As regulators, investors and wider stakeholders increase their demands for companies to improve governance and compliance standards, subsidiary boards of large organisations are coming under scrutiny as well as directors at headquarters.

The shift in focus comes with the tightening of corporate governance regulation, following the 2008 financial crisis. Parent companies, particularly big multinationals with complex operating group structures, are seen by regulators to be particularly in need of a robust governance framework across their subsidiaries.

Directors are responsible for the actions of their companies and subsidiaries around the world and must comply with local and international legal and regulatory requirements in multiple jurisdictions. A lack of global harmonisation on regulation and legislation makes this a particularly difficult task in large, sprawling groups.

Subsidiary governance has been an unappreciated risk in the past, but parent organisations are attempting to gain better oversight of affiliate boards and to ensure they have good governance in place instead of hoping for a trickle-down effect from the main board. Adopting this approach before a problem blows up into a crisis in part of a widespread business—whether regional, global, government-owned, private or quoted—can prevent costly reputational and financial damage.

An accounting scandal at BT Italia, a subsidiary of the UK telecoms group, blew up in 2017, revealing malpractice such as false invoicing and off-balance sheet loans. In the same year, Tesco, the UK retailer, was fined by the Serious Fraud Office and the FCA for accounting fraud at its subsidiary, Tesco Stores Ltd, which dated back to 2014. The retailer also had to pay compensation to investors for overstating profits.

Brexit

A strong governance framework across subsidiaries is particularly important at a time when the UK is poised to leave the European Union on 29 March 2019. The extent to which UK companies will have to comply with EU regulations in order to trade is still unclear and the final details in any exit deal will affect a raft of issues from human rights to labour laws, environmental standards and money laundering.

Although, in the past, UK governance has led the way in many countries, breaking away from decades of EU regulation and corporate governance—such as the Shareholder Rights Directive—could present new challenges and risks for companies and their subsidiaries.

Organisations need to be diligent to ensure that in a post-Brexit environment their governance at parent and subsidiary level is at least as robust as the current one.

Balancing act

Companies that want to ensure an effective global subsidiary governance framework face lots of challenges. Parent company oversight of subsidiary boards is a difficult task as the balance between centralised control, devolved responsibility or autonomy varies enormously depending on whether the subsidiary is partly or wholly owned by the parent, and also on the structure of the legal entity. Balancing parent group needs and subsidiary independence involves fine-tuning and often needs adjusting.

Working out who is responsible for what, avoiding overlaps or unwanted interference is equally demanding. While the main board sets the objectives, values and culture in the organisation’s strategy for the subsidiary board to follow, it is down to the latter to achieve them.

Directors on parent boards and subsidiaries

Some parent organisations assign responsibility of subsidiary governance to a company secretary, senior executive or a subsidiary governance officer. Others prefer to appoint one or more go-between directors on parent and subsidiary boards to encourage better understanding of the objectives and needs of both and to share viewpoints.

Common directors are a good way to get across strategy, cultural values and behaviour that affect decision-making at subsidiary level. Culture varies hugely across countries on practices such as commissions for contracts, corporate hospitality and gift-giving.

Board composition

One of the best routes to building a good subsidiary governance framework is to make sure high-calibre directors are on the board. The task of securing the best mix of talent is as important at subsidiaries as at main boards, and finding a diverse mix of people with the right skill sets and backgrounds can often be time-consuming and expensive. A regular review of board composition to maintain a healthy balance is an important part of the process. If the subsidiary board is large enough, a director with a strong governance background is a useful addition.

The recruitment process must be transparent for all parties with clear descriptions of job roles. “First-rate directors with the right experience and skills are a vital part of building good governance at subsidiary boards,” says Thomas Deutschmann, CEO of Brainloop, a board portal provider.

Regular training for subsidiary directors on best practice governance and an induction programme for new appointments are also practical measures.

Communication flows

Good, frequent communication lines between a subsidiary and parent at board, management and operating levels are an essential part of building effective governance. Timely, comprehensive information exchange helps ensure objectives, problems and potential risk areas are shared, discussed and worked through. Good information flow enables subsidiary board members to ask the right questions to the main board and parent management and builds up their involvement in the main organisation. This is particularly important for subsidiary non-executives. Clear communication also helps avoid misunderstanding and error, and maintains a close relationship between headquarters and subsidiary boards.

As regulators demand more information and accountability from companies and their subsidiaries, transparent data trails are becoming increasingly important. Some companies are turning to board portals where current and historic documents can be stored and shared easily, and board agendas, minutes and decision-making—past and present—are clearly laid out. “Digital board portals are useful for tracking information flows and changes between parent groups and subsidiaries and for a transparent audit trail. Platforms can manage data securely and support compliance and governance policies,” says Deutschmann.

Parent group shareholders increasingly want to see transparent information on subsidiary activities and decision-making.

Subsidiary board evaluation

Experts advise that subsidiary boards and their committees need to be evaluated in the same way and as often as those of parent organisations. The UK Corporate Governance Code recommends that FTSE 350 companies carry out external evaluations at least every three years and internal ones on an annual basis. Following this procedure helps parent organisations to understand whether subsidiary board governance complies at an international level.

Thorough, objective evaluation, both internal or external, is key to improving director performance. Feedback on the strengths and weaknesses of directors provides a learning curve for members who are keen to raise their game and, crucially, gives the parent some understanding of the effectiveness of the affiliate unit. Such reviews can be a litmus test for parent organisations to identify weak areas before problems bubble up at the subsidiary.

Savvy parent organisations also evaluate the audit committee regularly to determine the quality of work on risk, audit and internal control, knowing that scrutiny leaves them less exposed to risk.

Strengthening governance to mitigate subsidiary and, ultimately, parent group risk, is moving up the agenda at all levels and is becoming an essential part of overall best practice.

This article has been prepared in collaboration with Brainloop, a supporter of Board Agenda.