The Raxon Limited, one of the subsidiary companies owned by Canopy Pavilion Limited, operates and owns a warehouse that stores cigars that are awaiting distribution. The Canopy Pavilion Limited is a fully-fledged and well-capitalized company mainly involved with importation and distribution of fine wine and cigars. Apart from owning all of its shares, the Canopy Pavilion Limited also nominates a majority of Raxon's directors and receives all of the profits.
The warehouse Raxon Limited operates requires humidifiers to keep fine cigars at optimum humidification. Aaron, who operates a business which supplies and installs those industrial humidifiers, signed a contract to supply and install new humidifiers to Raxon limited. After completing the work that took six months, Aaron sent his account to Raxon Limited for payment. However, Canopy Pavilion Limited put Raxon Limited into liquidation before Aaron was paid his outstanding payment. The major reason cited by the company for its closure was the recent anti-smoking legislation enacted that caused a downturn in Canopy Pavilion Limiteds cigar business. For fear that the Canopy Pavilion limited, the Liquidator, will not pay him in full, Aaron now wants to make the company liable for the indebtedness of its former subsidiary. This paper offers an assessment to determine when a parent company should be held liable for the liabilities accrued from a wholly-owned subsidiary in the event it is closed or put on liquidation.
Wholly Owned Subsidiary
The liquidation of Raxon Limited before settling the payment of suppliers contravened the company law that regulates the management of wholly owned Subsidiary companies. As defined under Company Law act section 588V, a wholly owned subsidiary company common stock is hundred percent owned by another company, known as the parent company (Judge & Moore 2014, p.24). A firm can be a wholly owned subsidiary either by having been decentralized from the parent company or through acquisition by the parent company. Typically, a parent company owns between 51 to 99 percent of a regular subsidiary (Taylor 2015, p.31). In the event, it is not possible to obtain majority, complete control or when risks are desirable, the parent company may introduce an associate or an affiliate company in which it would own a minority stake.
But as stipulated in the Company Act regulation, parent company owns all the shares of a wholly owned subsidiary as there are no minority shareholders (Taylor 2015, p.30). For this case, Raxon Limited operated with the permission of the Canopy Pavilion Limited, the parent company, which had a direct input into the operations and management of Raxon Limited. As presented, Canopy Pavilion Limited had a direct control of the subsidiary for it nominated most of Raxons directors and receives all the profits. Therefore, Raxons senior management structure was directly controlled by the parent company before its liquidation.
Subsidiary companies adopt numerous decision-making levels that are tasked with the formulation of strategic objectives, implementation, and monitoring of strategies, dissemination of corporate culture, management of corporate risks, corporate reporting and mitigation of potential conflicts of interests (Taylor 2015, p.31). This implies that subsidiaries may have various shareholders at different times. The subsidiaries are established to discharge specific and unique business lines intended to serve the overall objective of a parent company. Thus, the parent company in a bid to foster an efficient decision-making process adopts corporate governance to align interests and establish an adequate setting for the sustainable development.
The parent company primarily influences the operations and management of a subsidiary company. It directly controls wholly owned subsidiaries through the implementation of different measures such as the creation of a clear communication of a groups general strategy, establishing corporate policies and procedures for major operations and conducting shareholder vote or consent rights for specific matters (Taylor 2015, p.33). They control subsidiary companys affairs by having regular monitoring meetings among representatives from the parent company and from its subsidiary to follow-up on the implementation of directives. They implement risk management practices and set a corporate-wide independent internal audit function with a direct reporting line to the parent company.
The board must approve the incorporation of wholly-owned subsidiaries. The opinion of the board-level committee is often solicited to ensure the process of incorporation or acquisition is materialized. In the event the acquisition is immaterial, the due process to undertake a respective approval may be handled at the managerial level. As a benchmark to establishing a general recommendation for an approval system, the functions and involvement of subsidiaries is set per the materiality of the transaction, in most cases creating approval procedures that are in line with investment thresholds.
The level of control of wholly-owned subsidiary by a parent company largely depends on the degree of flexibility and operational autonomy it is given. This arrangement adds value, align interests and ensure an effective control of a subsidiary company (Taylor 2015, p.33). There are several governance mechanisms available that allow a parent company keep an adequate level of control over its wholly-owned subsidiaries. Therefore, in this case, the creditors of Rexon Limited have a right to demand full payment of any pending funds from Canopy Pavilion Limited. This because as the parent company, Canopy Pavilion limited exercised direct control over Rexon.
Despite the adoption of anti-smoking legislation that caused an overall downturn in Canopy Pavilion Limiteds cigar business, appropriate reporting framework should have been adopted to ensure all suppliers including Aarons case is addressed. As provided for in Company Act Division 5 regulations adequate reporting framework is layout as an essential prerequisite requirement for the establishment of a subsidiary company (Sheikh 2014, p. 65). The regulations further stipulate that a parent company must put in place permanent communication structures in an organized manner. This is in addition to a full and direct access of subsidiary information when the parent company regularly participates in shareholders meeting and the appointment of subsidiarys board members. With clear-cut internal reporting procedures that enhance timely and accurate disclosure of information, it is clear that the Canopy Pavilion limited had prior knowledge about Aarons unsettled payment before the liquidation of Rexon limited.
They had direct access to the management and operation of the subsidiary because the parent company appointed its directors. This signifies an open control of the parent company at the subsidiarys board, an apparent demonstration there was a higher degree of communication between the two companies before it was liquefied. Besides having a direct appointment, the parent company is allowed to appoint senior management members from the parent company as the board members at the subsidiary company. For instance, in most cases, they are allowed to bring on board members to occupy executive positions such as the Chief Financial Officer or Chief Executive Officer. This regulation proves that the parent company has the mandate to settle in full the funds the subsidiary owed to creditors and suppliers before it was put on liquidation.
Liability of the Indebtedness of a Subsidiary Company
Whereas the claim by Aaron that Canopy Pavilion limited should repay him in full is legally binding, his second claim of the parent company causing indebtedness of its former subsidiary is unlikely to hold any basis. The company operations were influenced by anti-smoking legislation, which subsequently affected the distribution and importation of cigars. Rexol limited was established purposely as a warehouse to store cigars and upon enactment of anti-smoking legislation; the companys only option was to close the subsidiary to cut cost and restructure its business operations.
Although the courts may occasionally hold liable a parent company for the debts of its subsidiary company on behalf of creditors, this case is complicated because the cause of insolvency is external. For this case, Canopy Pavilion limited closed the subsidiary as a precautionary measure and in the best interests of the company's creditors. When the debts of the company exceed its assets, the parent company have a statutory duty to close its operations to avoid further incurring of the cost that would not be sustainable in the long run (Taylor 2015, p. 36). In doing this way, the company must demonstrate that they did everything possible under their power to ensure all the creditors and the suppliers are repaid using the available resources at the company of the company.
It is forbidden for Canopy Pavilion limited directors to take any action that in the long run would jeopardize its stability and increase its debts. Once a severe downturn in companys business operations is detected, the company must do all it can to settle the pending payments among the creditors and close its business operations without undue delay (Taylor 2015, p.33). In this period, the settlement of debts should not be based on any favoritism toward any particular creditors or suppliers. If there is valid evidence that some directors meddle in the smooth payment of debts, they should face personal liabilities and disqualification from acting in such capacity in future. Besides, those directors who deliberately cause the debts of the company to go unpaid, they may be held liable to repay the outstanding amount. Other penalties include heavy fines and a custodial sentence for serious violations.
The parent company would be held accountable if in any case, they acted inappropriately in handling the finances of the subsidiary before its closure. Aaron would win this case if proven otherwise that directors were liable for the failure to settle down pending debts. For instance, if there are available records, which show that the existing funds in the company were utilized for non-business activities or that the companys assets were sold at less than their market value, then this case will be binding.
Only acceptable means of payment should be used to repay the creditors. However, as envisaged in the Company act, attempts to obtain funds in any fraudulent manner to settle debts would amount to a cross illegality that the parent company will ultimately be held accountable (Lipton, Herzberg & Welsh 2016, p. 37). If Aaron provides sufficient evidence that the parent company used its undue influence to offer misleading or inaccurate information to breach the terms of his contract, then the Canopy Pavilion limited would be held liable to service the debt in full.
The liquidation procedures must have been fully followed, and formal communication of the impending insolvency should have been adhered to. The company must demonstrate that there were no wrong trading or inappropriate actions taken that resulted in the indebtedness of the subsidiary. A thorough investigation of the factors surrounding the closure of the subsidiary must be carried out to ascertain this claim (Lipton et al. 2016, p. 37). Particularly the conduct of directors and companys affairs should be scrutinized well before the court gives its final verdict. Any evidence of potential breach should be reported to the Department of Business, to carry out further investigation.
If the indebtedness of Rexon Limited were a result of related party transactions marked by potential abuse of resources,...
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