By Tuomo Kauttu, Aliant Finland. Beyond the exceptional high-profile risks recently highlighted in the news, several general key risk-related concerns commonly arise in cross-border contexts. How can a parent company minimize these risks? What degree of control should a parent company have over its overseas subsidiaries, and what constitutes the right balance between risk and liability?
As regards contract issues, business activities in foreign jurisdictions generally create similar concerns to the parent company as those of cross-border transactions. Secondly, when estimating the level and importance of the degree of control, it is first necessary to clarify the definition of “control of a foreign corporation”. Thirdly, the parent company and its overseas subsidiaries are separate legal entities, incorporated under the corporate laws of each country, and the character or determination of “corporation” in various jurisdictions is not identic.
When representing a client with significant business activities in foreign jurisdictions, the primary risk-related concerns usually stem from the structure of the transaction. These include high-risk contractual provisions, conflicts between the agreement and mandatory local laws, choice-of-law issues, implementation challenges, and potential liability exposure.
Once the optimal structure has been determined—balancing the interests of all parties—negotiations can proceed more effectively. Key factors influencing the structure typically include implementation practicalities, tax implications, and liability allocation.
From the parent company’s perspective, provisions relating to governing law, dispute resolution, and liability require particular attention in an international setting.
Negotiations often focus on whether disputes will be resolved in the courts or arbitration tribunals of one of the parties’ home countries, or in a neutral third jurisdiction. Parties may also include alternative dispute resolution (ADR) clauses, which are frequently favored by the party more likely to initiate claims
In general, parties enjoy autonomy to choose the law governing their contract and to agree on a dispute resolution forum. However, this freedom is not unlimited: mandatory local rules or applicable conflict-of-laws principles may restrict or invalidate such choices. The same limitations can apply to the enforcement or recognition of any resulting judgment or arbitral award.
Regarding liability, mandatory rules in foreign jurisdictions—and the growing international trend toward expanding the bases for parent company liability—pose significant risks to a parent entity located in another jurisdiction.
To assess the appropriate degree of control, it is first necessary to clarify the definition of “control” over a foreign corporation.
Although definitions vary by jurisdiction, certain common principles apply. In many cases, a “controlled subsidiary” is defined by reference to a stock ownership test—typically met where the domestic parent company owns more than 50 percent of either the total combined voting power of the subsidiary’s voting stock or the total value of its stock.
Determining ownership may include stock held directly, indirectly, or constructively, depending on the applicable rules. The degree of control exercised by the parent can affect its protection under limited liability principles.
Consequently, “control” of the subsidiary may affect the parent company’s immunity regarding the owners’ isolation against liability. Such risk of “piercing the corporate veil” means that the corporate structure with its attendant limited liability of stockholders, may be disregarded and personal liability gets imposed on stockholders in the case of wrongful acts being carried out in the name of the corporation. Among other things, degree of control may be one of the aspects that should be considered regarding such liability. Such “control” has also an influence to taxation aspects. It may result in a tax obligation to the parent company on its foreign subsidiary’s income and earnings tax, even if not distributed.
The optimal degree of control by parent company over its overseas subsidiaries varies case by case, taking into account on the one hand business reasons, and the risks related to legal aspects, such as liability and taxation on the other. Business reasons may require a maximizing of control and power on the decision making of the foreign subsidiary. Conversely, minimizing risks regarding liability and tax issues may require that the test of “control of a foreign corporation” shall not be met as the case may involve various jurisdictions.
The parent company and its overseas subsidiary remain separate legal entities, each incorporated under the corporate laws of its respective jurisdiction. The legal concept and characteristics of a “corporation” are not identical across borders. Nevertheless, a business entity generally qualifies as a corporation if it features centralized management, continuity of life, free transferability of interests, a profit-making purpose, and—most importantly—limited liability.
Limited liability is a fundamental advantage for both entities. As a rule, each company bears its own risks and liabilities: the parent should not be liable for obligations of the subsidiary, nor should the subsidiary be liable for those of the parent.
Maintaining strict separation between the two entities therefore provides the optimal balance between risk and liability in most circumstances. In practice, however, a parent company typically holds 50–100% of the subsidiary’s equity. As a result, it always bears the economic risk of losing its invested capital and contributions. In exceptional cases, business needs may require the parent and subsidiary to share certain risks or liabilities. Common examples include the parent providing guarantees for the subsidiary’s loans or other obligations, offering security, or agreeing to indemnify the subsidiary against specific losses. Where commercial reasons genuinely justify such commitments, they can represent an appropriate and balanced allocation of risk and liability.