Legal Management of Subsidiaries: Group Company Rules and Internal Controls

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When a business consists of just one company, management and administrative staff can often keep track of where contracts are stored, how decisions were made, and whether registration procedures were missed. As the company gains one or two subsidiaries, that becomes much harder. The parent company's administrative team and the subsidiary's staff may have different understandings of which entity signed a contract, who gave final approval, and whether documents support a transfer of funds.

Those gaps can widen as the number of subsidiaries reaches two or three. An officer of the parent may have served concurrently at the first subsidiary and overseen it directly, but that becomes harder as the group grows. If staff proceed with contracts without rules specifying which decisions remain with the subsidiary and which require parent approval, group-wide oversight becomes difficult. An early framework for management can help the group legal function work as intended.

Allocating authority through group company management rules

One early task for a growing group is to prepare group company management rules. These rules establish which subsidiary decisions require the parent's prior approval and which matters must be reported, providing a basis for group management.

Prior approval often covers borrowing and guarantees above a threshold, acquisitions or disposals of important assets, changes in capital, appointment or removal of subsidiary officers, and significant intra-group transactions. Reports may cover monthly performance, contracts below the approval threshold, personnel changes, and litigation or complaints. If the approval scope is too broad, subsidiary decisions may stall while awaiting the parent. If it is too narrow, significant transactions may proceed without the parent's knowledge. The practical starting point is to set specific monetary thresholds and transaction categories in light of the subsidiary's business and the parent's resources.

The rules should also specify who requests approval, through which route, and how the subsidiary holds a transaction pending when a decision is delayed. A parent's rules alone do not automatically give it authority to halt a subsidiary's transaction, so the rules must be consistent with each company's corporate decisions and internal policies. If staff routinely proceed first and notify the parent afterward, the rules will lose their practical effect.

Conflicts of interest for officers serving both companies

As the number of subsidiaries grows, officers of the parent often also serve as directors or representative directors of a subsidiary. When the parent and subsidiary enter into service arrangements or lend funds to each other, the question is whether the transaction constitutes a conflict-of-interest transaction for the shared director under Article 356 of the Companies Act. The article requires disclosure of material facts and approval, including when a director transacts with the company for the director or a third party. In a company with a board of directors, the board is the approving body and a report after the transaction is also required under Article 365. For each company, check the transaction structure, the director's position, and the company's governance structure, and establish a process that captures the approvals required in that company.

Documenting intra-group transactions and addressing risks

Groups often rely on custom rather than written contracts for everyday transactions such as management fees, employee secondments, and loans. Some companies use only oral arrangements or internal notes because the parties belong to the same group.

The absence of a contract can make a tax inquiry harder to answer. If a company cannot explain how management or service fees were calculated and what work was actually performed, payments may be treated as donations or disallowed as deductible expenses. A contract describing the services and the calculation of the fee, supported by consistent records of actual work, helps the company explain the arrangement in a tax audit.

The existence of contracts also matters during due diligence for an M&A transaction or fundraising. Buyers and investors scrutinize intra-group transactions. Without documentation, they may lack evidence to assess whether consideration is appropriate and may raise concerns about unrecorded or contingent liabilities. A written contract allows the company to explain the agreed terms; an oral arrangement may require the parties to reconstruct its history, increasing the burden of responding.

Where a subsidiary has minority shareholders, the parties must also consider whether transaction terms harm their interests. A structure in which the parent extracts funds without a clear basis can be difficult to justify when the transaction is challenged. For secondments, the sending and receiving companies should document supervision, salary cost allocation, and social insurance arrangements; otherwise, the employee's working conditions and responsibility for labor management at the receiving company may be unclear.

Group internal controls under the Companies Act

Article 362(4)(vi) of the Companies Act lists the establishment of systems to ensure proper operations of the company and its corporate group, including subsidiaries, among matters that a board of directors cannot delegate to directors. Article 362(5) requires a board decision on those systems for a large company with a board of directors. A company with a board that is not a large company must also address the matter at board level if it decides to establish those systems. The applicable provisions depend on the company's size and governance structure.

Article 100(1)(v) of the Regulation for Enforcement of the Companies Act identifies components of the system for the corporate group: reporting to the parent on the performance of subsidiary directors and others, rules and other systems for managing subsidiary loss risks, systems to ensure efficient performance of duties, and systems to ensure that subsidiary officers and employees comply with laws and the articles of incorporation.

When deciding on internal control systems, the company must address reporting from subsidiaries, risk management, operational efficiency, and compliance as well as its own operations. When subsidiaries are added, the parent should examine whether its existing policy reflects the group's circumstances and revise reporting routes as needed.

Legal issues in post-acquisition integration

Legal alignment can be overlooked during post-merger integration (PMI) when an acquired company joins a group. The target previously operated independently, so its internal rules, contract forms, and approval procedures will ordinarily differ from the parent's.

Begin by reviewing the target's internal rules. If its work rules, accounting rules, or approval procedures differ substantially from group standards, decide whether to align them or retain them for the time being; otherwise, different approval standards may persist without a conscious decision. Next, examine existing contracts for change-of-control clauses and whether a change of parent triggers termination. Even when this was reviewed before acquisition, rebuilding the contract register after closing may reveal missed provisions.

Permits and licenses also require attention. Changes to the representative or officers after an acquisition can trigger succession or change notifications under the applicable laws. A share purchase alone may require no procedure for a particular license, while other cases may require a notice of officer changes or a procedure for a change in business activities. Identify the target's permits early and incorporate the required steps into the integration plan.

Phased development and professional support

When a group has two or three subsidiaries, it need not initially aim for the extensive management systems of a listed company. Rules that are too detailed for the group's size may delay approvals and become ineffective because staff cannot apply them in practice.

First, check whether group company management rules exist and, if not, identify the matters for prior approval and reporting. Also inventory continuing transactions between the parent and subsidiaries and among subsidiaries, including management fees, secondments, loans, and services. Document those with greater value or continuity first. If an internal control policy exists, check whether it addresses the whole group and, for a company with a board of directors, have the board review it as needed. These tasks do not all have to be completed at once. Updating rules, contracts, and approval thresholds as subsidiaries are added can reduce the need for a hurried overhaul when the group grows further.

Designing group company rules, documenting intra-group transactions, and reviewing the basic policy require continuing checks for consistency as subsidiaries are added. LegalAgent's corporate governance support covers the design of group company rules, documentation of intra-group transactions, and review of internal control policies. When the legal team is stretched, legal outsourcing is another option for ongoing support from contract review to policy development.

If a group waits for issues to be identified by outsiders during fundraising or an acquisition, the volume of transactions and documents to review can make the response burdensome. Related preparation for legal due diligence is discussed in Why Companies Ready for M&A and Due Diligence Manage Legal Work Differently and Legal Due Diligence Around Series A: What Investors Look For.