Managing subsidiary boards

Many companies have subsidiaries, either wholly or partially owned, whose financial data are consolidated into the par- ent’s financial statements. The subsidiaries also may make separate filings, perhaps because they have a stock-market listing that is distinct from their parent. When subsidiaries do prepare separate financial reports, it helps all of the group’s execu- tives, directors and board committees, as well as investors and analysts, in their efforts to better understand the perform- ance of each business unit.

Consider Altria, owner of the Philip Morris tobacco brand, majority owner of publicly quoted food producer Kraft and large minority stakeholder in brewing giant SABMiller. While Kraft and SABMiller have their own boards, Altria consolidates these companies’ financial data into its quarterly and annual reports (fully for Kraft and in proportion to its stake in SABMiller). So, beyond its oversight function at the parent, the Altria board also needs to closely monitor events at these other companies, which have a heavy influence on Altria’s overall performance.

A parent company will want representation on the board of a subsidiary for a variety of reasons. For example, parent-employed executives who sit on a subsidiary’s board can work to ensure that the latter’s business strategies and financial report-ing practices are in harmony with those of the parent.

In a January 2003 letter to the SEC, Greg Swalwell, vice president and controller of holding company Contran, observed that ‘there are valid business reasons for the overlap among the various boards of directors, since the knowledge and expe-rience gained by an individual sitting on the subsidiary’s board, and any relevant expertise such individuals may have, would be useful in their capacity as a member of both boards of directors.’

Louis Camilleri, chairman and CEO at Altria, is also chair-man of the board at Kraft, and shareholders seem satisfied that this is no impediment to good corporate governance. But a subsidiary board heavily weighted with parent-company employees may risk losing focus on the primary interests of the subsidiary and its other shareholders. Also, when parent-company executives sit on the board of a subsidiary, there is a perceived issue concerning their inde-pendence. With new Sarbanes-Oxley independence rules, this has become a serious consideration.

‘With the advent of regulator-imposed governance standards, subsidiaries engaged in certain regulated businesses must have independent audit committees,’ observes Stephen Norman, corporate secretary and general counsel at American Express. ‘This means subsidiary boards, for the first time, consist of persons who may feel a greater duty of loyalty to the subsidiary.’

Under Delaware corporate law, prin-ciples governing board membership are clearly defined. ‘Whether you are on the board because you have been invited by the executives or board of the company itself, or because a major investor – including a parent company – has nomi-nated you to represent it on the board, your primary obligation is still to the company and its shareholders,’ advises Karl Groskaufmanis, corporate partner at the law firm Fried Frank Harris Shriver & Jacobson.

Audit committee independence

Sox recognizes the pressure on company executives to satisfy market expectations, coupled with the self-interest produced by the presence of incentives based on stock price appreciation, and notes that an independent audit committee is one guarantee against such potential conflicts of interest. The requirements of the final rule pertaining to audit committees include the independence of committee members, the commit-tee’s responsibility to select and oversee the issuer’s independent accountant, the authority of the committee to engage advisors, and funding for the independent auditor and any outside advi-sors engaged by the committee.

The SEC web site notes: ‘Under the final rule, an audit com-mittee member may sit on the board of directors of a listed issuer and any affiliate so long as, except for being a director on each such board of directors, the member otherwise meets the independence requirements for each such entity.’

Under Sox, audit committee members, as nonaffiliate persons, are barred from accepting any direct or indirect consulting, advi-sory or other compensatory fee from the company or its affiliates, other than in their capacity on the board of directors and any board committee. Therefore, independent directors at the parent may be invited onto the board of one or more subsidiaries, pro-vided they meet independence criteria with respect to those sub-sidiaries. ‘If the same independent directors sit on the audit committees both at the parent and at its subsidiaries, then the exchange of information is a whole lot easier,’ notes Norman.

But NYSE rules allow directors to sit on a maximum of three public company audit committees; moreover, many independent directors also have full-time jobs elsewhere. Thus, companies with multiple quoted subsidiaries may be dealing with various audit committees at these subsidiaries. Also, subsidiaries that are controlled by virtue of a large shareholding, but are not majori-ty-owned, can fall outside this requirement.

Altria’s Nancy De Lisi, senior vice president of mergers and acquisitions, is considered independent enough to sit on the audit committee of SABMiller, in which Altria has a 34 percent stake. In cases where a company has a large minority stake in another, the SEC may have accepted the view of Lucia Rodríguez Jorge, director of securities markets at Telefonica, expressed in a March 2003 letter: ‘While we share the Commission’s view that the audit committee should be an independent check on a listed company’s financial reporting system and management, we believe that full participation of controlling shareholders in the audit committees is consistent with this aim.’

Still, the independence bar may prove troublesome, opines David Smith, president of the Society of Corporate Secretaries and Governance Professionals. ‘Given the level of experience now required to sit on an audit committee, it’s gotten a whole lot more difficult to find qualified members,’ he says.

Extra work

An important part of the audit committee’s function is choos-ing and engaging with the external audit firm. ‘It is a positive governance step to have one audit firm that is responsible for the consolidated group,’ says Norman. The parent’s auditor will have to sign off on the group’s consolidated results, and infor-mation is easier to share if the same firm is involved across the group, something that should also provide accounting consis-tency for the parent and its subsidiaries. This is not always pos-sible, however.

‘Multiple audit firms may be appropriate in a transition, such as the period following an acquisition when the acquired company uses a different auditor from the acquiring company until such a time as the latter can absorb the knowledge and processes of the subsidiary,’ notes Norman, ‘but ultimately the companies should have a single auditor to ensure the application of similar standards across the firm.’

‘In the case of wholly owned subsidiaries, it makes sense for a subsidiary to have the same auditor as the parent,’ agrees Kevin Klock, corporate governance analyst at the National Association of Corporate Directors, noting that the specific rela-tionship between the subsidiary and the parent is important. A company that owns 30 percent of another effectively controls it, but board members at such ‘controlled subsidiaries’ have a duty to all shareholders, not just the parent, he says. ‘In this case, the subsidiary’s board will need to consider carefully when choosing an auditor. Opting for the same auditor as the parent may raise eyebrows.’

‘If a parent wishes to appoint a new audit firm, it should get input not only from the parent-company audit committee that makes the final decision, but from other interested persons within the company, including its subsidiaries,’ posits Norman.

A subsidiary’s business areas and geographic location may be remote from the parent company, and the subsidiary audit committee should be sure its priorities are factored into the par-ent’s decision on the choice of a new auditor. ‘While the par-ent-company audit committee appoints the new auditor, the subsidiary’s audit committee will need to ask itself if the per-sonnel assigned to the subsidiary by the audit firm have the experience and skills necessary to take care of the subsidiary’s business,’ Norman advises.

Extended oversight

Subsidiary board input also may be necessary with respect to key employees assigned to the subsidiary by the parent compa-ny. Although directors on subsidiary boards might not be directly involved in the identification or selection of officers at the parent who have a group-wide mandate, they still need to exercise a duty of care when expressing opinions on the suit-ability of the subordinates who serve the subsidiary. ‘Independent directors of subsidiaries cannot dictate the par-ent’s choice of executive officers, but they can make their obser- vations known with respect to the per-sons whom the parent company assigns to serve the subsidiary,’ says Norman. ‘You aren’t allowed to choose the cap-tain, but you can have a say in who is on the team assigned to your unit.’

Many observers also suggest that for reasons of good governance, members of the subsidiary’s committees should be invited to provide input at parent board meetings when appropriate. ‘Subsidiary boards can be an important aid to the oversight function of the parent’s board,’ suggests Smith.

But is this the limit of their role? Are subsidiary board members effectively the poor cousins of the parent board? ‘It is clear that subsidiary directors cannot be active on all issues that concern the par-ent, but they add value to the parent by focusing on the safety and soundness of the subsidiary and percolating up any concerns that may arise at the subsidiary level,’ concludes Norman. ‘Companies need to ensure that subsidiary directors are able to do their job effectively, but that they are also able to provide mean-ingful input to the parent.’

Klock agrees. ‘When we look at the appointment of, say, the audit firm or a new group CFO, the decision will ulti-mately lie with the parent,’ he says. ‘But it should also be clarified what sort of input is expected from both the subsidiary’s executives and its board members.’