Shareholders Loan vs Preference Shares

In the global market one would adopt the mantle of a created entity to converge into the sphere of corporate competition.  In this regard one would have to consider the objective of the proposed business entity before even taking into account the plethora of methods in which a business may be conducted, structured and/or financed.

The focus hereof will be of shareholder loans to the company, a common manner in which the capital necessary is raised by a new business entity and the possibility, implications and rationale of restructuring such a loan into preference shares. Of interest here is the definition of a distribution and the working of the Solvency and Liquidity Test in the context of the Companies Act, No. 71 of 2008 (“Act”).

What is a Distribution:

“A direct or indirect transfer of company property (including money), other than its own shares, to or for the benefit of the holder of a share or the holder of a beneficial interest in such a share in the transferring company or any other company in the same group of companies. It can also, in addition, be the incurrence of debt or other obligation for the benefit of persons above and in the third instance the waiver of a debt or obligation by the owed by those persons to the company.

In terms of Section 46 of the Act a distribution may only be made if, inter alia, it reasonably appears that the company will satisfy the Solvency and Liquidity Test immediately after completing said distribution.

The Solvency and Liquidity Test entails the following: considering all reasonably foreseeable financial circumstances of the company, the assets of the company, fairly valued, equal or exceeds the liabilities, fairly valued, and it appears that the company will be able to pay its debts as they become due in the ordinary course of business for a period of 12 months following that distribution (“Test”).

In Capitex Bank Ltd v Qorus Holdings Ltd 2003 (3) SA 302 (WLD), it was established that the Test is based on the principles that as long as the Test is satisfied, creditors will not be prejudiced if the “capital” of the company is used other than for the ordinary business purposes of the company.

The Solvency and Liquidity Test takes into account the following:

  • accounting records that satisfy the requirements of section 28; and
  • financial statements that satisfy the requirements of section 29;

Section 4(2)(c) of the Act states the following –

unless the Memorandum of Incorporation of the company provides otherwise, when a person applying the test in respect of a distribution contemplated in paragraph (a) of the definition of ‘distribution’ in section 1, a person is not to include be regarded as a liability any amount that would be required, if the company were to be liquidated at the time of the distribution, to satisfy the preferential rights upon liquidation of shareholders whose preferential rights upon liquidation are superior to the preferential rights upon liquidation of those receiving the distribution.”

Simply stated, in respect of certain distributions, the solvency, not liquidity, test is adapted, but subject to a provision to the contrary in the company’ Memorandum of Incorporation, the effect being that liquidation preferences are not required to be included as a liability (solvency test) in respect of distributions in respect of which the receivers rank below those holding the preferential rights upon liquidation. It is not yet clear why this is the default situation.

The general tendency of the Act is to avoid manipulating the investment profile of the company in a way which disadvantages creditors.

 The Solvency of a company depends upon, based on all reasonably foreseeable financial circumstances that the fairly valued assets are in excess of the fairly valued liabilities as indicated on the balance sheet.

While with regard to liquidity it must appear, that based on all reasonably foreseeable financial circumstances, that the company will be able to pay its debts as they fall due in the ordinary course of business for 12 months after the Test was applied.

It would be safe to assume that the Test is an objective test rather than an absolute factual test, as the requirement is that based on “reasonably foreseeable financial circumstances” it appears that the company is solvent and liquid. The particular board must be satisfied, which indicate a subjective test, however justified through the objective “reasonably foreseeable financial circumstances”.

A company may be in a solvent position, with healthy prospects for future profit generation, but as a result of a lack of liquid resources or access to such resources, not be able to pay its debts in the ordinary course of business as and when they fall due.

Preference shares may be issued with various rights attached (Section 37 of the Act) to them and, as such, preference shares may possess both equity, as well as debt characteristics, depending on the rights attached to them.

In light of the abovementioned how does one determine whether preference shares are to be considered as debt or equity?

The most essential standards to review with regard to any entity most certainly will be the internationally accepted principles of the International Financial Reporting Standards (“IFRS”). Clearly stated in the IFRS, preference shares should be treated as debt rather than equity, if the redemption is beyond the control of the company or if dividends should be paid periodically.

Consider the following:

  • should the holder of the preference share have the right to cash in that share at his/her own discretion or within a fixed period, then the preference share will be regarded as a debt and accordingly be considered in the Test; and
  • should the company have the discretion over when preference shares can or cannot be repaid, the general rule is to treat the preference share as equity.

If a company issues preference shares that pay a fixed rate of dividend and that have a mandatory redemption feature at a future date, this will constitute a contractual obligation and therefore be included as a liability. Should preference shares be issued without a fixed maturity and where the issuing company does not have a contractual obligation to make any payment, the preference shares will be considered equity.

This, however, is not as simple as it seems, you will need to examine the capital, income, liquidation and voting rights of the preference shares and determine where the discretion lies, taking into account that in terms of section 37 of the Act, companies are allowed to assign practically any right and/or preference to such a class of shares.

In this regard it would be wise to take note of contingent assets and liabilities. In terms of IAS 37 (International Accounting Standards) a contingent liability is defined as –

a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

a present obligation that arises from past events but is not recognised because:

(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or

(ii) the amount of the obligation cannot be measured with sufficient reliability.”

In light of the aforementioned, reverting back to our original question. The restructuring of a shareholder’ loan to the company into preference shares doesn’t have a direct all-encompassing answer.

The inclusion or exclusion of preference shares in the Test considerations will need to be answered on a case by case basis. It is clear however that one is required to determine where the discretion lies effectively after restructuring taking into account all relevant factors. Whether this was the intention of the Act or a void therein, beneficial or not remains to be seen.


16 November 2012