Section 38: Some relief for BEE

Introduction

As part of a comprehensive overhaul of South Africa’s corporate legislation, the Companies Act of 1973 is to be replaced in its entirety by a new Act of the same name. However, because of the sheer magnitude of the exercise, the process is proving to be a protracted one. Whilst the latest draft of the Companies Bill awaits cabinet review before publication, indications are that this Bill will not be passed into law earlier than 2010.

However, in the interim, urgent legislative intervention was needed to address the discrepancy between the law and economic activity. This intervention has come in the form of the Corporate Laws Amendment Act of 2006, which is to be effective from a date to be promulgated in the Government Gazzette.

Current section 38

Arguably, none of the changes brought about by the Amendment Act was as urgent as the amendment to section 38 of the current Companies Act. Because of South Africa’s discriminatory history, it has become necessary to empower previously disadvantaged persons. One of the ways this empowerment takes place is the facilitation of equity acquisition in companies by black people (and women in general). However these persons often do not have, and because of collateral issues cannot raise, the necessary capital to finance the acquisition of shares in these companies.  Until now, section 38 of the Companies Act has prohibited companies, except in certain limited circumstances, from directly or indirectly providing financial assistance for the purchase of their own shares by third parties.  Section 38 provides that:

‘No company shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares of the company, or where the company is a subsidiary company, of its holding company.’

This prohibition, which has its origins in English law, was notionally aimed at preventing the abuse of company resources to the detriment of creditors and minority shareholders. However, it is now generally accepted that the prohibition is no longer useful and, in the present environment, is not only unnecessary, but is even harmful. In any event, there are other, more effective, ways of protecting the interest of creditors and shareholders. The solvency and liquidity tests, initially introduced into our law by the Companies Amendment Act of 1999 in respect of share buybacks (an amendment which section 38 mysteriously survived), have proven effective in this regard.

Impact of current section 38 on BEE

In practice, section 38 has gradually proven to be a legislative headache for companies (and corporate attorneys), especially those who wish to conclude Black Economic Empowerment (“BEE”) transactions. On the one hand, companies are legislatively expected to empower previously disadvantaged persons, who have neither capital nor access to it through the conventional market, whilst on the other hand, the law prevents companies from assisting in financing the acquisition of those shares.

Companies have attempted to device means of avoiding the application of section 38 to empowerment transactions, but these methods were costly and overly complex and some were even in very murky legal waters. An example of such a scheme involved the BEE participants forming a company (usually a consortium) known as a special purpose vehicle (“SPV”) and then approaching an external financier (usually a bank) to fund the acquisition of shares by the SPV in the target company. The SPV’s shareholding in the company would then serve as security for the SPV’s obligations to the financier. Such a structure, because of its complexity, increased both the costs involved and the amount of risk the parties were exposed to.

Amendmended section 38

Section 38 has now been amended by the insertion of sub – section 2A which provides as follows:

‘(2A) Subsection (1) does not prohibit a company from giving financial assistance for the purchase of or subscription for shares of that company or its holding company, if—
(a) the company’s board is satisfied that—
(i) subsequent to the transaction, the consolidated assets of the company
fairly valued will be more than its consolidated liabilities; and
(ii) subsequent to providing the assistance, and for the duration of the
transaction, the company will be able to pay its debts as they become due
in the ordinary course of business; and
(b) the terms upon which the assistance is to be given is sanctioned by a special
resolution of its members.
(2B) For the purposes of paragraph (2A)(a), the directors must consider any
contingent liabilities which may arise to the company, including any contingent
liability which may result from giving the assistance.’.

Impact of Amendment

The solvency and liquidity tests introduced into section 38 by this amendment will allow companies to finance the purchase of their own shares, provided that the company will remain solvent and liquid post the transaction.

The result of this is that the cost of concluding BEE transactions can decrease considerably. In the example mentioned above, the need for an external financier is removed (which removes the need for the involvement of banks) and the ability for direct funding also removes the need for the SPVs, which makes the transaction less complex. Because the amendment makes it easier and less expensive to conclude BEE transactions, this will likely result in the increase in the number of BEE transactions concluded.

In addition to the cost advantage, the removal of the banks as necessary parties to these transactions will enable the parties involved to agree on more mutually acceptable terms for the BEE partner to meet its repayment obligation to the company – a situation that would previously have been rarely possible because of the considerably reduced negotiating power the BEE partner invariably had when negotiating with a financial institution. This imbalance in the negotiating power often resulted in a situation where the entire dividend that accrued to the BEE partner as a shareholder in the target company, was transferred over to the financier as repayment of the loan granted to implement the transaction. This postpones the benefit the BEE party receives from the transaction until such time the loan is fully repaid.

Of course, it is still possible (perhaps even likely) that banks will still feature in BEE transactions. This is because companies wishing to conclude BEE transactions by assisting in the financing of the acquisition of their shares may still approach banks for loans to finance those transitions, so as not to compromise the company’s liquidity. Alternatively, companies may choose to provide the necessary collateral to, or stand as surety for, the third party BEE partner acquiring a loan from a bank for the purpose of acquiring shares in the company, and in this way create more accessible security for their BEE partners.  This is however unlikely to be problematic as companies carry substantially less credit risk.

One Difficulty

The Amendment Act however presents one major practical difficulty; sub –section 38 (2A) (a) (ii) requires the directors to be satisfied both that the company will remain liquid ‘subsequent to providing the assistance’ and ‘for the duration of the transaction’. Whilst it is necessary to require directors to be certain of the company’s solvency and liquidity ‘subsequent to providing the assistance’, where the transaction takes place over a protracted period of time, directors will simply be unable to forecast the company’s liquidity over the entire period and can therefore never be satisfied of the company’s liquidity for ‘the duration of the transaction’. If indeed, ‘duration of the transaction’ is interpreted to mean that, where a company provides financial assistance to a third party in the form of a loan, the transaction continues, for the purpose of the law, until the loan has been fully repaid, the benefits of section 38 may only be limited to transactions that will be speedily concluded and these transactions are likely to be small, minimal impact transactions. 

Conclusion

The above difficulty notwithstanding, by allowing companies to assist in financing the purchase of their own shares by third parties, the amendment to section 38 has made BEE transactions less complex and expansive and has therefore paved the way for more BEE transactions. 

Martin Mota
martin-m@adamsadams.co.za
Candidate Attorney
Adams & Adams