Part 1: Enhancing corporate governance of a foreign subsidiary – a case study


Multinational conglomerates often seek to invest simultaneously in the domestic market where it is headquartered, as well as abroad in foreign countries. It is therefore not uncommon for these entities to have foreign subsidiaries set up to promote their presence and competitiveness in the local market.


Number of overseas companies that are registered in Hong Kong since 2009.

Source: CEIC Data


Foreign subsidiaries

A foreign subsidiary is a company operating overseas which belongs to a larger corporation headquartered in another country, often known as a parent or a holding company. It is common for multinational corporations to own foreign subsidiaries worldwide which can present benefits from a business, tax and legal perspective.


Legally speaking, a foreign subsidiary is considered to be a separate legal entity which operates independently from its holding company. It is subject to the regulations and the oversight of the authorities where the entity is incorporated, and should be responsible for its own assets and liabilities.


Further, a board of director and a management independent from the holding entity consisting of local employees are often appointed to a foreign subsidiary, which presents certain benefits such as geographical convenience and access to the knowledge and expertise of the management in the local market.


Nonetheless, pitfalls reveal themselves over time with this managerial structure, a common one being that the holding entity may find itself losing oversight over their foreign subsidiaries and only minimal control, if any at all, is retained. Before the Covid pandemic this was mostly triggered by time differences between the continents and language barriers between the subsidiary’s employees and the employees of the mother company that were supposed to supervise subsidiary. However, This became more serious with the pandemic over the past years when physical visit to and in-person supervision at a foreign subsidiary were made difficult, if not impossible.


There have been cases where employees holding a senior position attempt to take advantage of the situation and seek personal gain from their position in the subsidiary. This could be done in various ways including solicitation of customers of the subsidiary, incorporation of a competitive business, and tampering with its accounts with a view to profiting and obtaining financial benefits.


Quarantine restrictions in Mainland China and Hong Kong

make traveling to local subsidiaries harder.


Case study

The issues described above may be illustrated with the case of one of our clients. The subject entity is a German conglomerate founded in the 1900s with a global presence specialising in appliances, electrical and electronics manufacturing. It owns subsidiaries and branch offices in more than 60 countries, including both Hong Kong and Mainland China, with over 4,000 employees worldwide.


The event began to unfold when our client was approached by one of its customers in China in early 2021 with allegations against the subject employee, who was the then-Chief Financial Officer (CFO) and a member of the board of directors of the Chinese subsidiary (such employee hereinafter referred to as “X” for the purpose of anonymity).


From then onwards, suspicions against X were raised within the management of the holding entity. However, due to uncertainties surrounding if and how other personnel of the local senior management may be involved, our client decided to keep the matter strictly confidential on the headquarters level until further information was obtained.


Chances came soon, when our client took the annual audit of the Chinese subsidiary as an opportunity and engaged the auditor to carry out an internal investigation against X in addition to the general audit work.


The auditor compiled a report revealing details of several entities which seemed to be connected with X and/or X’s relative, among which some of them were allegedly distributors or suppliers of our client, and others were third parties in which X was alleged to hold positions and/or shares.


Our client approached our firm immediately, following which rounds of emergency meetings were held to discuss on the possible grounds of termination of X and the legal implications under the relevant laws. Nonetheless, despite the detailed discoveries, the evidence against X appeared to be circumstantial, which was insufficient to justify an immediate termination, of which the threshold was relatively high under the applicable law.


We performed calculations on the compensation X would be entitled to under different grounds of termination. To achieve a win-win solution, which was in our view the most time and cost efficient, we advised our client to attempt a mutual termination agreement with X, to which our client agreed. Our team proceeded to prepare a draft mutual termination agreement for the client’s internal review and parallelly, our client began its internal discussion process on the settlement terms and amounts to be offered to X.


Unfortunately, due to the travel restrictions in place at the time, our team was unable to travel to China for an in-person meeting with X. We thus engaged our HQ team to travel to the subsidiary for the said settlement negotiation, and scheduled a meeting with X.


Our client was reminded to keep its intention confidential at this point to minimise the risk of potential detriment X may cause to its business. Aside from X herself, our client was also advised to refrain from alerting other persons within both the Hong Kong and the Chinese subsidiaries, especially the senior management and other members of its board of directors, of the intended termination.


The client did not follow all the advice given,

which may have been a factor of X's disagreement.


Separately, we advised our client on the factors to be taken into account when considering the terms of the settlement agreement and the settlement offer made to X. These factors included:


1. The existence of a connected employment: Aside from her position as the CFO in the subsidiary in China, X was also employed by a Hong Kong company of which our client is the holding entity. The two employment contracts go hand-in-hand and thus should be terminated simultaneously.


2. X’s recognisable years of service in the company: X has been employed by the company for over 20 years and her severance payment entitlement under both Hong Kong and Chinese laws was relatively substantial. Given that X should be well aware of her legal entitlement, the settlement amount put forward by the client should be a reasonable one, i.e. the amount of which should be the same, if not more than the statutory figures.


3. Legal consequences of an unlawful termination: As our client intended to proceed with a termination for a good cause, i.e. one with immediate effect under which a severance payment is not payable, our client was advised to note the legal consequences in case an immediate termination was found to be unjustifiable and unlawful, and the penalty payment associated therewith.


4. Resort to legal proceedings: Moreover, our client was advised to note X’ rights to bring claims against the company in a competent Labour Court in China, and the possible timeline and costs of the proceedings, which should be considered when deciding on the settlement sum offered.


As the date of the meeting with X was approaching, at least one of the local employees had to be informed due to practicality concerns. Our client therefore notified one of the members of board of directors one day prior to the scheduled meeting to make appropriate arrangements for logistics and accommodate the legal team’s arrival at the subsidiary office. Given the work-from-home arrangement in place at the time, our client, on the headquarters level, scheduled a meeting with X and requested her presence at the office. Of note is that at this point X remained ignorant of the purpose of the meeting.


Then, with the presence of two legal representatives from the headquarter team, the meeting with X took place at Chinese subsidiary’s office, which lasted for appr. 6 hours with no breaks in between.


X admitted some of the allegations made against her, including her shareholding and management position in some of the connected companies. In her defense, X claimed that these interests were disclosed to members of the former management of the Chinese subsidiary. Alternatively, she alleged that she was acting merely as a nominee shareholder without any real interest or involvement in the said companies. On this basis, X believed that she was never at fault and refused to agree on a termination with immediate effect in absence of any compensation.


Throughout the meeting, regardless of X’s seeming willingness to negotiate, there was a unreconcilable discrepancy between the client’s maximum offer and X’s expectation, no settlement was ultimately able to be reached. As a result, a termination notice was served on X, and X was terminated unilaterally by our client with immediate effect. Note that the entire termination discussion and handover procedure were recorded with X’s knowledge. Hence, despite X refusing to sign on the termination notice as an acknowledgement of receipt, the recording served as a proof of the delivery of the termination notice to X in case of future dispute.


Following the termination, in mid-August, X filed a claim at a Labour Court in China, which remains ongoing and pending as of the date hereof.


Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.


For specific advice about your situation, please contact:


Authors

Stefan Schmierer

Managing Partner

+852 2388 3899

sschmierer@rs-lawyers.com.hk

Chloe Lau

Associate

+852 2388 3899

clau@rs-lawyers.com.hk