiaries. They may have a subsidiary in each country to perform services. If there are development or manufacturing locations in a country, they too may be separate subsidiaries. Further each subsidiary may be owned completely or in part by a separate subsidiary called a holding company that is ultimately owned by the parent company. Major multinationals will usually have hundreds of subsidiary companies. You can also have subsidiaries that are called affiliates. The way I define an affiliate is the situation where no one company has fifty-one percent interest in the company, but a parent company has multiple subsidiaries that own a majority interest in the company so in effect they control the company.

What does all this have to do with contracts? Since each subsidiary is a separate legal entity when you contract with one subsidiary, that subsidiary is the only party that you have privity of contract with. That means you can only look to that company’s resources and assets in the event of a problem. This means you should ensure that they have the necessary assets and resources to stand behind their contractual commitments. Those commitments include performance, indemnifications, and damages that could occur upon breach of other commitments such as carrying required insurances.

The only way you can look to the assets or resources of the parent or other subsidiaries is if they are either a party to the agreement where they agree to be jointly and severally liable. Simply having them as a signatory on the contract isn’t enough. They need to agree to be jointly liable so they are responsible for the actions of the subsidiary if you can’t collect from that subsidiary. Another way they can become responsible is if they provide what is called a corporate or parent guarantee for their subsidiary where they agree to be financially responsible for the subsidiary’s acts or inaction. (See the blog post Parent Guarantees.)

In contracts you can agree to have litigation or arbitration in one location, using the law of that or another location. That will get you a ruling. The next issue is enforcement or collection. When you have a court award or a binding arbitration ruling issues in one location, if you want to enforce it against a subsidiary or parent company in another location to collect what is owed, you would need to get a court order in the location of the company whose assets you seek to go against. This means that collection is not 100% guaranteed. To enforce a foreign judgment, a court would look to its “conflict of laws” procedural rules. Things that would be against local law or policy may not be enforced. For example if the contract with the subsidiary provided for a penalty for non-performance, and the jurisdiction where you are seeking enforcement does not honor penalties, they may not honor the portion of the award that represents a penalty.

The best advice is to know who you are contracting with and know whether they have the assets and resources to stand behind their commitments. If they don’t, either have the parent or another subsidiary that has the assets sign the agreement and agree to be jointly and severally liable or have them provide a parent guarantee or a financial guarantee. Also check to see in general whether that location would normally honor foreign judgments or binding arbitration findings.

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