Article by Christopher Bennett MBA and Professor Mak Yuen Teen (National University of Singapore) reproduced with kind permission of The Business Times, Singapore.

FOR some considerable time, we have been thinking about a part of the corporate governance ecosystem that has received little attention: the issues relating to subsidiaries and other entities within a group (including joint ventures, associates and special-purpose entities) and the problems faced by directors in these entities.

Most listed and large unlisted companies are company groups. Often, entities within these groups operate across a number of regions and industries, each bringing its own financial, operational and compliance risks.

For example, in its latest annual report, Singapore Telecommunications Ltd (SingTel) listed 77 wholly-owned subsidiaries, 6 partly-owned subsidiaries, 24 joint ventures and 10 associated companies within its stable of companies. Together, these group entities account for a substantial amount of the profit, cash flow, assets and liabilities of the group.

Some multinational companies have thousands of subsidiaries and other group entities. In some cases, the listed company is a pure investment holding company, and business is conducted totally within the subsidiaries and other group entities.

Public companies are often in the spotlight for fraud, corruption, misconduct and other lapses. But the truth is that many of these problems occur within entities in the group, not at the parent company level. Take the case of BP's Deepwater Horizon oil spill in the Gulf of Mexico in 2010. The rig was operated by BP Exploration and Production Inc.

As The Guardian put it (on Dec 16, 2010):
"BP Exploration and Production Inc is a subsidiary of BP America Production. BP America Production is, in turn, a subsidiary of BP Company North America, which is a subsidiary of BP Corporation North America, which is a subsidiary of BP America Inc, which is a subsidiary of the parent company BP plc."

That is, the disaster occurred many layers down from the ultimate parent company (BP plc) but caused enormous reputational and financial damage to it (to say nothing of the environmental damage). As is often the case, it appears that the directors of BP Exploration and Production Inc had relationships with other "group" companies and, in some cases, line responsibilities within the subsidiary and the group. One can only wonder about the robustness of the risk management discussions on the subsidiary board. It also raises questions about the oversight which BP plc exercised, or should have exercised, over this and other subsidiaries.

There are also issues of how to deal with conflicts between the parent and the subsidiaries, and these arise even where the subsidiary is wholly owned. Examples of some specific issues that we have seen include:

• New product launches: The parent wants to launch a new product but a majority of the subsidiary board believes this is costly and inappropriate
• Declaration of dividends: The parent wants maximum dividends declared while the subsidiary board wants to retain profits for investment in the company
• Regulatory issues: The parent wants to comply with home country regulation or practice, but the subsidiary believes that is inappropriate
• Minimum working age/time/pay: The parent wants to follow the home country or its view of global practice, but the subsidiary believes that such action puts the subsidiary at a disadvantage in the local market
• Factory closure: The parent wants to consolidate manufacturing but the subsidiary finds it hard to justify redundancies when manufacturing is moved offshore.

From a financial reporting standpoint, the impact of group entities is accounted for through accounting methods and procedures, such as consolidations; equity accounting; disclosure of subsidiaries, joint ventures, associates and special-purpose entities; and related-party disclosures. Accounting has recognised the economic substance of groups and moved away from the legal demarcations that exist among different entities.

In contrast, corporate governance standards and guidelines have evolved more along the "legal" than the "economic substance" route. Rules, regulations and codes for corporate governance largely ignore the governance issues that entities within a group and directors serving on the boards of these entities face. The focus of most governance literature and most director education is on those who sit on the boards of listed companies.

Beyond the issues of how the parent should exercise oversight of its group entities and how to resolve conflicts between the parent company and these entities, there are issues of how directors of group entities deal with role conflicts and discharge their fiduciary responsibilities.

Most people who hold "director" titles are in fact directors of subsidiaries and other group entities, and are frequently also employees in these entities. Often, they act as shareholder representatives for another company elsewhere in the organisational chain. These directors constantly have to make decisions involving conflicts between the interests of the parent and the group entity.

Complex reality

While the legal position is clear - that directors of a subsidiary or joint venture or associated company must act in the best interests of that entity - the practical reality is far more complex, especially as these directors often have line responsibilities or are directors of the parent or other group entities.

We have seen it get so difficult that local employees of the "owner" refuse to serve on the subsidiary board. It does not help that most organisations provide little training and have, frankly, little sympathy for the predicament.

We are not advocating that parent companies "micro-govern" their subsidiaries. This is not only impractical given the complexity of company groups, but may undermine the separate legal entity status of subsidiaries and the ring-fencing of risks in these subsidiaries. In some cases, this may even violate local laws and regulations. However, it is also inappropriate to let the subsidiaries completely self-determine their corporate governance.

Some large company groups are realising the importance of subsidiary governance by putting in place a subsidiary governance programme. The emerging literature and our own experience suggest the following as being key components of a robust subsidiary governance programme:

• Overall corporate governance framework/policy: This should deal with key issues such as board composition, the role of the board and its responsibilities, conflicts of interest, the process for appointment of directors and officers, director training, and director remuneration.
• Board composition: Having the right people on any board is critical. We have seen cases of unlisted subsidiaries having non-executive independent directors (IDs) who are not employees of the organisation, although this is relatively rare. At the other extreme, it is common for unlisted subsidiaries to have boards comprising entirely of management of the subsidiary, which raises questions about the effective oversight by the board.

Some company groups have introduced policies requiring some directors who are independent from the subsidiary - for example, from unrelated business within the group or from the head office. However, care is needed to minimise the risk of conflicts of interest for these "outside" directors because of the other positions they hold within the group.

• Board's role: The respective roles of the parent and subsidiary boards need to be clearly delineated - for example, through the drafting of board mandates dealing with issues like what is the subsidiary board's role and the parent board's role in relation to the remuneration of executives within the subsidiary.
• Specific policies and procedures: These can include those relating to qualifications of key officers (for example, compliance and risk officers); delegation of authority; communication between entities within the group; the creation and dissolution of subsidiaries; the development of materials and guidance for subsidiary directors in the form of guidelines and directors' handbooks; audit requirements, code of conduct and whistleblowing policy.

Of course, if the subsidiary is listed, its corporate governance will have to take into account rules and codes applicable in the jurisdiction of listing.

In the case of joint ventures and associated companies, the "owner" has to calibrate its approach to ensuring proper governance so that it does not breach the joint-venture agreement, violate the spirit of good governance, or, in the worst case, break the law by overasserting its rights.

For example, we have come across situations of directors representing the "owner" of an associated company going directly to the management of the associated company to obtain detailed operational data which was not made available to the other shareholders of the associated company.

However, despite these difficulties, the "owner" must take steps to ensure proper governance because it faces financial and reputational risks.

There is clearly a need for greater focus from parent company boards and regulators on issues relating to the governance of subsidiaries and other group entities and for better education of those who are directors in such entities. In some ways, these issues are more vexing than those relating to boards and directors of listed companies.

Christopher Bennett is the founder of BPA Australasia and has held senior positions in two international consulting firms and in a multinational company.

Mak Yuen Teen is an associate professor at NUS Business School, where he teaches corporate governance and ethics