Abstract

Keywords

Shareholder loan accounts; private companies; Companies Act; shareholders; creditors; Insolvency Act.

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1 Introduction

Limited liability 1

 Richard Stevens. BA LLB LLM LLD. Vice-dean, Learning and Teaching, Faculty of Law, University of Stellenbosch, South Africa. E-mail: rastev@sun.ac.za . ORCiD: https://orcid.org/0000-0002-0364-7630.

 Liline Steyn. BA LLB LLM. PhD Candidate in International Law at the Geneva Graduate Institute. E-mail: liline.steyn@graduateinstitute.ch.ORCiD: https://orcid.org/0000-0002-3853-2446.

1 The foundation of limited liability is that all debts incurred by a company are the company's liabilities and are not directly the legal liabilities of the company's shareholders or directors.

Gower refers to two arguments that are used to advance the principle of separate juristic personality and limited liability in English law. 6

6 It has been stated and acknowledged that English Law has had a decisive influence on South African Company Law, which is why it is critical to discuss the English influence when discussing limited liability. See Girvin 1992 J Legal Hist 77, where he states, "[t]he most important influence on South African company law has been English Law following the establishment of a British settlement at the Cape in 1806."

investors. The idea was that these individuals who were not investment experts would not want to risk their personal assets by becoming shareholders of a company with unlimited liability. They would prefer being lenders to the company instead. The company, however, sought investments and not loans, and, the concept of limited liability was introduced to facilitate investment. 8

8 Davies Gower and Davies' Principles of Modern Company Law 177.

The nature of a private company is an obstacle from an investment point of view since such a company must restrict the transferability of its securities and may not offer securities to the public. 9

9 Section 8(2)(b)(ii) of the Companies Act.

The terms in respect of the repayment of these shareholder loans, which are often (if not always) contained in shareholder agreements, often do not envisage (a) repayment (date). This raises the question of whether typical shareholder loans are, in fact, true loans or whether they are not, in effect, equity financing disguised as loans, as they are missing an essential characteristic of loans: that of certainty of contract relating to performance. When equity financing is framed as a loan, shareholder funding has the same status as other concurrent creditor claims in liquidation, instead of being ranked below concurrent claims. As mentioned above, this article, therefore, seeks to address whether typical terms in shareholder agreements dealing with shareholder loans satisfy the test for true loans. Put differently, what is the legal nature of a shareholder loan account?

Typical terms in shareholder loan agreements indicate either that these loans are subordinated to external creditor loans, alternatively that these loans are repayable only at the discretion of the company (exercised either by way of a board decision or by a super majority shareholders' vote of 75%;

i.e. a special resolution imposed by the memorandum of incorporation or in the shareholders' agreement, or even a higher percentage), or the repayment date is simply not provided, which implies that repayment would be on demand. The latter two typical terms are the focal point of the question raised in this article, namely whether loans provided with these terms (or lacking them) are, in fact, true loans. The reader may wonder at the outset what the ultimate significance of a potential finding may be that some loans are de facto equity: should the loans then also be treated as equity, and not enjoy any preference? Would this require legislative change in insolvency law, or could a similar effect be achieved by the courts "subordinating" the loan agreements, so that it is practically speaking equity?

An ancillary issue is that the financial interest of a shareholder, i.e., a shareholder has an equity interest (in the form of securities) and also a claim as creditor, is more than often (if not always) treated as a disposable interest. Shareholders would ordinarily not dispose of their shares without also disposing of their creditor claims. This makes sense because should a shareholder dispose of his shares but retain the claim as a creditor, the shareholder who exits the company would have no more right in terms of the Companies Act to view the annual financial statements of the company and would be unable to safeguard his interests. 10

10 Section 26(1)(c) of the Companies Act provides holders of beneficial interests with the right to view the annual financial statements.

2 The paradox: equity or debt financing

Despite being common in small private companies, shareholder loans remain a paradox due to the prima facie inability to determine to which financing structure they ascribe (debt or equity). The funding of small private companies is governed by two distinct areas of the law, namely company law regarding equity finance and contract law regarding debt finance, each of which has its own set of applicable legal principles. The classification of a shareholder loan as either equity or debt financing has a significant impact on an investor. In analysing the financing structure of a company where one person holds shares in a company as well as having provided loan financing to the company, it must be appreciated that such a person is both a shareholder and a creditor and that this can result in a complex relationship between the person and the company. 11

11 Goldstein 1960 Tax L Rev 3.

long-term view of the company. On the other hand, a creditor is a party to an obligation 12

12 Hutchison and Pretorius Law of Contract 499: "[o]bligation: a legal bond (vinculum iuris) between two or more persons obliging the one (the debtor) to give, do, or refrain from doing something to or for the other (the creditor)."

2.1 Equity financing

In South Africa, a private company is regulated by the Companies Act 71 of 2008 (hereafter the Companies Act). Section 19(2) of the Companies Act provides the concession of limited liability to shareholders of companies that comply with the requirements in the Companies Act that are applicable to them. 14

14 Section 1 of the Companies Act defines a company as follows: "A domesticated company, or a juristic person that, immediately before the effective date (a) was registered in terms of the (i) Companies Act, 1973 (Act No. 61 of 1973), other than as an external company as defined in that Act; or (ii) Close Corporations Act, 1984 (Act No. 69 of 1984), if it has subsequently been converted in terms of Schedule 2; (b) was in existence and recognised as an 'existing company' in terms of the Companies Act, 1973 (Act No. 61 of 1973); or (c) was deregistered in terms of the Companies Act, 1973 (Act No. 61 of 1973), and has subsequently been re-registered in terms of this Act."

equity it will be subject to the restrictions as contained in section 8(2)(b) as it becomes part of the "securities" as referred to in this section.

The business needs of a company will determine the amount of financing that it requires. 18

18 McLaughlin Unlocking Company Law 138.

Equity financing entails that a company issue shares to one or more investors 21

21 McLaughlin Unlocking Company Law 146.

are defined by the contract, which grants the debt holder rights against the company.

The restriction on the company in respect of whom it may issue securities limits the options for the company to secure investment financing because investment finance, or equity finance, can be raised only from existing shareholders or private placements which are not in contravention of "offers to the public". The Companies Act does provide shareholders of private companies with an anti-dilution measure should the company issue new shares. Note that this right applies to shares and not to securities. Essentially the Act provides shareholders with the right to maintain their existing shareholding before the company may issue to non-shareholders where a new share issue is done. 28

28 Section 39(2) of the Companies Act.

Shareholders are not creditors for the amount they invested in the company. 30

30 Cassim Contemporary Company Law 17.

Interestingly German law recognises shareholder loans as loans, but effectively reduces them to equity should the company go into liquidation. Courts in Germany initially took the initiative to protect external creditors against internal creditors. 31

31 Raiser and Veil Recht der Kapitalgesellschaften 623.

management of the company. 32

32 Section 32a III of the German Insolvenzordnung (Insolvency Act), 1994. See further Raiser and Veil Recht der Kapitalgesellschaften 626-635.

There are substantial differences between a shareholder and a creditor of a company with regard to rights against the company and the ranking of claims on insolvency. 34

34 Cassim Law of Business Structures 171.

The provisions of a shareholder loan agreement are subject to the usual rules of contract law and depend on the particular agreement between the company and the shareholder. Among the common provisions that may be included in such an agreement are the specified loan amount, the interest rate charged, if any, and the repayment terms, including any provisions for the early repayment or extension of the loan term.

2.2 Debt financing in a private company

As mentioned above, the law that regulates debt financing is contract law. 38

38 McLaughlin Unlocking Company Law 139.

The foundation of debt financing is that a company has a contractual obligation to repay the amount that was loaned to it according to the terms of performance as set out by the loan agreement. 42

42 McLaughlin Unlocking Company Law 147.

Most contracts, including loan agreements, are reciprocal in nature. One party's performance is undertaken on the understanding that there will be a reciprocal performance by the other party. 47

47 Hutchison and Pretorius Law of Contract 7.

One of the main requirements for a valid contract is that its contents must be certain or ascertainable. 49

49 Lubbe and Murray Farlam & Hathaway: Contract 307.

A typical example of uncertainty, which is relevant in the present context, concerns contracts with an indefinite duration. 53

53 Hutchison and Pretorius Law of Contract 222.

usually give effect to these contracts by looking at the intention of the parties. 54

54 Hutchison and Pretorius Law of Contract 222.

According to the maxim id certum est quod certum reddi potest, 58

58 If something is capable of being made certain, it should be treated as certain. In Law and Martin Dictionary of Law 72.

In Erasmus v Senwes Ltd (hereafter the Senwes case) 66

66 Erasmus v Senwes Ltd (31964/04) [2005] ZAGPHC 5 (1 January 2005) (hereafter Senwes).

performance. The court clearly recognised that the debtor (promissor) could also have such a power, as long as this power is also (like that of the creditor/promissee) exercised reasonably. In fact, the court went on to argue that there is no reason to restrict the rule (that discretionary contractual rights must be utilised arbitrio boni viri 67

67 De Lange v ABSA Makelaars (Edms) Bpk 2010 3 All SA 403 (SCA) para 17 "[d]iscretion in this regard had to be exercised arbitrium boni viri, 'with the judgment of a fair-minded person.'"

3 Arbitrium boni viri

3.1 The principle of arbitrium boni viri in South Africa

We now discuss the application of the principle of arbitrium boni viri to the interpretation and enforcement of shareholder loan accounts in more detail. In this article it is necessary to differentiate between two scenarios regarding the debtor (the company): i) the debtor is using his contractual right or power to modify the terms of the contract that pertain to his obligations (as described by Senwes), or ii) the debtor is using his contractual right or power to determine the timing of his performance without altering any particular term. 69

69 In NBS Boland para 23 a distinction is made between the validity of a condicio si voluero, i.e. a condition that the promissor is bound to perform only should he wish to do so and a contract or stipulation where the promissor may determine his own prestation.

principle of arbitrium boni viri, meaning that the debtor must act reasonably and in good faith when deciding on the timing of his performance. Determining what is a reasonable way of exercising such power will depend on the specific circumstances of each case. Contracts normally demand a more or less absolute quality of certainty in each and all the terms of the agreement. In terms of performance this can be satisfied with a relative quantum of certainty; namely, with that which is reasonable in the particular circumstances of the case. 70

70 Samek 1970 Can Bar Rev 203.

The principle of arbitrium boni viri was discussed in both the NBS Boland 71

71 NBS Boland para 7.

The Senwes case centred on an employment contract and a clause regarding a subsidy for a medical scheme. Senwes provided its employees with a medical scheme membership through SAKAV 77

77 Membership of a medical scheme called SAKAV (the judgment does not provide full name of medical scheme, only the abbreviation) in Senwes para 6.

of the options available. 79

79 Senwes para 8.

It has been stated that in certain cases if one party to a contract is allowed to modify its terms (condictio si voluero), this will render the contract void. 86

86 Senwes para 23.

Ultimately the court had to determine whether Senwes acted reasonably when it made its decision and whether the changes were necessitated by financial need or motivated by a desire to increase profitability. 90

90 Senwes para 32.

balance these interests in a reasonable manner, always bearing in mind the nature and content of the original contractual obligation. 92

92 Senwes para 32.

In the context of the scenario where the company may decide when to repay the loan, it would appear that in the light of these recent case law developments, such a provision would not necessarily be void. The company, through its board of directors, would have to act reasonably in determining when to repay the loan of the shareholder. Whether the company could refuse to repay a loan where no time for performance has been provided appears to be the more vexing problem. It is, however, entirely possible that a shareholder loan agreement would provide no time for the repayment of the loan. In theory, this would mean that it would be payable on demand. What if the shareholder, however, never in his lifetime calls up the loan? Would the law still treat the loan as a loan?

3.2 Possible criteria for the exercise of the arbitrium boni viri in the performance of a shareholder loan: the Cork Report

Determining what is reasonable in the context of the performance of a shareholder loan account can amount to a complex exercise. Certain criteria need to be established to provide insight into such an exercise. An interesting perspective in the context of inter-group loans is the Cork report, 93

93 The aim of the report was to review the law in the United Kingdom that related to insolvency, bankruptcy, liquidation and receivership and to consider necessary or desirable reforms.

The report focussed specifically on the effect on creditors when one of the companies in the group becomes insolvent. The report considered different options to protect external creditors of the liquidated company due to the fact that the inter-company indebtedness could often rank above the claims of these external creditors and therefore prejudice them. One possibility that was considered was to defer the intercompany indebtedness; i.e. all the debts that a company owes to other companies in the same group should

be suspended until the claims of external creditors have been met. 96

96 Cork Insolvency Law and Practice 440.

The report further stated that in terms of connected persons, a director's loan to his own company will also be deferred where it has formed part of the company's long-term capital structure. 98

98 Cork Insolvency Law and Practice 442.

Effectively the report suggested that the payment of a loan account that has been defined as equity should be deferred until the claims of creditors have been met. 102

102 Cork Insolvency Law and Practice 442.

From this one can deduce that the intention of the shareholder plays an important role in determining what is reasonable in the circumstances and how performance should be determined. This is also evident in the Senwes case, when the court had to determine whether Senwes had acted reasonably when it made its decision, whether the changes had been necessitated by financial need or motivated by a desire to increase profitability. The court clearly focussed on the intention of the party in its determination of what was reasonable in terms of performance.

3.3 Case law

In Burman v Commissioner for Inland Revenue (hereafter the Burman v Commissioner case) 104

104 Burman v Commissioner for Inland Revenue 1991 3 All SA 950 (AD) 962 (hereafter Burman v Commissioner).

Goldstone JA held that the minority judgment disregarded the commercial reality and legal consequences of Burman's loans. 110

110 Burman v Commissioner para 953.

fictitious or disguised transactions. 111

111 Burman v Commissioner para 953.

In the light of Burman v Commissioner, one should ask the question of whether a shareholder loan account should not be considered sui generis in nature. It does not ascribe to either of the traditional categories of equity or debt financing and yet it has characteristics of both. In truth, the way a shareholder loan will be structured very much depends on the type of agreement that is concluded between the company and the shareholder, which can take the form of a loan agreement including all the requisite terms for a loan, or it can be an informal agreement between the parties with almost no specific terms. Essentially the foundational agreement of a shareholder loan can fundamentally differ from one agreement to the next. It is most common for a shareholder loan to lack terms regulating the repayment of the loan. The difference between the majority and the minority illustrates that even the courts find the categorisation of this form of financing difficult.

Two main arguments emerge, namely the first, as upheld by the majority, of the commercial reality of the loan agreement, and the second of the purpose or intention of the agreement, both of which are subject to the specific circumstances of the shareholder loan in question. This again reinforces opinion of the sui generis nature of the loan, since no two shareholder loans may have the same purpose, as this will be determined by the intentions of the parties to the foundational agreement. It appears, however, that the mere fact that the economic interest of a shareholder may consist of both equity and loan financing is not sufficient to hold that the loan financing is not a loan. Should a shareholder dispose of his shares in the company, it

makes practical sense also to dispose of the loan account that he holds. This should therefore not be held to treat the loan as equity.

4 Conclusion

The article has explored two issues regarding the legal nature of loan accounts in two specific contexts and whether these contexts change the legal nature of a loan possibly into equity: the first, where no provision is made for their repayment. The second issue concerns the situation where there is a clause in the shareholder's agreement in which the majority has the power to decide when repayment is due. The question was whether these two situations differ and if they do, the nature of the difference.

In the context of small private companies, the practical reality is that they are often financed by loans. The equity finance (share capital) is usually only a nominal amount and the shares that have been issued constitute the minimum number to reflect each shareholder's interest in the company. 114

114 McLennan 1993 SALJ 686-710.

In South Africa NBS Boland and Senwes make it clear that a debtor can have the discretion to determine performance. Where no date for repayment has been set but the right to decide when to repay the loan is vested in the company; i.e. the board, the prima facie implication of these cases which allows a debtor to decide "what" to perform could have a profound impact on the status of a shareholder loan where the company may decide when or how to repay it, because the company is able to allocate a portion thereof as equity. However, it creates a limitation whereby it is held that the exercise of such discretion must be based on the arbitrium bonum viri principle, i.e. the "judgement of a reasonable person". Arguably, changing the loan to equity could not be within the power of the board as this would be an attempted unilateral amendment to the contract.

Further, issues that arise from such an agreement where no date has been set for performance could be detrimental to external creditors of the company. In this scenario, the debt would be payable on demand. However, here the unique position of a shareholder creditor comes to the fore. The shareholder, or rather the person with the beneficial interest, will have access to the annual financial statements of the company. 115

115 Section 26(1)(c) of the Companies Act.

there is no repayment date in the loan agreement, the loans may, therefore, be called up when the company is not able to service its debt. Should the company go into liquidation, the Insolvency Act may assist by having these dispositions (payments of the loans) set aside. However, this is a costly and reactive process. Instead, it could be advisable to legislate proactive measures with respect to the repayments of loans made by shareholders. Here a recommendation in the Cork Report that these loans be deferred could be helpful. Considerations could be (a) the initial debt-equity ratio, (b) the sufficiency of the paid-up share capital, (c) the lack of a reasonable expectation of repayment, (d) the terms and duration of the advance, (e) whether external parties would provide such advances, and (f) the intentions of the parties involved. Furthermore, the automatic subordination of shareholder loans to those of external debt providers could be considered. The provisions of the German Insolvency Act in terms whereof the shareholder loans are subordinated to those of external creditors are also something that the legislature could consider. Where the company has issued only one class of shares, these shares rank equally in liquidation. 116

116 Section 37(3)(b)(ii) of the Companies Act.

The article has not attempted to argue that shareholder loans are simulated equity because the intention of the lender and the debtor is to enter into a loan agreement due to the benefits a loan agreement provides in insolvency of the debtor company. The question is whether the lack of repayment terms, or where the debtor decides when/how to pay, makes loans of this type valid loans. The article attempts to show the unique nature of loans of this type. Where ordinary loans from external debt providers are usually clear in respect of when the debtor has to perform, shareholder loans are typically not clear in this respect. Either they do not stipulate a time of repayment or they provide the company with a discretion in respect of repayment. There is essentially no difference between these two situations. In the second scenario, the company must exercise its discretion reasonably. Ultimately, however, shareholder loans appear to be loans, and this is not a fiction but a fact. If external creditors are concerned about the pool of creditors becoming larger in the event of the insolvency of the company, the only intervention which would assist them would be by the legislature. The nature of legislative intervention would be to subordinate the claims of shareholder creditors to those of external creditors. The only tool that the courts could use would be to hold the loan as a simulated transaction to disguise the true nature of the transaction, i.e. that the shareholder intended to provide equity finance. This option, however, appears to be unlikely.

Bibliography

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Case law

Burman v Commissioner for Inland Revenue 1991 3 All SA 950 (AD)

De Bruyn v Du Toit (1162/2015) [2015] ZAWCHC 20 (27 February 2015)

De Lange v ABSA Makelaars (Edms) Bpk 2010 3 All SA 403 (SCA)

Deeb v Absa Bank Ltd; Friedman v Standard Bank of SA Ltd 1999 4 SA 928 (SCA)

Erasmus v Senwes Ltd (31964/04) [2005] ZAGPHC 5 (1 January 2005)

Juglal v Shoprite Checkers (Pty) Ltd t/a OK Franchise Division 2004 5 SA 248 (SCA)

NBS Boland Bank Ltd v One Berg River Drive CC 1999 4 All SA 183 (A)

Praesidium Capital Management (Pty) Ltd v Kay-Davison (17332/2010) [2010] ZAWCHC 531 (8 November 2010)

Standard Bank of SA Ltd v Oceanite Investments (Pty) Ltd 1995 4 SA 510 (C)

Standard Bank of SA Ltd v Ocean Commodities Inc 1980 2 SA 175 (T)

Legislation

Germany

Insolvenzordnung, 1994

Modernisierung des GmbH-Rechts und zur Bekämpfung von Missbräuchen Gesetz, 2008

South Africa

Close Corporations Act 69 of 1984

Companies Act 61 of 1973

Companies Act 71 of 2008

Insolvency Act 24 of 1936

United Kingdom

Joint Stock Companies Act, 1856

Limited Liability Act, 1855

List of Abbreviations