Preference shares in BEE deals

Preference shares in BEE financing: some of the pros and cons.

When the framers of the BEE Codes wrote paragraph 3.14 of Code 100 (the ownership section) they opened a door to creative schemes, especially when they wrote “An Equity Instrument carrying Preferential Rights that have the characteristics of debt, regardless of whether the debt is that of an Entity or a Participant, must be treated as a loan.

What “Preferential Rights” are was not spelt out in the Codes.  But, in terms of company law, as soon as a share has some priority over another share it is a preference share (i.e. a company has to have ordinary shares before it can have preference shares).  These priority rights typically relate to the payment of dividends, but they can also include rights on the return of capital and certain votes.

Basic preference shares (or prefs as they are commonly known) receive a fixed rate of return, which is only paid if there are company profits available to pay it.  Unless specified otherwise, these are cumulative and so, if not paid, the shortfall must be clawed back when the profits do exist.  Sometimes preference shareholders get even more from the residual profits (after their preference dividends have been received) alongside the ordinary shareholders.  These are known as participating prefs.

Redeemable prefs:

Sometimes the prefs are redeemed (paid back) by the company.  These are known as redeemable prefs.  Redemptions are not share repurchases or buy backs – as the redemption is a condition established at the time of the share issue.  Therefore, the Companies Act provisions relating to share cancellations do not apply and the redemptions can happen in accordance with the pref’s terms without applying the solvency and liquidity tests.  This can be very advantageous, especially in BEE deals. The terms will stipulate when the redemption will take place which might be (i) when the company choses, (ii) when the shareholder choses or (iii) when something occurs (like a date or a condition).  Companies would like the first option, as they never HAVE to repay.  But shareholders prefer the other two as they can then get their money back.  Of course, if the company MUST redeem the prefs, it is a debt of the company and cannot be treated as equity.

Using prefs to finance BEE ownership:

BEE plans have therefore focused on prefs where the company has to redeem them, and for good reasons such as:

  1. The Codes specifically exclude prefs from ownership calculations, as they are basically debt instruments and not equity instruments;
  2. Economic interest calculations focus on returns of ownership – and ignore returns to creditors (those who MUST be repaid);
  3. Voting rights can ignore preference shareholders as prefs do not confer votes in almost all issues. Pref shareholders only get to vote on matters affecting their rights or when there has been a default on the prefs;
  4. Prefs are liabilities of the company. They cannot be “acquisition debt” and can be ignored from deemed value and net value calculations.

Some BEE structures have used these features to ensure that the economic interests can be skewed away from the ordinary shareholders, who meet BEE ownership targets.

While this might frustrate the objectives of the BEE Act (and therefore constitute the criminal offence of fronting), this can be legitimately used where shareholders in a company introduce black shareholders at the same time as the prefs.

To achieve this, the measured entity changes some of their ordinary shares into prefs (to avoid cancelling or selling them, which needs to comply with the solvency and liquidity requirements in sections 46 and 48 of the Companies Act, or might attract CGT).  The prefs are issued at the value of the ordinary shares given up.  Ordinary shares are then issued to the incoming BEE shareholders which they might even get for free.

Illustrative example:

To illustrate let’s say that a company is worth R100 and has 100 ordinary shares in issue.  It could become 51% black owned by converting 51 ordinary shares into R100 of prefs (owned by the existing ‘white’ shareholders) and issuing 51 new ordinary shares.  The company is now worth R0 (the R100 it was worth to start with less the R100 liability it now has to repay).  The preference shareholders will get R100 back (the current value of the firm, see below) and the future profits will be split 51:49 between the BEE shareholders and other shareholders.  The BEE shareholders have not had to pay (or take on any debt) and will share in the upside after they have come on board.  The pref holders will get their money out (plus interest)– being paid by the company (and not some “unreliable counterparty”).  If the prefs carry no votes, as is the norm, the verification agents count the ownership points on the company’s scorecard and voila it’s a win:win.

Where’s the catch?

If only the world was just about BEE…..and didn’t involve accountants, lawyers and the taxman….

Let’s consider the reality – this structure is put in place because the pref holders want their money out i.e. they want to get their existing value off the table and not share this with incoming BEE shareholders.

If repayment of the pref was at the company’s option and the BEE shareholders have a majority stake and company directors can do what’s right for the company, would the “vendors” ever get their money out?  Would they accept these risks or just obligate the company to pay?.  They obviously want the company to pay, and if the debt is a liability some accounting niceties follow…

Valuation, goodwill and insolvency:

First what if the value used is more than the book value of the business?  We will write another whole article of how the value used could be abused to ensure that the BEE partners will take a long time to see any economic benefit – but in theory why would the new BEE shareholders complain if they got shares for nothing?  Well, going back to the illustration above, if the value of the business was R100 but its book value was say R60 there would be R40 of goodwill etc which often arises in arm’s length transactions.  However, accountants write off this goodwill if internally generated (as in arranged by “friendly” parties in a non-arm’s length way) which would one way or another mean that there is now R100 of debt and R60 of other assets and the company is R40 insolvent.  It now owes more than it owns.

Directors clearly have to take this possibility seriously, as do auditors, financiers and reliant customers.  Technical insolvency can be very nasty and should be carefully considered. The write off also affects profits, which affects the ability to repay the pref or distribute any dividends.

Tax treatment of interest earned by holders of the pref:

Secondly, if the pref is a liability of the company then someone has a corresponding asset.  The tax angle is important here: if the pref attracts interest then, despite being termed a dividend, tax will be due on the interest earned. Now there is a difference in tax rate between what most people pay on the interest they earn and the dividends they earn.  Dividends between 0% (for local companies) and 20%.  Some interest is tax-free but otherwise it is taxed at the taxpayer’s marginal rate of 28% (for companies) and up to 45% for individuals (and higher still for trusts).  But that’s not all …. dividend taxes are deducted from dividends and so are paid from receipts – one always has the cash to pay dividend taxes.  Interest is taxable as it is earned and not as it is received.

In other words, you may not have the cash to pay the tax on the interest on your prefs, putting you in a personally insolvent/illiquid position.

Preference dividends, which are cumulative (unless otherwise specified), are earned every year, but not received every year, and taxes may be due on pref dividends not actually received.  The good news is the company can claim a deduction for this at the same time – but this is shared with the BEE shareholders, not just the prefs.  But, to reiterate the taxable income is taxed at a higher rate than the deduction (28% versus the recipient’s tax rate) and none would be payable by the BEE shareholder.

Then there is a problem if the rate is not market related and arms’ length (especially as the deal was reached by connected parties).  The return paid is not just about the rate, but the nominal amount too.  If the company now is thinly capitalised (i.e. its debt is disproportionately high to its capital base) the deduction may not be fully allowed anyway in the company. Astute directors and proper governance are required.

The problem may be further compounded if the “vendors” swap ordinary shares for prefs.  Share swaps are great for deferring capital gains taxes, but only apply to “equity shares”, as defined in the Tax Act.  If a pref is only entitled to a set amount (i.e. is not a participating pref) it is not an “equity share” and the swap is not CGT-friendly.  This is why some lawyers focus on changing the terms of a share instead.

SARS might attack this when there’s insufficient commercial rationale to this, so one has to hope this does not fall foul of evasion rules such as those about substance over form or sham transactions.

The first problem is IFRS related and the others SARS related and neither seems to care that the BEE box was ticked.  This is not to say preference shares do not have a role to play in BEE.  There are billions of Rands of listed prefs on the JSE and they have featured in law longer and wider than BEE has.

Do your homework:

Preference share structures can work, but each shareholder needs to do substantial homework in terms of tax and solvency requirements in the business and in their personal capacities. These effects often play out years after the BEE deal with serious financial and legal consequences – none of which are quick or cheap to fix. We suggest if you are considering a pref structure that you consider the BEE, valuation, tax and solvency requirements carefully, and model these over the next decade. Sometimes a fix to a problem in one area leads to a real issue down the line in other areas.

If you’re looking to sort out your BEE ownership, please get in touch – we have a far better option than pref structures.