Friday, March 20, 2009

Parent-subsidiary rules - Corporation Code

POSSIBLE BAR QUESTION (This question is prompted by developments relating to AIG and its subsidiaries in the Philippines, such as PhilAm Life, an insurance company).

Facts: A parent corporation P is in financial difficulty.  It has a subsidiary S that is in good financial condition.  

(a) Is it legal for the subsidiary to lend to the parent? It seems this would be legal if the transaction is allowed by the corporate purposes of S (after all P and S have separate corporate personalities).  It is probably not among the corporate purposes of S to “bail out” its parent P, but investment of funds of S in a “secondary purpose” is allowed, if provided for in the corporate charter of S.  Of course the transaction is likely barred by the rules that require the subsidiary to maintain adequate capital under banking or insurance laws.  Thus, regulation of the insurance and banking industries is an argument to support the idea that the Philippine subsidiaries of AIG are safe.  But this argument may be weakened if the regulatory framework has loopholes that would allow AIG access to the liquidity of its subsidiaries.

If S lends to P, and P goes bankrupt, S can suffer since it is a creditor of P. 

If P lends to S, and this causes P to become insolvent, the lending could be attacked as a transaction in fraud of creditors of P.  In short, the ability of P to “support” S is obviously weakened when P is in financial difficulty, and creditors of S would be more careful dealing with S.  In this case, potential customers of S may go to a competitor knowing that the parent P is in trouble. There is a view on the working of the insurance industry in the US that customers of an AIG subsidiary there would have some incentives to switch to another insurance company, particularly if the customer chooses an insurer on the basis of the financial strength of its parent company. (Maybe this is because it is either possible or practiced that the parent is a reinsurer for the subsidiary.) 

Thus, it seems generally that the financial condition of S is to some (unclear) extent potentially or actually affected by the financial problems of P.

(b) If the parent is insolvent, what is the effect on the subsidiary? None, because insolvency of a stockholder (P) does not affect the corporation (S), unless P owes money to S.  But if S owes P, and P goes under, the creditors of P may demand that P “call” its loans to S, which could trigger a liquidity problem for S (thereby affecting the creditors or customers of S).  More likely, perhaps, as discussed in (a) above, the business of S may be affected by “reputational” considerations, since the parent is usually there to give the public some assurance that the subsidiary is in good shape.  After all, the normal event is for the parent to be financially stronger than the subsidiary. 

(c) If the parent is an insurance company, and the subsidiary is a bank, will the answer to (b) be the same? It seems yes, subject to the safety net given by special laws as discussed in (a) above.

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