The Corporate Hierarchy

On 8 June 2012 the Financial Stability Board (FSB) published a paper titled "A Global Legal Entity Identifier for Financial Markets" which stated a number of recommendations for the introduction of the Global Legal Entity Identifier System (GLEIS).
Recommendation 12 stated:

" The FSB LEI Implementation Group should as soon as possible develop proposals for additional reference data on the direct and ultimate parent(s) of legal entities and on relationship or ownership data more generally and prepare recommendations by the end of 2012. The group should work closely with private sector experts in developing the proposals. ”

On 7 September 2015 the Regulatory Oversight Committee (ROC) for the GLEIS released a consultation document on collecting data on direct and ultimate parents of legal entities in the GLEIS. Without the collection of hierarchy information then no further understanding into systemic risk across counterparties would be achievable.

The collection of corporate hierarchy information for any system is complex and the gathering of parent relationships for the GLEIS will be no different. The typical challenges faced when collecting parent relationship data are:

  • Definition of Terms: terms such as "ownership" and "control" can be defined differently depending on circumstances;
  • Corporate Actions: actions such as mergers, acquisitions, reverse-mergers and spin-offs cause changes in the corporate hierarchy, these changes would need to be captured and presented in a timely manner and
  • Jurisdictional Differences: The separation of ownership and control can vary by jurisdiction and is most pronounced among family controlled firms in countries such as Korea, Singapore, and Taiwan. Another complexity is entities may reside in jurisdictions where there is no requirement to divulge ownership or control information as it is considered confidential.

Definition of Terms

In 2006 the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agreed on a Memorandum of Understanding that identified the tactical and strategic convergence projects that would attempt to eliminate differences between their two respective accounting standards: International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP). For example, US GAAP has a legalistic approach to defining control, whereas the IFRS has a broader definition of control including effective control. As the ROC has stated the "variation underscores the difficulty of achieving universal applicability of any definition of parent", more on this later.

It should be stated that in some jurisdictions there has is no local GAAP, for example in the UAE, but the relevant authorities in all but 8 of 138 jurisdictions (Belize, Bermuda, Cayman Islands, Egypt, Macao, Suriname, Switzerland and Vietnam) have made a public commitment to IFRS as the single set of global accounting standards.

With the Financial Stability Board (FSB) encouraging the IASB and FASB to offer a consistent implementation of their respective standards and the IASB being a member of the FSB then it is perhaps not surprising that the ROC has stated that account consolidation rules should prevail in establishing a first set of standard control/ownership relationships within the GLEIS. The ROC felt this was appropriate as accounting standards are applicable to both financial and non-financial companies and the definition of "parent" should be:

"The "direct accounting consolidating parent" of legal entity X could be defined as the lowest level legal entity that prepares consolidated financial statements that consolidate entity X. ”

The IFRS (IAS 27(2011).4) offers a definition of "consolidated financial statements" as the "financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity". Within that definition IAS 27(2008).4 defines a parent as "an entity that has one or more subsidiaries" and a subsidiary as "an entity, including an unincorporated entity such as a partnership that is controlled by another entity (known as the parent)". This does raise the question what is meant by control, which is defined as "the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities".

Control is assumed to exist when a parent entity acquires more than 50% of the voting rights of another entity, but control can also exist when the parent owns 50% or less of the voting power of an entity but is based on power when there is [IAS 27(2008).13]:

  • power over more than half of the voting rights by virtue of an agreement with other investors;
  • power to govern the financial and operating policies of the entity under a statute or an agreement;
  • power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or
  • power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.

Additional complexity arises with contractually agreed sharing of control between parties and joint ventures. Allan Grody in his paper "Final Report on Global Identification Standards for Counterparties and Other Financial Market Participants" has proposed the concept of the Ultimate Control Point LEI (UCPL). UCPL would be an entity that "controls the activity of the structure, and not necessarily having majority or even a partial ownership interest in it".

The concept of using voting rights does not equate to liability for debts and sharing of profits. In a recent paper submitted for the Enterprise Risk Management Symposium in Chicago, Irina Leonova and Nigel Jenkinson suggested not being drawn into the "quagmire" of definitions but to store relationship data between entities from different types of hierarchies which can be defined as required. The example highlighted in the paper is if Company A owns 30% of the common stock of Company B, 75% of its voting rights and guarantees all of its credits, then if we define ownership/control based on 50%+ of equity, company A would not be considered as owning company B but if a credit officer assessing credit exposures wants to define ownership as any firm that guarantees the credit of another company, then the hierarchy would show company A as owning company B.

Control can also be based on supervisory control which can be applied for supervisory consolidation purposes, this differs from accounting consolidation, for example, U.S. GAAP determines that control has been established if the parent owns more than 50% of the voting stock, while for supervisory purposes, this limit is only 25%. In a recent paper entitles entitled "A Structural View of U.S. Bank Holding Companies" the largest Bank Holding Company by total assets was JPMorgan Chase which controls 3,391 subsidiaries; this number would differ if the accounting standards' definition of control was used.

Corporate Actions

Allan Grody and Peter Hughes in their paper "The Global Risk Regime - New Roles for Auditors" have suggested that auditors can offer significant input into the tracking of corporate ownership changes and the control of hierarchies. Auditors need ownership and control information of legal entities in accordance with accounting standards to produce consolidated financial statements on an annual basis. These are then certified by the auditors. The use of an audit firms as a certifying agent is consistent with other objects stated by the FSB related to auditors playing a more substantial role in stabilizing the financial system as outlined in the press release "Enhancing the contribution of external audit to financial stability"

Jurisdictional Differences

What has been discussed so far on ownership is predicated on the agency model of corporate governance, where shareholder ownership controls companies, this model is not always followed in all European countries and different structures exist in Asia.

In some sovereign jurisdictions there is no requirement to divulge ownership or control information. This arrangement might be beneficial for asset protection or tax affairs. Usually Sovereign regulators, exchanges and their auditors are privileged to this information. The FSB has put some thought into the how the parent information is redacted or obfuscated for the aggregation of OTE derivatives data where privacy/blocking laws restrict a Trade Repository from transmitting/disclosing counterparty information. One of the suggested solutions is to use a key that maps the true LEIs to a masked LEIs. The masked LEIs would be a random alpha-numeric code. The key would be created by a trusted third party (TTP), possibly an auditor, with the public only seeing the masked LEIs and Regulators only seeing the name by a formal request to the TTP for the key. This way the aggregation of data through hierarchy would not be impeded.

Beneficial Owner

Finally, lets draw the distinction between legal ownership and control and beneficial ownership. The Financial Action Task Force (FATF), an independent inter-governmental body's definition of beneficial owner extends beyond legal ownership and control to consider the notion of ultimate (actual) ownership and control. In other words, the FATF definition focuses on the natural (not legal) persons who actually own and take advantage of capital or assets of the legal person; as well as on those who really exert effective control over it.


Comments, References & Further Reading:

  1. Milne, Alistair and Parboteeah, Paul, Counterparty Risk Management and the Global Legal Entity Identifier (LEI) (November 20, 2014). Available at SSRN: http://ssrn.com/abstract=2528436
  2. Grody, Allan D. and Hughes, Peter J., The Global Risk Regime – New Roles for Auditors (April 21, 2015). Available at SSRN: http://ssrn.com/abstract=2508399
  3. Grody, Allan D. and Hughes, Peter J., Risk, Data and the Barcodes of Finance (April 21, 2015). Available at SSRN: http://ssrn.com/abstract=2544356
  4. Grody, Allan D. and Hughes, Peter J. and Reininger, Daniel, Final Report on Global Identification Standards for Counterparties and Other Financial Market Participants (March 10, 2015). Journal of Risk Management in Financial Institutions - Special Issue on Counterparty Risk, Vol. 5, No. 2. Available at SSRN: http://ssrn.com/abstract=2016874
  5. Leonova, Irina S. and Jenkinson , Nigel, Relationship Data: The Missing Link of the Current Financial Infrastructure (August 29, 2014). Paper for Enterprise Risk Management Sep 29 – Oct 1. Available at SSRN: http://ssrn.com/abstract=2504167
  6. Grody, Allan D. and Hughes, Peter J. and Reininger, Daniel, Final Report on Global Identification Standards for Counterparties and Other Financial Market Participants (March 10, 2015). Journal of Risk Management in Financial Institutions - Special Issue on Counterparty Risk, Vol. 5, No. 2. Available at SSRN: http://ssrn.com/abstract=2016874
  7. LEI ROC, Consultation document on collecting data on direct and ultimate parents of legal entities in the Global LEI System (September 7, 2015) Available at: http://www.leiroc.org/publications/gls/lou_20150907-1.pdf
  8. A paper from Deloitte entitled "Business combinations and changes in ownership interests: A guide to the revised IFRS 3 and lAS 27". This paper gives some interesting scenarios on control in section 6 on page 22. Available at: http://www.iasplus.com/en-gb/publications/global/guides/pub2690/at_download/file/
  9. Pacter, Paul, IFRS as global standards: a pocket guide (April 2015). Available at: http://www.ifrs.org/Use-around-the-world/Documents/IFRS-as-global-standards-Pocket-Guide-April-2015.PDF
  10. FSB Press Release "Enhancing the contribution of external audit to financial stability". Ref no: 15/2012 (March 15, 2012) Available at: http://www.financialstabilityboard.org/wp-content/uploads/pr_120315.pdf
  11. Avraham, Dafna and Selvaggi, Patricia and Vickery, James I., A Structural View of U.S. Bank Holding Companies (July 16, 2012). Economic Policy Review, Vol. 18, No. 2, pp. 65-81. Available at: http://ssrn.com/abstract=2118036
  12. FATF guidance, Transparency And Beneficial Ownership (Ocotber, 2014). Available at: http://www.fatf-gafi.org/media/fatf/documents/reports/Guidance-transparency-beneficial-ownership.pdf


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