Comment: “Subsidiary boards must get ready before the regulator calls”

Scrutiny on subsidiary governance is growing, with a range of key regulators and new legislation, such as the EU’s Corporate Sustainability Reporting Directive, embedding new expectations about how main boards approach subsidiary governance.

This has long been an area of governance challenge, but this is now being exacerbated by rising geopolitical risk, a growing divergence in expectations of international businesses across different governments and a slow but perceptible process of regulatory fragmentation for businesses operating in different jurisdictions.

Geopolitics therefore poses an increasing challenge for boards generally, but also raises acute questions over subsidiary governance, especially where subsidiary entities operate across geopolitical fault-lines or in more volatile markets.

From tax efficiency to geopolitical resilience

For group entities operating in these circumstances, the traditional approach had been to optimise subsidiary entity structures for a range of factors, often tax or any local licensing requirements. There are now early signs this approach is changing, with some organisations concluding structures need to change to adapt to geopolitical realities.

The exit, often rushed, of many international firms from the Russian market after February 2022 is perhaps the starkest recent illustration of where geopolitical realities had profound consequences for subsidiary entities, but growing geopolitical volatility elsewhere can also place stress on the main board-subsidiary board relationship.

Local insight isn’t enough

Issues here start with a robust understanding of the geopolitical risk environment. Many boards tend to avail themselves of geopolitical briefings on an occasional basis and when developments take place in any given country or region, an organisation’s response is often to consult local teams because ‘they’re on the ground and will know what’s going on’.

This is fine up to a point, but to consider the potential shortcomings in this approach, how many subsidiary boards operating in GCC markets had flagged the risks flowing from potential military action, or were aware of how imminent this action was likely to be, before Israel launched an air campaign against Iran’s nuclear programme in June this year?

Or, for that matter, how many boards of Russian subsidiaries were in a position to do similar prior to February 2022?

Important though authoritative insight is, the governance challenge goes further. The local actions of a subsidiary entity can have wider impacts for an international firm and vice versa. There are prominent examples of global banks operating entities in both the US and Chinese markets, where recent geopolitical developments, for instance in relation to Hong Kong, have required local actions that have been badly received by other governments and external stakeholders

One of the world’s largest banks summarised this well in annual reports in recent years, saying that  “the compliance by multinational corporations with their legal or regulatory obligations in one jurisdiction may be seen as supporting the law or policy objectives of that jurisdiction over another, creating additional reputational and political risks for the Group” in the context of rising geopolitical tension.

Questions have also been raised by US lawmakers and policymakers about US and European business exposures to the Chinese market as new investment restrictions and other trade measures are applied, and how these might be affected in the event of military confrontation around Taiwan or in the South China Sea.

Governance gaps in multinational groups are not new, and can manifest in decision-making, risk oversight and reporting. But growing geopolitical volatility brings these gaps into even sharper focus and raises the potential downside costs to an organisation.

Practical steps for boards and company secretaries

What could boards and their company secretaries consider doing to aim off for this challenge? Practical steps include:

• Clarifying board responsibilities and the governance approach to the oversight of decision-making where geopolitical issues may be a factor.
• This will need to be driven by the main board, but a subsidiary board is also in a good position to ask what the main board is doing on this agenda – just as a subsidiary’s management team can ask about the Group ExCo’s proposed approach to geopolitical risks
• Ensuring board deliberations in this area, whether at subsidiary or group levels, draw on robust and authoritative geopolitical insights
• These can of course be augmented by local insights, but with geopolitics increasingly transnational, a wider perspective is needed – and main boards may need to challenge the approach taken by subsidiary boards/entities here accordingly
• Asking whether main or subsidiary boards have access to the right expertise to identify how geopolitical developments may affect their organisations so that, for example, a board would know in advance whether a subsidiary’s decisions may have downside geopolitical risk implications
• Identifying areas where international regulatory or legal requirements may not align with local approaches and addressing these proactively

Find out more

Derek Leatherdale, Senior Geopolitical Risk Adviser at Sibylline, will be exploring these issues and practical steps in more detail at the Institute's Subsidiaries Governance Conference on 16 September.