REFORM OF LAW ON PARENT COMPANY’S LIABILITY

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REFORM OF LAW ON PARENT COMPANY’S LIABILITY FOR THE DEBTS OF AN INSOLVENT SUBSIDIARY

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Reform of Law on Parent Company’s Liability For the Debts of an Insolvent Subsidiary

Introduction

Parent companies may organize for subsidiary companies for brand recognition purposes or financial considerations such as tax consolidation by the government. Business law creates a foundation at which the parent company should relate with the subsidiary company, on its operations, management, and stakeholder activities. A parent company may have total power over the subsidiary or allow the subsidiary company to be independent. This entails having its responsibilities differentiated from those of the parent company. Incorporate business law; the liability of the parent company is determined by the dependence or independence of the subsidiary company. The parent company is liable to an insolvent subsidiary if the company was used to conduct the affairs of the parent. However, the liability may extend to directors of the company on circumstances where they are found liable. This law requires a reform to ensure the protection of both the parent company and the creditors.

Parent Company Liability

A company is recognized as a parent company when it owns 50% of the stock of another company. The other company then becomes the subsidiary company and may be fully or partially dependent on the public company. Partly owned is where the parent company owns at least 50% of the shares, but the control does not rely on one side. When a subsidiary is wholly owned, the parent company has total ownership of the stock, which is 100% of the shares. However, ownership is not related to the physical property of the company. The tangible property is only mentioned if it has been included in the tax decisions of the company by holding some amount of stock that consists of the physical property. The subsidiary may be a separate legal entity having its concerns on taxes, regulations, and liabilities. It has its independent operations, but the parent company consolidates the financials as it is part of it.

Relationship Between Parent and Subsidiary Company

Subsidiary companies are mostly independent in that they do not rely entirely on the parent company. However, independence is also laid down by the parent company as it may form regulations or draft articles of incorporations and provisions to solidify the control. The subsidiary company then runs based on the drafted constitution and requirements and may have to consult whenever a decision involves contrary action. It has its managers and makes decisions based on its interests and not of the parent company. However, the parent company has the power to replace directors if the decisions made through them are not satisfactory. But after replacement or appointment, the directors independently work towards the success of the subsidiary company and not the parent company. Issues of taxes to the government is consolidated and is the obligation of the parent company to pay for it.

Parent Company Liability Over Insolvent Subsidiary

Corporations set subsidiaries to protect themselves legally. Therefore, the parent is not responsible for any criminal or negligence acts. It is a requirement in the company law that a company has a separate legal identity separate from that of the shareholders. This law led to a reform in the corporate law reform act 1992, section 588v, that a parent company should be liable to the debts of a subsidiary company. The law means that in cases where the subsidiary company owes the creditors and is incapable of settling the debts, the parent company should come in to cover the indebtedness. The liability of the parent company over the subsidiary is unlimited; hence the shareholders may also be affected. When a subsidiary becomes insolvent, it is unable to pay the debts owed, and its property may be taken and liquidated to cover the liabilities. The law has been critiqued since the subsidiary performs its operations independent of the parent company hence should also be able to pay for its obligations without relying on the parent company. The law protects the creditors as they would receive their payments but deems unfair to the parent company.

Effect of the Law

In 1980, corporate groups in the UK conducted debates to address the problems of creditors, which required intervention by the legislation of corporate law. The insolvency law was reviewed, and an alteration suggestion made to make parent companies liable for the debts of its subsidiary companies. An analysis of the alteration found that it would create a difference between corporate and individual shareholders, as the corporate ones would be the ones liable. This decision would make it difficult for shareholders to embark on new ventures due to the fear of being accountable for debts they have less information about. The law then limits a firm from expanding due to fear of the shareholders as they have to be consulted before the decisions of expansion occur. Therefore, the debate on making the parent company liable to the debts proved futile to the development of the business sector, with individual companies stagnating in the current situations.

Corporate law reform act section 588v provides scenarios where a parent company is expected to be liable to the debts of the subsidiary company. First, the existing parent corporation should have been the parent company at the time the subsidiary incurred the debt. Secondly, the company is insolvent, and its insolvency can be proved. Thirdly, the directors of the corporation should be aware of the reason for the bankruptcy of the subsidiary company. The presence of these factors makes the parent company have full responsibility for the debts of the company. The liability is irrespective of the reason for the credit. The shareholders of a subsidiary company are limitedly liable to the obligations of a company; hence creditors can only access payment to the amount owed by the company but not the personal properties of the shareholders. Thus, when all the company’s stock and assets have been liquidated and still not enough to cover the debts, the parent company has to be involved in finishing up the remaining balance.

Corporate law is designed to protect creditors against bad debts. However, as Ramsay critiques, the creditors should have their designed contracts from protection with the subsidiary company without involving the parent company. This is because there would be a conflict of interest between the shareholders and the creditors. Shareholders would wish to continue with investments to earn more dividends while the creditors want for their money back hence the conflict of what to first prioritize. The amount needed by the creditors may be the same or more of the investment cost, thus affecting all other operations and plans of the parent company. Due to these conflicts, a shareholder may decide to incur more debt hence the adverse effect on the parent company than the subsidiary company. However, the parent company may have been named as a guarantor in the subsidiary company. Therefore, in this case, the parent company willingly decided to guarantee the repayment of the debt, hence must comply.

The involvement of the parent company goes against the principle of separate corporate entities. The parent company is a separate entity from the subsidiary company. The law requiring a parent company to be liable to the debts of the subsidiary is contrary to the principle of independent existence. This may result in evasion of the payment of liabilities by the subsidiary as it is fully aware that the parent company should cover its debts. The law encourages crimes such as to defraud and ignorant actions of directors of the company. Also, a subsidiary company managing director may be entirely reliant on the decisions of the parent company, making it hard for them to brainstorm a challenge and find the solutions independently. Communication with the parent company on the issues affecting the company may also be a challenge as the company assumes that the parent company is managing all the problems of the subsidiary. Therefore, the effects of the law on companies may be fatal than the benefit it has on creditors. Debts get paid to the creditors, but the subsidiary and the parent companies may collapse because of the massive liabilities and unplanned costs of the subsidiary company. This is a risk that the parent company has to take due to the law stipulated.

Need For a Reform

Obligating the parent company to pay for the debts of a subsidiary company goes against the principle of a company that it is a separate legal entity, and its shareholders are only liable to the extent of their shareholding. The law obligates the settlement of debt irrespective of the shareholders’ plans of expansion or amount of dividends. For example, using Lewis Holdings limited vs. Steel and Tube Holdings Limited, Lewis leased property to a subsidiary of Steel called Stube. Steel handled the decisions regarding the property and the payment. During the liquidation of Stube, Lewis went to court with proof of debt. The court used section 271 of Companies act 1993 to obligate Steel to the payment of the obligation to Stube as it was the parent company and had compromised the independence of the subsidiary company. Therefore, the freedom of the subsidiary company must be kept. As it performs its operations self-reliant, it should also allocate funds for risks and, as such, be able to cover its debts. The parent company should not be liable for the debts of the subsidiary company.

The obligation of parent company law to pay a subsidiary company’s debts has led to an increase in crime and civil cases in the companies. There is a dissatisfaction with the protection of the parent company from frauds conducted by the subsidiary company. Directors in the subsidiary companies may defraud a creditor for their benefits and not for the company. Such a scenario will make the parent company pay for debts that have not benefited the subsidiary company nor the parent company. This decision leads to losses in the parent company, but a positive impact on the personal lives of the directors after receiving the cash. The law also needs to include the personal liability of the directors in the subsidiary company. For example, if a subsidiary company becomes insolvent, the court should first prove that the business is bankrupt because of failure in normal operations, and there is no defrauding that has occurred. Defraud of creditors should change the liability of the directors to unlimited, in that they have to cater for a part of the debt before the parent company becomes responsible. Such a law would reduce abuse of the protection of limited liability by subsidiary company directors.

Besides, the directors oversee all the operations of the subsidiary company; therefore, they know the source or reason for insolvency. The insolvency act should also apply to directors of a subsidiary company. Section 214 of the insolvency act addresses the issues of wrongful trading that the director is aware of and has led to the bankruptcy of the company. Therefore, a director should be liable first, if, after knowledge of the company’s insolvency, he still prioritized shareholders over creditors. Giving the shareholders a priority over creditors uses more of the company’s finances without reducing the debts already incurred. Secondly, if the director disposed of the company’s assets at a price lower than the market value or for free, he should be liable to the liabilities of the company. Thirdly, if there is an overdrawn director’s loan, it should first be settled to reduce the amount of the loan. Lastly, if any funds have been obtained through fraudulent means, the director should be made liable. These laws in the insolvency act of companies could also be included when relating to subsidiary companies, to make the directors responsible and accountable for a company’s fate.

Section 588X of the corporate reform act provides a defense for the parent company on the liability of the subsidiary. It permits the parent company to provide reasonable proof of suspecting subsidiary insolvency, either due to the director’s illness or that the company took all reasonable measures to prevent the company from having a considerable liability. A parent company may be free from incurring subsidiary debt on the stated grounds. However, the subsidiary company is independent, and the parent company does not involve itself so much in the operations of the company; hence may fail to be aware of the risks when not communicated to in time. Article 588X may work well for group companies whose operations are intertwined and assets consolidated. It is complicated for a parent company to get knowledge of the risks; hence the section does not protect parent companies. Therefore, an article on the protection of the parent company is appropriate, especially in cases where it does not know the risks of a subsidiary company. This decision can be made by providing proof to the court of the unconscious debts of the subsidiary company.

The law in section 588V of the corporate reform act is limited in scope as it provides a partial solution to a parent company’s unaccountability to the debt of its subsidiary company. It fails to protect tort or criminal offenses. This means that there is a likelihood of the parent company to paying debts incurred due to criminal offenses or tort. Tort claimants can easily contract to protect themselves from undesirable behaviors hence could not be recognized by the court. This act does not protect the parent company under such circumstances. Also, it gives a lot of evasion methods, through which a company is excluded from debt responsibility. A subsidiary company may use these evasion strategies by organizing situations to avoid the relationship between the parent and subsidiary to evade payment duties. Therefore, the aim of protecting creditors may fail to apply through this law.

Shareholder and director’s interests are contrasting; hence the law may create a conflict between them. Directors aim to settle the debt to protect their brand or company’s reputation in public and also because of the fear of losing the creditors. Shareholders, too, may have a fear of lacking capital in the future through the drop of the creditors. However, the anxiety will only occur if the company operates as a going concern. Contrarily, if a corporation is a periodical, the law of taking responsibility of subsidiary debt may not apply as both the shareholders and the directors are aware that the company will be dissolved within a short period. Also, as much as the shareholders may want to take action regarding the debt, the law prevents them due to separation of ownership and control, thus have no control over management hence increasing the conflict between them and the managers. To avoid the disputes between the shareholders and directors, the law needs t to be more specific and including all the parties involved in the process of payment.

The law may jeopardize the independence of subsidiary companies on debts since parent companies would wish to be more careful about its operations. This entails more efficiency strategies such as monitoring the operations of the subsidiary company, including its managerial actions. A parent company may decide to use its directors to manage the subsidiary firms to know all the operations and debt incurred by the company. Monitoring creates a good leverage when defending themselves in court, to have proof of debt borrowed and its action on knowledge of insolvency. The full power over the subsidiary company ensures that the parent company makes all the actions and decisions of the company. These choices include liability sources, amounts, and interest to be incurred during repayment. Measures to create protection for creditors through contracts or after purchasing may also be included. Therefore, it is easier to know when a company is incurring a lot of losses; hence strategies are developed to prevent insolvency from occurring.

Solution Strategies

Principles guiding the liability of parent companies and providing protection for the parent company and as well protecting creditors may be applied should be included in the law. For example, in the United States, the principle of equitable subordination in the united states bankruptcy law which allows the court to give the order of debt obligation to a parent company; only it is just and fair. Equitability is confirmed through a research done by the court on the parties and nature of the liability. Research on the relationship between the parent company and the subsidiary is conducted to understand the source of debt. This principle prevents the parent company from being accountable for losses that occur due to fraud or director misconduct. Also, in most European countries, piercing the corporate veil principle is applied in solving liability debt issues. This is whereby the court ignores the limited liability of shareholders and directors and make everyone liable for debts. This method ensures every party is responsible and accountable to avoid bankruptcy or insolvency of the company.

Parent companies have given the subsidiary companies the right to be independent. However, the company can participate in the activities of the subsidiary company. If proven to participate in the management of the subsidiary company actively, the parent company is acting as a shadow director of the subsidiary company. Therefore, any debts incurred by the subsidiary during insolvency must extend to the parent company; hence the debt has to be covered by the company. Also, the assets of the subsidiary company are included in the settlement of the creditors. When piercing the corporate veil strategy is applied, the lack of independence of the subsidiary relates to the management by the parent company. The autonomy of a subsidiary company gives leverage to the parent company not to be liable to its debts. Independence should stretch to cover the payments of debts and any other liabilities independently incurred by the company. Hence, parent companies need to allow its subsidiary companies to be self-sustaining and self-reliant and so be accountable for its obligations.

Reform on the law could include the protection of all the parties and equitable actions imposed by the court. The parent company should not always be liable for all pending debts incurred by a subsidiary company. The court needs to investigate the directors of the company and know the reasons for acquisition of the liability. Also, the reasons for solvency is essential. When a reform is undertaken to address these factors, the bill will be considering the protection of both the creditor and the parent company. Also, the directors of the subsidiary companies would be more accountable for their actions as the law also involves them. As a company is gong insolvent, a director will have to communicate with the parent company and find solutions before it collapses. Every action conducted by the subsidiary company will try to consider the effects on the financial state of the company and its benefit to prevent the accumulation of more debts that may lead to personal liability to the obligations of the company. This act will ensure the creditors get from bad debts and that they also support the company financially in the future when in need of more funds.

Conclusion

A parent company is a company that owns 50% of the stock of a company. The company by which the parent owns the shares is the subsidiary company. A parent company has power over the subsidiary but allows it to be independent and have its operations. Due to the control and ownership of half of the subsidiary shares, the law requires the parent company to take the liability of an insolvent subsidiary company’s debts. This law needs a reform as it only addresses the settlement of the mortgage without considering the reasons for the accumulation and bankruptcy of the subsidiary company. Changes involving the directors, creditors, and ideas for insolvency before settlement. Also, applying strategies such as equitable subordination ensures all parties are responsible and account for their actions. The existing laws create conflict between shareholders and directors and even creditors and parent company. Besides, to avoid such conflicts and unjust liability of debts, the parent company may decide to have close monitoring of the subsidiary company. This act will ensure that the parent company will have complete knowledge of the activities and operations of the company to be able to defend itself and evade the liability. A reform is appropriate to avoid the challenges affecting both subsidiary and parent companies.

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