The business world is full of terms which many of us with years of professional experience can still find confusing or unclear. For example, two terms which often get interchanged are “affiliate” and “subsidiary”. Although these words appear in the news, magazines, and investment statements, most of us may not really be sure how to differentiate between them when it comes to a legal obligation to pay.
Hardly a day passes at James O’Brien Associates where we don’t have a client ask us if we can cover their customer’s subsidiary, sister company, or affiliate. Our answer is almost always the same, “it depends”. To what extent any insurance carrier is able to rope in another legal entity under a policy or whether that coverage needs to be placed separately depends on several factors. However, the most important is to understand to what extent one entity is related to another. In order to get our bearings on the legal relationships between entities, let me take a moment to explain them in laymen’s terms.
1) Parent Company
A business becomes a parent company when it owns another legally separate entity. The parent company establishes ownership by either creating the entity or purchasing the majority of voting shares of stock. It further influences the operation and management of the other entity, which is known as having a ”controlling interest”. A parent company can change its ownership status by purchasing more shares, or by selling some or ultimately all of its shares. The entities that a parent company has controlling interests in are called “subsidiaries”.
As stated above, a “subsidiary” is a legal entity that is majority owned by a parent company, i.e. 51% or more of the voting stock. A subsidiary is also sometimes referred to as a “child company”. Wholly-owned subsidiaries are 100% owned by the parent company. A subsidiary can also have controlling interests in its own set of subsidiaries.
3) Sister Company
Sister companies are subsidiary companies owned by the same parent company. Each of the sister companies can operate separately and may have no connection other than sharing the same parent company. Sister companies can be quite different from each other, producing different products and selling to completely different markets. For example, as Berkshire Hathaway is the parent of many subsidiary companies, these subsidiaries are then sister companies to one another.
Because both subsidiary and sister companies are separate legal entities, it is not always obvious that the companies are subsidiaries of a parent company, let alone the same parent. Furthermore, interaction between the sister companies or subsidiaries is not required and may not take place at all. In fact, in some cases, sister companies may compete against one another in the same market.
“Affiliates” and “subsidiaries” are both measurements of ownership that a parent company has in other companies. An affiliate has only a minority share of its stock controlled by the parent company. Multinational corporations often set up affiliates under other names to break into the markets of other countries. This is done to protect the parent company’s name in the event that the affiliate does not succeed, or where the name of the parent corporation may not be perceived in a favorable light.
A division is a part of a business entity. This means that a division, although it can often operate under a different name and have its own financial statements, is still a part of the business entity itself and not separately incorporated. A division is like a hand on the body, whereas a subsidiary is like an offspring. Although parents, subsidiaries, and affiliates can all have several divisions with their own profit centers, they are still under the legal entity to which they belong.
So why is understanding the difference between these terms so important? At the end of the day, every creditor needs to know the legal obligations of the entity with which it is doing business. For example, although a division may be operating under another name, its debts and all other obligations are technically still the responsibility of the parent company, in which the financial condition of the division will affect the parent company and vice versa.
On the other hand, the financial condition of a subsidiary company, especially in view of taxation and various regulations, does not always impact the parent company. Even if the subsidiary company is experiencing a financial crisis, this does not necessarily mean the parent company will be affected. At the same time however, we’ve seen situations where although the parent is not doing well, it’s wholly owned subsidiary is still quite viable and cash gets drained from the subsidiary to support the parent. Unfortunately, sometimes the result has been where the parent has dragged the subsidiary down with it and both eventually failed.
In corporations with many subsidiaries, affiliates, and divisions, trying to sort out the chain of ownership and confirming which entity has the ultimate legal obligation to pay can be a complex process. Understanding a corporate family tree can be very confusing, we encourage clients to always call us when they are unsure as to how certain buyers should be included in their policies.
Guest Article by: Gary Kirshenbaum Regional Director of Business Development, James O’Brien Associates, A Coface North America Agency All Rights Reserved
About Community Insurance Group
Community Insurance Group is one of the largest independent insurance agencies in West Central Ohio with offices located in Sidney, Minster and Fort Loramie. We take pride in offering a wide range of insurance carriers and products, and work hard to create a successful and viable resource our communities can depend on. We specialize in Agribusiness and Farms, Contractors, Energy Dealers, Manufacturers, Trucking, Underground Storage Tanks, and Volunteer Fire Departments.