RSM South Africa

Adequate consideration - The risk in what you can't justify

Whether the economy of a country is in a period of retraction or expansion, one element of commerce which remains relevant is the intermittent reliance of companies on its shareholders for the provision of adequate capital funding in conducting its business. The motivation for the provision of capital funding may well differ, i.e. during periods of economic retraction, a much needed capital injection may just be what is needed to restore solvency and liquidity requirements for a company having fallen on troubled times, or during periods of economic expansion, the company may be emboldened enough by its confidence in the economic environment to take on new projects, which may require funding from shareholders in the form of capital.

Whatever the motivation for the provision of capital funding to a company may be, it is important that not only the rights of existing shareholders be protected in terms of the potential dilution of their shareholding, but also that the directors of a company are aware of their fiduciary duties in attending to the allotment of new shares.

This article will set out to address the abovementioned matters in the light of the provisions of the Companies Act 71 of 2008 (the “Act”).   

SECTION 40(1) OF THE ACT

Section 40(1) of the Act provides that the board of a company may issue shares only for adequate consideration to the company, as determined by the board, or in terms of conversion rights associated with previously issued securities of the company, or as capitalisation shares.

From the outset, however, three elements in Section 40(1) of the Act is clear: (i) the allotment and issue of shares is a function of the board of the company; (ii) the shares can only be issued if the company has received a consideration for the shares; and (iii) Such consideration received has to be deemed as adequate by the board of the company. 

THE EFFECT OF SECTION 40(1) OF THE ACT

The immediate consequence of the allotment and issue of shares being a function of the board of the company, is that the board has to act within the ambit of their fiduciary duties when issuing shares. Effectively this means that the board has to determine what adequate consideration for the shares to be issued will be, whilst acting in good faith, for proper purpose and in the best interest of the company, and doing so with due care, skill and diligence, while also making sure to avoid any conflict of interest. Failure of the board to act in accordance with the aforementioned duties, will result in a breach of fiduciary duties, which could result in a director being held personally liable for any loss, damages or costs sustained by the company, as envisaged in Section 77(2) of the Act.

In the event of such an claim being brought against the board, a director would have to rely on the so-called “Business Judgement” rule, as envisaged in Section 76(4) of the Act, thereby providing justification that he/she had taken reasonable steps to be informed about the matter, had no conflict of interest, or properly disclosed any such conflict of interest in terms of Section 75 of the Act, and had a rational basis for believing, and did in fact believe, that his/her decision was in the best interest of the company.

In determining what “adequate” consideration would be, the most generally followed approach would be to determine the value of the shares to be issued with reference to the fair value of the company.

Fair value, however, is not the only manner to determine the adequacy of a consideration. There may be instances where the commercial nature of a transaction requires that the fair value of the shares would not be adequate consideration. It may very well be that the commercial strategic value of a particular allotment of shares dictates that shares should be issued at a consideration substantially less than the fair value of the shares. However, the onus remains on the board to justify such a value as adequate, given the circumstances of the particular case, within the ambit of their fiduciary duties.

The Act defines the word “consideration” in Section 1 as anything of value, including money, property, negotiable instruments, securities, an investment credit facility, a token or ticket, or any labour, barter or similar exchange, or any other thing, undertaking, promise agreement or assurance, irrespective of its apparent or intrinsic value, whether transferred directly or indirectly.

CONCLUSION

It is absolutely clear that the board of the company is at risk in the event that they cannot sufficiently justify the value of the shares to be allotted and issued in the light of Section 40(1) of the Act as adequate consideration. Although courts have been cautious to arbitrarily fetter the determination of value by the board, it has done so in cases where it has been clear that the directors are not acting in good faith, or in breach of their fiduciary duties. Therefore, it is essential, not only to protect the value of the shareholding of existing shareholders, but also to protect the directors of the board of the company, that adequate value considerations are carefully considered when attending to the issue and allotment of shares.

Phillip Kruger

Regional Divisional Director | Legal, Johannesburg


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