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Why subsidiaries need to embrace independence

By | 03/06/2019 in Blog posts

Even if a wholly owned subsidiary only differs from its parent company ten percent of the time, it matters that it can think and act in its own interests

For those holding companies that have flown under the radar of the UK regulators for some time, finding out that even a wholly owned subsidiary may not only be expected to have an independent board of directors, but also carry out external board reviews, can come as a bit of a shock.

The parent company after all has its own board and governance procedures in place, with the subsidiary totally answerable to the parent’s shareholders. So why the need for yet another board, let alone one created to act entirely in the interests of the subsidiary?

Why subsidiary independence matters
Although it might seem onerous to some, the reason the Prudential Regulation Authority (PRA) wishes to regulate and supervise wholly owned subsidiary financial firms conducting significant levels of business in the UK is because where a subsidiary’s interests are at odds with the group, it must act in its own interests, and not its parent.

For example, now that the UK Parliament has declared climate change a state of emergency, it might not be in the interests of the subsidiary of an American-owned company to take on investment risk, when this might still stand to reward the parent company and its shareholders overall.

In the event that there are common directors between both parent and subsidiary company, there is a risk that the subsidiary board will decide to act in the interests of the parent company. The PRA therefore takes the view that the board of a regulated subsidiary company will generally need to have its own independent directors if it is to have any chance of acting in the interests of the subsidiary as and when conflicts arise. However, this does not mean that a group executive or non-executive board member cannot sit on the board of a subsidiary, as a non-executive director, so long as the PRA feels this doesn’t adversely affect the overall independent balance of the board.

The PRA further takes the view that to further reduce the risks of an over-controlling parent company, a significant regulated subsidiary should adopt good practice by following the principles of governance typically associated with listed companies and conduct an independent external board review every three years.

The benefits of external board reviews
Of course a balance has to be struck between the subsidiary acting in ways that reflect the interests of the parent company or group as a whole, but in a way that ultimately puts the interests of the subsidiary first.

An effective external board review can help by creating an opportunity for subsidiary directors to “discuss undiscussables” and find solutions to any issues of concern to directors. As well as plan for regulatory issues and situations that differ in the UK. As well as ensure that the subsidiary is alert to the potential for conflicts of interest and able to take decisions independently where required to meet its own legal and governance responsibilities.

Critical to achieving these benefits is not just conducting a paper review, merely to be seen to be complying, but conducting an in-depth review. The reviews we carry out for subsidiaries for example, look at the culture, values and behaviour driving decision-making, as well as the more formal structures and governance processes in place. This matters because although it might be tempting to view any board as being governed by charters, mandates and codes, the reality is that a board is a social entity whose decisions are as much influenced by the informal culture in place.

By looking at both the formal and informal factors influencing the effectiveness of the board, an in-depth board review provides an opportunity to enhance how the board manages itself and director contributions, how it oversees performance, risk and compliance issues and how engaged it is with key strategic issues. It also encompasses the subsidiary’s recovery and resolution plans and the need for the board of an insurer to take into account the effect of its business decisions on those who are, or may become, policy holders.

This can provide valuable insights that reduce underlying tensions and greatly enhance the effectiveness of the leadership team, demonstrating to the regulator that it takes the need for independence seriously.

In this sense, while the need for a wholly owned subsidiary to undergo a separate board evaluation might seem excessive, it is in fact an opportunity to ensure that the governance of the subsidiary is effective and that the board is capable of taking decisions in the interests of the safety and soundness of their firm, even if this means taking decisions which are at variance with the holding company at times.

Peter Snowdon is a legal and corporate governance expert, with a particular interest in issues affecting financial services firms, banks and investment firms. A former partner at Norton Rose, he also worked for the Financial Services Authority (FSA) prior to joining Bvalco.

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