Thorts - Debt vs Equity: the solvency and liquidity test


Thorts - Debt vs Equity: the solvency and liquidity test

Published Date: 2017-06-29 | Source: DealMakers | Author: DealMakers

Thorts - Debt vs Equity: the solvency and liquidity test

A fundamental shift from the capital maintenance rules of the old Companies Act, 61 of 1973 (prior to the 2006 Amendment Act) to the Companies Act, 71 of 2008 ("Companies Act") was the introduction of section 4, namely the solvency and liquidity test ("Test").

While the Test is objective, it is not intended to be factual as it requires the consideration of all reasonably foreseeable financial circumstances at the time of application of the Test. This forward looking discretion applies not only to the forward looking liquidity statement (as one would expect), but also qualifies the factual test of solvency which is determined by reference to a particular point in time. However, it is also subjective in that the board of a particular company must apply it.

The Test encompasses two distinctive tests - solvency and liquidity - which require the application of various factors inherent to each test. Solvency requires a snapshot test of whether the assets of the company equal or exceed the liabilities of the company (taking into account the aforesaid discretion). Liquidity is a forward looking test that entails the assessment of whether the company will be able to pay its debts as they become due in the ordinary course of business for a period of twelve months after the date following application of the Test.

Many boards are tasked with the challenge of assessing whether certain financial instruments constitute debt or equity for purposes of section 4.

For purposes of the solvency test, loans are a liability and to be reflected as such on the balance sheet of the company. However, the terms of a loan will determine the way in which the loan is fairly valued, for example, whether such loan is subordinated, and within this analysis, whether the subordination is to all creditors (ie heavily subordinated) or to a limited class of front-ranking creditors. A subordinated loan may in certain circumstances be fairly valued at R0 or its face value or somewhere in between, depending on the extent of the subordination, and may be classified as an actual liability, or a contingent liability - or a combination of both. A determination as to the fair value of the loan must be made by the directors of company, together with assistance from the auditors of company.

With regards to preference shares, it is clear that any dividends declared on preference shares, but not paid, constitute actual liabilities and ought to be reflected as such. In addition, depending on the terms, any amount accumulated by the company under the preference terms in anticipation of a dividend being declared is not a liability (whether actual or contingent), because from a company law perspective, it is only the act of declaring a dividend that gives rise to an enforceable legal obligation on the company.

The issue with preference shares arises in the context of solvency i.e. whether the residual value of the preference shares (i.e. the redemption amount) is to be regarded as a liability. While the law is not settled on this point, our view is as follows:

  • the Companies Act, unlike accounting standards, applies in a binary fashion - something is either equity or debt. If it is the former, no liability is recognised on the balance sheet, whereas the latter will be;
  • a preference share is inherently equity because it is a share and while its terms may be amended to reflect or mirror debt provisions (which may affect the tax or accounting treatment), this does not alter the fact that its terms are attached to a share; and
  • as such, the position under the Companies Act is that the residual value of a preference share will never be regarded as a liability to be taken into account for the solvency and liquidity test unless the holder and issuer have otherwise agreed to reflect such amount as a liability in terms of section 4(2)(c) of the Companies Act.

Section 4(2)(c) permits the holder and issuer to deviate from the default position (as we indicate above). In summary, the section provides that, unless the memorandum of incorporation ("MOI") of a company provides otherwise, when applying the Test in respect of a distribution contemplated in paragraph (a) of the definition, any amount required - if the company were to be liquidated - to satisfy the preferential rights upon liquidation of shareholders whose preferential rights upon liquidation are superior to those receiving the distribution, is not to be taken into account as a liability in the Test. The legislature included s4(2)(c) to give protection to preference shareholders, should they wish to make use of it, in that their preference on liquidation is to be taken into account when applying the Test in the context of making a distribution. The error on the Legislature's part, it is submitted, appears to have been in limiting this test to apply to distributions only - but that can be cured by extending this recognition in the MOI of the company to apply to all other instances where the Test applies.

For purposes of the liquidity test:

  • 1.1. the repayment provisions of a loan would necessitate the way in which a company calculates the twelve month liquidity forecast. In the instance that the loan is repayable every quarter, then the twelve month liquidity forecast would need to account for 4 repayments. It is further necessary for the company to account for any subordination provisions attaching to such loan; and
  • 1.2. a company would need to factor in the specific preference dividend declaration dates as specified in the MOI as a liability into the twelve month liquidity forecast, but the amount thereof may not necessarily accord with the preference share terms if, in adhering thereto, it would cause the company not to be liquid or solvent. This is because any declaration of dividends themselves would need to pass the Test, and so only the amount that would cause a company not to fail the Test may, in law, be declared by the company. Obviously to the extent that the preference share is cumulative in nature, the next dividend date would need to factor in any amount which was not paid previously and which continued to accrue.

Shadrach-Razzino and Jennings are directors and Pick an associate in Corporate Commerical at ENSafrica.

Brian Jennings

Lydia Shadrach Razzino

(This article first appeared in DealMakers, SA's quarterly M&A publication)

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