Limiting Liabilities

Structuring holding companies to withstand insolvency

The concept of limited liability is one well known in the international corporate lexicon. Companies are organised to minimise their liability for the actions of related but legally separate entities, be they partners, suppliers or customers.

These divisions are generally fairly clear, but they become less so when applied to groups of companies, with subsidiaries and holding companies legally bound to each other via ownership. In these situations, under certain circumstances, a holding company and its directors may be held liable for the actions or performance of a subsidiary despite the fact the subsidiary is a separate business.

Insolvency is one such circumstance when liabilities within a group of companies are examined forensically. The insolvency or bankruptcy of a subsidiary will usually leave a range of creditors out of pocket and practitioners employed by those creditors will make every effort to recover losses, including exploring the potential liability of a holding company and its directors.

As a consequence, it is imperative that corporate structures are maintained using best practice techniques, prior to any future insolvency, to make it as difficult as possible for creditors to ‘pierce the corporate veil’ and make charges against assets held outside the insolvent business.

A good example of best practice technique, is the development of separate corporate governance, ensuring that different directors sit on the board of a subsidiary than sit on the board of a holding company. If it appears that the subsidiary is fully under the control of the parent company it is harder to resist liability for its actions.

Another would be the rigorous maintenance of board minutes, financial accounts, and appropriate documentation of intercompany transactions. This helps to rebuff accusations of preferential transactions.

Failure to adhere to these best practices can be easily tested under the insolvency laws of various jurisdictions around the world. The Instrumentality Test and the Identity Theory, for example, are used by courts in the US when deciding whether to pierce the corporate veil in pursuit of damages.

In the event of subsidiary insolvency, the behaviour of holding companies and their directors can have a significant bearing on liability. In some jurisdictions, related party transactions (between a subsidiary and a holding company) made up to five years prior to the insolvency could be examined. If any are found to have been made at an undervalue, the holding company can, in some cases, be forced to repay the entire consideration received by the transferee for distribution to creditors.

As another example, if a subsidiary fails to meet its obligations to the tax authorities for sales tax or employee contributions, the directors of the holding company can be held personally liable if it can be determined that they influenced those decisions. In extreme cases, money used for mortgage payments or children’s tuition fees has been reclaimed.

It is clear that correct corporate structuring and governance are required at the formation of a company group to avoid any future liability issues in the event of insolvency. The behaviour of directors and responsible employees during and immediately prior to insolvency is also critical to the outcome of any liability claims outside the immediate legal entity.

The following feature draws upon the expertise of five insolvency practitioners from around the world who are members of IR Global. Each of them gives a unique perspective from his or her jurisdiction on the issues to consider when attempting to limit holding companies’ liability during the insolvency of a subsidiary in a company group and further considers the possible damages and defences available should the worst happen.