Why Due Diligence Matters for U.S. Subsidiaries of International Companies: Avoiding Costly Government Filing and Governance Failures

In representing many U.S. subsidiaries and parent companies during financings, public offerings, exchange listings, acquisitions, sales, mergers and other business transactions, we have found that legal due diligence in advance of the transaction can help identify issues and allow the parties to move quickly to a successful closing.

Regular due diligence helps identify missed filings, compliance gaps, expired licenses and permits before they become significant liabilities.  Due diligence and Foreign Direct Investment (FDI) screening provide senior management, boards of directors and managing directors with confidence that the U.S. subsidiary or acquisition target is operating on a solid legal and regulatory foundation. Investing in periodic compliance reviews can prevent costly surprises, demonstrate that board members and senior management are exercising their oversight responsibilities, and help to support the company group’s long-term business objectives.

International companies often establish U.S. subsidiaries and acquire business lines and companies in order to expand into the North American market. While many parent companies have sophisticated governance and compliance programs in their home jurisdictions and comply with foreign direct investment (FDI) rules in their home jurisdictions, U.S. subsidiaries frequently face unique federal, state, and local filing requirements and United States FDI requirements that can be overlooked.  These often arise during periods of rapid growth, relocation of facilities, acquisitions, combinations, direct investments, financings, management changes, or internal restructurings.

A proactive due diligence review can help to identify and uncover compliance and governance gaps relating to a subsidiary or acquisition target before they result in costly enforcement actions, expose the subsidiary and parent to potential civil and criminal penalties, unwinding of completed transactions or portions of transactions, or pose obstacles to strategic and financial growth and transactions.

Hidden Risks and Potential Blind Spots

Many international companies assume that once a U.S. entity has been formed and begins operations, ongoing compliance is largely administrative. However, U.S. subsidiaries and acquisition targets are often subject to a complex maze of changing reporting obligations administered by multiple federal and state governmental agencies, departments, and commissions.

Common filing requirements may include:

• Annual reports and franchise tax filings with state authorities.
• Beneficial ownership or other ownership-related reporting requirements.
• Federal and state tax registrations, filings and information returns.
• Immigration and employment/work status reports
• Employment and payroll/tax/employee statutory insurance registrations.
• Local business licensing and permitting requirements.
• Industry-specific licenses, renewals and regulatory filings.
• Foreign investment and national security reporting obligations.
• Environmental, labor, and import/export compliance filings, depending on the business.
• Qualification of a subsidiary or the target company for doing business and for state and municipal tax purposes in a state where it has a new or existing facility or remote workers.

Each obligation has its own deadlines, filing requirements, renewal requirements, and enforcement mechanisms.

Some Common Causes For Filing Failures

In our experience, filing failures rarely result from intentional misconduct. Instead, they often arise from organizational complexity and from inexperience of new or seconded management or inattention by management of the acquisition target.

Common causes include:

• Turnover among finance, legal, or corporate secretarial personnel.
• Limited coordination of governance and filing matters between the parent company and the U.S. subsidiary.
• Decentralized financial and business recordkeeping across multiple jurisdictions.
• Reliance upon parent company finance, governance, audit and control systems
• Assumptions that outside service providers are handling all compliance obligations.
• Entry into new lines of business by the subsidiary.
• Acquisitions where inherited entities have unresolved (and sometimes undiscovered) compliance deficiencies.
• Changes in U.S. reporting and regulatory requirements that are not communicated across global compliance teams.
• Inconsistencies between regulatory schemes in the parent company’s jurisdictions and U.S. regulatory schemes applicable to the subsidiary or target company.

Even sophisticated multinational organizations can discover that required filings and renewals have been missed.

Possible Adverse Business Consequences

Potential impacts may include:

• Civil fines and late filing penalties.
• Criminal prosecution.
• Loss of good standing with state authorities.
• Loss of the ability to conduct business in affected states or with governmental agencies.
• Delays in financing transactions, license applications, or mergers and acquisitions.
• Increased scrutiny during government audits or investigations.
• Contractual issues with lenders, customers, vendors, or investors requiring certifications of compliance.
• Reputational harm with regulators and business partners.
• Possible unwinding of completed transactions or forced sales of businesses or lines of business.
• Reputational harm to the brand or public perception of the parent or subsidiary.
• Governmental investigations, potential product recalls and debarment from government contacting.
• Additional legal costs to restore compliance.
• Possible issues with insurance coverage.
• Possible personal civil or criminal liability of owners, directors, managers and officers for acts or failures of the subsidiary.
• Consent orders or agency or court orders mandating compliance with laws, periodic reports to government authorities, and monitoring by third party monitors.
• Increased fines and penalties under Chapter 8 of the Federal Organizational Sentencing Guidelines based upon “Culpability Factors” that are designed to provide “just punishment, adequate deterrence, and incentives” for organizations to maintain effective compliance and ethics programs.

Unresolved compliance issues often delay corporate transactions, financings, and offerings/listings while counsel and auditors find missing data, attempt to reconstruct or explain years of missing records and filings and advise management concerning possible exposures.

Diligence Reviews and Screenings as Tools for Protective Action

Periodic compliance due diligence linked with internal compliance audits, internal reporting and training provides organizations with an opportunity to identify issues before regulators, customers, competitors, plaintiffs, or transaction counterparties find problems.  This is more than just risk management.  It is good governance.

We have found that an effective review often includes many of the following:

• Verification of corporate good standing (existence and qualification) in every jurisdiction where the subsidiary operates directly or indirectly itself or though remote workers, agents, or contractors.
• Review of historical federal, state, and local filings.
• Review of product safety and quality control inspection reports.
• Review of the Committee on Foreign Investment in the United States (CFIUS) and Bureau of Economic Analysis filings.
• Review of IP asset protection policies and procedures.
• Review of advertising and promotional materials.
• Review of warranties issued by the subsidiary.
• Assessment of corporate governance records and internal audit reports.
• Review of governance and organizational documents.
• Review of ethics policies, antitrust policies and anti-money laundering policies and procedures.
• Confirmation of supply chain practices, policies and procedures with respect to forced labor, slavery, human trafficking, and child labor and audits of suppliers.
• Confirmation that required business licenses, permits and security clearances were obtained, renewed and remain active.
• Review of regulatory registrations applicable to the company’s industry, services and products.
• Review of financing and credit documents for compliance requirements and defaults.
• Review of material contracts for limitations on business activities, restrictions on competition, expiration, confidentiality provisions, warranty and indemnity provisions, limitations on liability, IP ownership, default, cure, renewal and termination provisions. 
• Review of government contracts that incorporate acquisition regulations, and “flow down” provisions applicable to supply agreements, subcontracts and vendor agreements with prime contractors.
• Assessment to identify data privacy risks and possible data privacy issues as they may relate to data processors, controllers, data subjects and their businesses, including policies and procedures to ensure lawful storage, data deletion, transmission, receipt and processing of personal data, protection of personal data, and accountability through documented compliance measures.
• Policies and procedures for vetting and qualifying new vendors, consultants, and trading partners.
• Evaluation of pending and threatened material litigation and claims.
• Review of insurance coverage for general commercial liability, advertising, personal liability, computer/cyber, fraud and other business specific coverages.
• Evaluation of record and beneficial ownership, beneficial ownership reporting and other disclosure obligations.
• Review of acquisition and merger agreements where the subsidiary was acquired and the schedules attached to such agreements.
• Identification of possible employee/independent contractor misclassification issues and payment of applicable minimum wages and overtime pay to misclassified individuals.
• Identification of possible VAT, sales and use tax issues for online sales and other cross-border sales.
• Confirmation that internal compliance processes, internal controls and responsibility assignments are adequate and senior management is committed to compliance.

The objective is not merely to identify deficiencies but to help the parent and subsidiaries to establish a sustainable governance, ethics and compliance framework going forward.

Due Diligence Before Major Events

Compliance reviews are especially valuable before:

• Acquiring or selling a U.S. business or line of business.
• Refinancing, expanding or obtaining new credit facilities for the parent or for the subsidiary, or both.
• Soliciting outside investors.
• Preparing offering materials.
• Internal corporate reorganizations.
• Leadership transitions.
• Changing financial auditors.
• Expanding operations into additional jurisdictions.
• Taking on government contracts as a prime or subcontractor.
• Exporting software or data to the EU or UK or importing personal information or data into the U.S. from the EU or UK or certain other foreign countries.
• Investments by the subsidiary outside the United States.

Discovering missing filings during a transaction often leads to unnecessary delays, increased legal and accounting expenses, pricing issues, and reduced negotiating leverage.

The Importance of Building a Strong Compliance Culture

For international companies, maintaining U.S. compliance requires more than written policies and periodic filings. It requires clearly assigned duties and responsibilities, governance and ethics policies, regular monitoring, effective communication between headquarters and U.S. management, training of subsidiary personnel, periodic independent reviews and penalties for non-compliance. This should be done in a manner consistent with both the European Union FDI Screening Policy and the U.S. federal Organizational Sentencing Guidelines.

Organizations that treat compliance due diligence as an ongoing governance function and not merely a reaction to regulatory, third party, or press inquiries are generally better positioned to manage business risks, support business growth, comply with parent company FDI screening requirements, respond to unforeseen events, and execute strategic objectives.

Conclusion

The regulatory environment applicable to U.S. subsidiaries and their parent companies continues to evolve.  Filing obligations span numerous government agencies and jurisdictions.  Often banks, insurance companies, underwriters and sponsors of parent company offerings or exchange listings, and other third parties request comfort, reports and opinions concerning material subsidiaries.  Unfortunately, over time, even well-managed multinational companies can develop compliance gaps concerning their subsidiaries and the subsidiaries’ businesses.  Periodic reviews and screenings can help parent companies and subsidiaries to be prepared and cope with these requests and for unforeseen events.