Avoid piercing the corporate veil
The internal management and corporate governance of private company subsidiaries is an important action item for corporate counsel. Among other reasons, maintaining orderly subsidiary governance and management is necessary to avoid a piercing of the corporate veil between a subsidiary and its parent company. Piercing the corporate veil exposes the parent company to the liabilities of the subsidiary.
Subsidiary management involves creating new legal entities and ensuring that all subsidiaries maintain their good standing and qualification to do business. It also involves overseeing the completion of all corporate formalities, including issuing stock to the subsidiary's stockholders; holding meetings or obtaining written consents of stockholders and directors; electing the appropriate directors and officers for each entity, each year; and documenting all material transactions and transfers.
Finally, subsidiary management also involves maintaining separate and complete records for all subsidiaries.
To ensure proper governance and management of subsidiaries, the company's corporate secretary or legal department must maintain central control over the creation, maintenance, and dissolution (when applicable) of all the company's subsidiaries. No subsidiary should be formed or dissolved without the knowledge or involvement of the company's legal department or other legal authority. To ensure that this practice is upheld, the board of directors or CEO should authorize the corporate secretary or legal department to maintain central control of subsidiaries, supported with the necessary information-management tools.
Maintaining distinct corporate identities
Companies manage their operational risk by creating corporate subsidiaries to conduct their businesses, including contracting with customers and suppliers and incurring debt. This corporate structure allows a parent company to:
- Have different risk profiles for different business lines
- Shield itself from each subsidiary's liabilities and limit its exposure to the amount of its capital contribution in the subsidiary
Plaintiffs asserting claims against a subsidiary often seek to disregard the corporate form of the subsidiary and hold the parent company directly liable for the subsidiary's obligations. This type of claim is commonly referred to as piercing the corporate veil. The corporate veil can be pierced if the parent company dominates the subsidiary to the point that the subsidiary shows no separate corporate interests of its own, and the plaintiff demonstrates that an injustice or wrong will likely result to the plaintiff if the corporate veil is not pierced.
Avoiding veil piercing
A parent company can minimize the risk that a court will pierce the corporate veil of its subsidiary to reach the parent company's assets. Corporate counsel should advise the board of the steps needed to minimize the risk, some of which may require commitment from senior management of the parent company. These steps include:
- Properly capitalizing each subsidiary to only hold those assets required for its operations and any statutory capitalization requirements. This can limit the amount potentially recoverable in actions against the subsidiaries.
- Adequately insuring each subsidiary to substantially weaken the possibility that the plaintiff will suffer an injustice if the corporate veil is not pierced. Courts are less likely to permit a plaintiff to reach the assets of a parent company if the plaintiff can collect the full amount of a money judgment from the subsidiary's insurer.
- Ensuring all transactions with the subsidiary are done on an arms-length basis, including any loan to or from the parent company.
- Keeping a balance between debt and equity that is appropriate for the type of business the subsidiary operates.
- Having the subsidiary hire its own employees, paid from the subsidiary's own funds.
- Not allowing the parent company to hire and fire the subsidiary's employees.
- Avoiding references to the subsidiary, at both the parent level and subsidiary level, as a division or department of the parent company.
Corporate counsel can oversee and implement other steps to mitigate risk without management action. These steps include complying with corporate formalities, properly filing each subsidiary’s certificate of incorporation, creating a separate and independent bank account for each subsidiary, and keeping separate books and records for each subsidiary.
Corporate counsel can also document the reasons for each subsidiary’s capital structure and its level of equity and debt, as well as fully document all transfers of money or other property between the parent company and the subsidiary. The board of directors of each subsidiary should also hold separate board meetings, or sign its own unanimous written consents. Each subsidiary should also file separate tax returns and annual reports with its jurisdiction of incorporation.
The information in this article was excerpted from Best Practices in Corporate Subsidiary Management. The full article, one of more than 65,000 resources, is available at the Thomson Reuters Practical Law website.