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CALIFORNIA CORPORATE & SECURITIES LAW

The Case Of The Wholly Owned, But Not Totally Held, Subsidiary That May Or May Not Be 100% Owned

When someone says that a subsidiary is “wholly owned”, I believe that the common understanding is that the parent company owns all of the issued and outstanding equity of the subsidiary.  What if the statement is that the subsidiary is “totally” or “100%” owned?  I suspect that most people would not intuit a different understanding.  The Securities and Exchange Commission, however, assigns different meanings to each of these terms at least so far as financial statements are concerned.  Here are the three definitions:

The term wholly owned subsidiary means a subsidiary substantially all of whose outstanding voting shares are owned by its parent and/or the parent’s other wholly owned subsidiaries.  17 C.F.R. § 210.1-02(aa).

The term totally held subsidiary means a subsidiary (1) substantially all of whose outstanding equity securities are owned by its parent and/or the parent’s other totally held subsidiaries, and (2) which is not indebted to any person other than its parent and/or the parent’s other totally held subsidiaries, in an amount which is material in relation to the particular subsidiary, excepting indebtedness incurred in the ordinary course of business which is not overdue and which matures within 1 year from the date of its creation, whether evidenced by securities or not. Indebtedness of a subsidiary which is secured by its parent by guarantee, pledge, assignment, or otherwise is to be excluded for purposes of paragraph (x)(2) [sic] of this section.  17 C.F.R. § 210.1-02(y).

A subsidiary is “100% owned” if all of its outstanding voting shares are owned, either directly or indirectly, by its parent company.  A subsidiary not in corporate form is 100% owned if the sum of all interests are owned, either directly or indirectly, by its parent company other than: (i) Securities that are guaranteed by its parent and, if applicable, other 100%-owned subsidiaries of its parent; and (ii) Securities that guarantee securities issued by its parent and, if applicable, other 100%-owned subsidiaries of its parent.  17 C.F.R. § 210.3-10(h)(1).

I am not an accountant but I’m willing to accept the notion that these definitions serve a useful purpose in financial statement disclosures.  I find them to be bizarre nonetheless.  Both “wholly” and “totally” mean entirely and yet the definitions of “wholly owned subsidiary” and “totally held subsidiary” do not actually require that shares be entirely owned.  According to the SEC, “wholly owned” and “totally held” are akin to horseshoes, hand grenades and ball room dancing.  Close is good enough and “all” actually means “fewer than all”.  In this respect, I’m reminded of Alice’s tête-à-tête with Humpty Dumpty:

‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’  ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’ ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

Lewis Carroll, Through the Looking-Glass.

I also find it counterintuitive that a parent (and/or the parent’s other wholly owned subsidiaries) need not own all (or even substantially all) of a subsidiary’s shares for the subsidiary to be wholly owned.  If, for example, Company A owns all 100 of the outstanding voting shares of Company B, which has no debt, and Company C owns all 100,000 of the outstanding non-voting shares of Company B, the SEC would consider Company B to be a wholly owned subsidiary of Company A even though Company A owns less than .1% of the total outstanding shares of Company B.  One might guess that Company B is a “totally held subsidiary” of Company C because Company C owns 99.9% of the outstanding equity securities.  However, Company B may not be a “subsidiary” of Company C at all because the SEC defines “subsidiary” as an “affiliate controlled by such person directly, or indirectly through one or more intermediaries”.  17 C.F.R. § 210.1-02(x) (The SEC defines “control” as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting shares, by contract, or otherwise”.)  Thus, the question becomes whether Company B is an affiliate controlled by Company C. (As an aside, I’m not sure why the SEC felt compelled to include “affiliate” in the definition of “subsidiary” because the SEC defines an “affiliate” in terms of control.)

In the above example, Company B would also be a “totally held” subsidiary of Company A because Company A owns all of Company B’s outstanding voting shares.  If Company A owned only “substantially all” (whatever that means) of Company B’s voting shares, then Company B would be a “wholly owned” but not “100% owned” subsidiary of Company A.

 

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