Financial assistance to purchase shares in a company

There is no reason why a company cannot give financial assistance to a third party to acquire shares in the company. This satisfies the need for the South African economy to unlock the wealth in many companies and to empower previously disadvantaged individuals to gain access to that capital.

Financial assistance to purchase shares in a company

There is no reason why a company cannot give financial assistance to a third party to acquire shares in the company. This satisfies the need for the South African economy to unlock the wealth in many companies and to empower previously disadvantaged individuals to gain access to that capital.

Graeme Fraser
BA LLB LLM HDip Tax 

If I had to bet that there was one section of the Companies Act that most lawyers had referred to at least once in their legal careers it would be section 38. Many would also have to admit that that the arrangement which their client had presented to them had indeed fallen foul of the prohibition against a company providing financial assistance in respect of the acquisition by a party of its shares. This did not necessarily prevent the underlying transaction taking place, but did usually require some smart foot-work by all parties to the transaction, not the least of which was the lawyer drafting the agreements. 

For this reason, section 38 in its original form became a type of “bogeyman” clause. The threat of its application was often enough to cause the parties to devise some unusual structures to finance the acquisition of the shares.

The sentiment behind the original prohibition which is still found in section 38(1) was simply that assets of the company were there to satisfy the claims of the creditors. 

Section 38(1) is virtually unchanged and provides: 

“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.” 

The test has been said to rest on two legs (Lipschitz V UDC Bank 1979(1) SA 789 (AD)), namely –

a)      was financial assistance given;

b)      for what purpose were the proceeds used. 

In a number of cases it was suggested that the test was whether the company had been become “poorer” as a result of the transaction (“the impoverishment test”) but that does not go far enough. 

Anyway, over time a number of “glosses” and exceptions have been introduced into section 38, essentially reflecting the changing times and commercial exigencies in South African society, including the need to unlock shareholder value and re-distribute access to the means of production to elements of the population to whom these opportunities were denied.

The CLAA has added the latest string to the bow. So while the original prohibition as couched in section 38(1) remains, the following exceptions are now provided for:-

·        the prohibition does not apply to the lending of money in the ordinary course of its business by a company whose main business is the lending of money (section 38(2)(a);

·        The provision by a company, in accordance with any scheme for the time being in force, of money for the subscription for or purchase of shares of the company or its holding company by trustees to be held by or for the benefit of employees of the company, including any director holding a salaried employment or office in the company (section 38(2)(b)); or

·        The making by a company of loans to persons, other than directors, bona fide in the employment of the company with a view to enabling those persons to purchase or subscribe for shares of the company or its holding company to be held by themselves as owners (section 38(2)(c); or

·        The provision of financial assistance for the acquisition of shares in a company by the company or its subsidiary in accordance with the provisions of s 85 for the acquisition of such shares.

All these exceptions have been in place for since at least 1999 and it is not necessary to examine them further. 

A major change in direction has in my opinion, however, been introduced by the insertion of a new section 38(2A) by the CLAA which provides – 

“(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”.

The first test thus requires the directors to essentially be satisfied with the solvency of the business at the time when the financial assistance is provided (and the assumption is that provided the company is solvent at the time when the transaction is implemented and remains so throughout the period for which the financial assistance is operative, the position of the creditors of the company has not been adversely affected). This solvency test (which may have some resemblance to elements of the old discarded “impoverishment test”) is a new yardstick that is being increasingly introduced as the means by which the decisions of the directors will be measured, and has been extensively used in the draft Companies Bill.  

The second test is actually a procedural formality, namely to have the shareholders sanction the arrangement by means of a special resolution. This obviously ensures that the directors, even though they may have satisfied themselves that the company was solvent as contemplated above, will have to open that decision to scrutiny and comment by the shareholders. And having had an opportunity to debate the wisdom of the decision the shareholders cannot later be heard to complain (in the absence of any fraud or deception by the directors or any other person involved in the transaction) that they were prejudiced by the transaction. 

In essence, provided these tests are satisfied, there is no reason why a company cannot give financial assistance to a third party to acquire shares in the company. That is miles apart from the original prohibition - previously there was a broad-based prohibition, with a few exclusions, whereas now it would seem that provided the company is in a financially sound position there is in effect little to prevent the company providing financial assistance except for the dictates of common-sense (as would be encompassed in the solvency test) and procedural compliance (through the notification to the shareholders and their assent by special resolution). 

As I have already indicated the driver of this change in philosophy is the need for the South African economy to unlock the wealth in many companies and to empower previously disadvantaged individuals to gain access to that capital.  

It will be interesting to see the circumstances which will lead to the Courts having to first pronounce that a transaction should not have been entered into because the tests discussed above were not met.