Highlighting Legal Structure Risks With Entity Diagramming

Lauren Mcmenemy
The nature of modern business is not straightforward. Jurisdictional requirements can vary wildly, and the way a corporate structure is put together can follow an almost infinite number of paths. And within all of this variance lie inherent risks ' risks that are not always immediate, even to the trained eye.

When looking at how a business is structured and how its entities relate to each other, it's good practice to look at entity relationship diagramming. An entity diagram is a data visualization tool that aims to capture the full complexity of a modern enterprise as it gains in size and complexity. It's a way to highlight structures at a glance, tapping into our basic learning needs and making a structure come to life on screen. Entity diagramming can become an essential tool in risk management as you seek to highlight entity structure risks.

Highlighting Legal Structure Risks

Let's look at just three of the risks inherent in entity structures, and how entity diagramming can help to highlight those entity structure risks.

Risk 1: Choosing the wrong entity type for the need

The first step any in-house counsel or advisers take when dealing with a new company or new entity is to consider the type of entity that best fits the needs of the company. This is true whether it's the first entity being set up, or it's just the latest in a long line of entities to be managed.

For example, if you're setting up your business in the US, you'll need to choose between a business corporation, such as a C or S corporation, or a limited liability company. In the UK, it's the choice of a public limited company, a private company limited by shares, a company limited by guarantee, a limited liability partnership and so on. The choice of entity is not an arbitrary one; the type of entity can bring its own entity structure risks for the entire group. And if it's an additional entity in a jurisdiction in which you're already operating, there could be a whole raft of extra aspects to take into consideration.

The risks of having the wrong business structure are great, but with a focus on profitability and future growth, the entity structure risks are not always top of mind when making the choice of which entity type best fits one's needs. Here, a visualization through entity diagramming can highlight any potential risks within the structure as a whole, or within a specific jurisdiction, to ensure the optimal structure is chosen. It can bring to life those risks that may not immediately be obvious, and align entity management information to the visualization to help make these entity structure risk decisions.

Risk 2: Causing an unnecessarily complex group structure

Multi-jurisdictional companies can find their legal structure getting unwieldy, especially if the company has grown its entity numbers through mergers and acquisitions. This can result in highly complex structures with scores of entities in relationships with each other of various depths. This can bring headaches for the legal operations and compliance teams who need to manage these entities and understand how they interact.

One solution can be to simplify your legal structure. This can reduce risk and cost, as well as those compliance headaches entailed in trying to manage multiple entities. The legal entity rationalization process of evaluating each entity for its importance and purpose can also highlight where an entity may no longer be needed, or where it could better serve the company if it were of a different type.

Here, an entity diagram can help to visualize the entire structure of the company, from the parent or holding company and flowing through all subsequent entities regardless of where they fall or report to. This visualization, coupled with the resulting links to documentation and entity information, can reveal any duplicate entities, any nonperforming entities or even where multiple entities could be merged for greater efficiencies.

Risk 3: Noncompliance with local regulation on substance or directorships

Every jurisdiction has its own regulations — that's common knowledge in entity management circles — but how can you be sure that every single one of your entities and directors are completely in line with the needs of each jurisdiction in which you operate or have an entity?

The Organization for Economic Cooperation and Development (OECD) has been cracking down on the 'substance' behind an entity since it started work on its Base Erosion and Profit Shifting (BEPS) project ' it's an attempt to end the cycle of setting up shell companies, or entities for tax avoidance or for moving money around an organization unethically. BEPS says that an entity must have 'economic substance' for it to exist in a jurisdiction and to avail itself of any benefits held in formation in that jurisdiction. That means it must have directors, hold Board meetings and show that some form of decision-making is done in that jurisdiction ' not just having some office space and a couple of people on the payroll.

The risk of non-compliance with substance is huge, though it does differ between jurisdictions, so it pays to have an idea of what is behind each entity. Equally, you will need to consider whether your directors comply with the regulatory requirements in each jurisdiction. For example, some jurisdictions require a director to not be shared with the parent company, while others allow it.

Visualizations can help you to get the complete picture of your organizational structure, where directors sit and what the operational structure looks like in each entity. By completing an entity diagramming process, you can see at a glance any risks involved in the structure and start to make plans to mitigate those risks immediately, rather than waiting for the regulators to discover the issue first.

Harnessing Technology for Your Entity Diagramming

These sorts of entity relationship diagrams can only come to life by harnessing 21st-century technology. Spreadsheets and hand-drawn charts just don't have the same level of detail, meaning that risks could be missed or misunderstood in the push for corporate growth.

Diligent's entity management software comes with a robust entity diagramming function that enables smarter decision-making. It features those aspects essential to entity diagrams, including:

  • Color, text, shape, line, alignment and percentage options to represent data effectively
  • Hyperlinks to get more detailed information on each aspect of the chart
  • Ways to envision the best hierarchy among entities and operations
  • The ability to automatically generate PDF reports that chart the global structure of the entity

Get in touch and request a demo to see how Diligent's entity management software can help you to highlight entity structure risks with entity diagramming, and start your investigations for entity rationalization.
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Lauren McMenemy

Experienced journalist Lauren McMenemy has been writing about compliance and governance for several years, and has covered finance, professional services, healthcare, technology, energy and entertainment.