Chapter 22 Financial Assistance 2
Overview of the chapter 2
Financing strategies 2
Financing usually required 2
Company assets as collateral in the financed asset sale 2
Company shares as collateral in the financed share sale 3
Company assets as preferred collateral in the financed share sale 4
Form of security given by the company 4
Security over company assets as financial assistance 4
Financial assistance under the 1993 Act 5
Financial assistance under the 1955 Act 5
Financial assistance under the 1993 Act 6
Financial assistance as problematic under the s 76 modes 6
Financial assistance under s 161 7
Financial assistance under s 107 recommended 8
The solvency test 8
Financial assistance subject to solvency test 8
Financial assistance as equivalent to a buyback 9
Modification of the solvency test for financial assistance 9
The proposed assistance under the balance sheet test 10
Revaluation of assets and the balance sheet test 11
The proposed assistance under the trading test 11
The sequencing of dividends and financial assistance 12
A troublesome issue 12
Creditor protection in the asset sale 13
Possible impact on creditors 13
Doubts about the solvency test 14
Duties on trading and obligations under ss 135 and 136 14
Sections 135 and 136 as constraints on financial assistance 14
Section 136 as applicable 15
Section 136 as contravened by the proposed financial assistance 15
The two critical factors under s 136 16
Identity of the board 16
Tax ramifications 18
Financial assistance as a dividend or fringe benefit 18
Financial assistance under the accrual rules 18
A common practice 19
Tax consequences also divergent 19
A dubious reform 20
Overview of the chapter. This chapter examines the 1993 Act’s regime for financial assistance. These rules impact on a wide variety of transactions ranging from share issues to corporate restructurings. Chapter XX considered their potential application to the issue of unpaid shares. This chapter focuses primarily on their operation in the sale and purchase of a small business, the subject of the previous chapter. Judging from both case law and commentary, this appears to be the context in which the rules have caused most difficulty for closely held companies and their principals. As its main topics, the chapter reviews the applicability of the regime for financial assistance in various acquisition structures, the operation and suitability of the statutory modes for assistance, the constraints imposed by the solvency test, liability issues for the principals and tax ramifications. The 1993 Act, while it purports to relax and rationalise the rules on financial assistance, has created a number of unexpected and perplexing new issues for business advisers.
Financing usually required. In most situations, the purchaser of the business can defray only a part of the price out of own funds. The share sale or asset sale must then be accompanied by a separate transaction which provides the necessary finance.
Example. V and P are considering two alternative structures for the transfer of the undertaking operated by V Ltd, the company described in the preceding example. In the one, P will acquire the shares of V for $50,000. In the other, P's wholly owned company P Ltd will purchase the assets of V Ltd for $130,000. In either event, P has only $20,000 of own funds to invest in the acquisition.
The price for the shares equals their net asset backing plus a premium for goodwill. The price in the asset sale alternative reflects the same goodwill plus P’s insistence on clear title to the assets. As P has only $20,000 in own funds, the balance of the purchase price—$30,000 in the share sale and $110,000 in the asset sale—must be financed by V and/or a third party. In either case, the financing party will demand security. Typically, a purchaser in P’s position lacks not only sufficient own funds to finance the acquisition, but also lacks sufficient unencumbered own assets to collateralise the needed extension of credit. In these situations, the extension of credit must be secured in whole or in part by the acquired property, ie, the shares in V Ltd and/or the assets owned by the company.
Company assets as collateral in the financed asset sale. In the asset sale alternative, the purchaser P Ltd requires $110,000 of outside finance to complete the transaction. The assets, purchased free of encumbrances in an arms length transaction for $130,000, might suffice as adequate collateral for a third party loan of $110,000 at a high rate of interest and secured by a first ranking debenture and P’s personal guarantee. More likely, P will have difficulty finding an outside party willing to lend much more than half the asset value at an acceptable rate of interest. In such a event, V might be persuaded to finance the remaining $40,000 to $50,000 at a higher interest rate and against a second ranking debenture over the assets. This use of the business assets to collateralise $110,000 of purchase credit is a corporate transaction that is subject to only minimal regulation under the Companies Act 1993. As the amount of the incurred debt exceeds one-half the value of the assets, the financing arrangement will constitute a major transaction in relation to P Ltd. The special resolution approval required under s 129 is a mere formality in the case of a one-person company.
Company shares as collateral in the financed share sale. In the share sale alternative, the purchaser P requires $30,000 of finance to complete the transaction. As in the financed asset sale, P could offer the acquired property—in this case, the shares—as collateral for the extension of credit from the vendor or a third party. Security over shares can be implemented by a pledge or by a legal or equitable mortgage.1 The use of these security arrangements can continue under the Personal Property Security Act 1999 subject to its uniform rules on attachment and perfection.2 Acquired at a price of $50,000 in an arms length transaction, the shares ostensibly represent substantial security for this amount of borrowing. However, for a number of reasons, shares in closely held companies are not particularly good collateral. Most importantly, the shares confer on the secured party no greater rights than enjoyed by the debtor shareholder. Were P to default on the loan, V or the third party lender would, if it wished to realise the collateral, have to liquidate the company or sell the shares. In the event of liquidation, the net proceeds would be distributed first to the creditors of the company. Even an unsecured creditor without a preferential claim (ie, under the Seventh Schedule) would be entitled to payment before any distribution to the secured party. Secondly, the value of the collateral shares is not independent from the events leading to default on the underlying debt. In most cases, P will fund her payments to V or other lender out of distributions and remuneration from the company. P’s default on the loan will likely reflect and result from financial difficulties at the company level. These may prevent the secured party finding a buyer for the shares or receiving a satisfactory distribution in liquidation. Finally, the value of the shares as collateral may also be diminished by events uniquely within the control of the debtor. Distributions, bad management and an increase in debt unaccompanied by an equal increase in assets will erode the net assets of the business and therewith the value of the shares.
Company assets as preferred collateral in the financed share sale. For these reasons, a creditor who finances P's purchase of the shares will prefer to take a security interest over the company‘s assets rather than over the shares. Even a subordinate debenture over the company's assets will place the financier in a position of priority over the unsecured creditors and the shareholders of the business. Further, the security agreement will include covenants that enable the creditor to control the various risks that threaten the value of the assets. In the case of a closely held company, those covenants can give the financier control powers equivalent to those associated with ownership of the shares. As sole director and shareholder of the company, P is in a position to cause the company to give security over its assets and enter whatever covenants are required by the financier.
Form of security given by the company. The circumstances indicate that company’s assets should probably suffice as security for a $30,000 obligation. Of the $80,000 in liabilities, $50,000 are assumed to be secured. This represents about half of the company’s $100,000 in assets taken at book value. The fact that shares with a book value of $20,000 sold at a $30,000 premium is consistent with a $130,000 value for the company’s assets as a going concern. On a going concern basis, the value of the company’s unencumbered assets is around $80,000. Accordingly, even if the assets realised only half their book value or a third of their going concern value, the $30,000 loan would be repaid. The creditor will access the unencumbered value of the assets by means of personal and property securities. The personal security will take the form of a company guarantee of P's debt. The property security will take the form of a debenture, generally a second- or third-ranking one, over all of the company's assets. The debenture will secure both P's obligation to V as well as the company's obligation under the guarantee. The guarantee complements the debenture in that it makes the company personally liable for the debt. In the event of default, the financing creditor will be entitled, either in its own right or through a receiver, to take control of the business and realise assets sufficient to pay the prior creditors and then the secured debt.
Security over company assets as financial assistance. Whilst the guarantee and debenture are in essence no different from those executed in the case of the financed purchase of assets, they have very different consequences under the 1993 Act. They comprise financial assistance. While financial assistance is not the subject of a formal definition, the proposed security measures surely qualify under s 76(1) as:
… financial assistance to a person for the purpose of, or in connection with, the purchase of a share issued or to be issued by the company, or by its holding company, whether directly or indirectly,
Further, s 76(5) provides that financial assistance specifically includes a loan, a guarantee and a provision of security.3 Whilst there will be situations where it is not clear whether a transaction gives rise to financial assistance4, there is no question that the proposed guarantee and debenture in the example comprise such assistance.
Financial assistance under the 1955 Act. Section 62 of 1955 Act forbade financial assistance except in three narrowly defined cases: where provided in the normal course of the company's lending business; where given to an employee of the business; and in connection with a trusteed share scheme for employees. The prohibition of financial assistance was a rule unique to Commonwealth company law, without any direct counterpart in the companies legislation of the USA or Continental jurisdictions. It first appeared in s 45 of the Companies Act 1929 (UK) upon recommendation of the Greene Committee which viewed financial assistance a circumvention of the prohibition against traffiking in own shares.5 Thirty years later, the Jenkins Committee advocated the rule on the more general grounds of creditor protection.6 The Committee were particularly concerned with so-called bootstrap acquisitions, ie where a person purchases a controlling parcel of shares and finances the acquisition with proceeds from realisation of company assets or by means of loans secured by company assets. Such an acquisition technique results in an unequal allocation of costs and benefits. If the venture succeeds, the acquirer captures all the profit through ownership of the company’s shares. If the venture fails, the acquirer having invested no own funds in the acquisition, any loss is born by the creditors of the company. Further, their exposure is increased by the diversion of company assets which would have, in the absence of the change in control, been available to meet their claims. Under the 1955 Act, a great deal of corporate planning was directed toward circumvention of the prohibition of financial assistance. Some stratagems succeeded and others failed with spectacular consequences in terms of both civil and criminal liability. On the civil side, financially assisted transactions outside the scope of s 62 were held to be void and the parties liable as constructive trustees.7 On the criminal side, the 1955 Act made contravention of s 62 an offence subject to a fine of only $50. However, much more significant liability attached under s 229A of the Crimes Act 1961 which makes the use of a document with intent to defraud and to obtain a benefit a crime punishable by up to seven years' imprisonment.8 As a means to protect creditors, the s 62 prohibition was clearly deficient. Financial assistance could be channeled under the three exceptions in s 62 as well as under various avoidance stratagems without being subject to any financial constraint except the general rules against reckless trading in ss 319 and 320.
Financial assistance under the 1993 Act. Widespread dissatisfaction with s 62 led to its abolition in the 1993 Act. Section 76 now authorises the company to provide financial assistance. While financial assistance does not, in contrast to buybacks and redemptions, require authorisation in the constitution, it is otherwise subject to a regime very similar to the one applicable to those transactions. Like buybacks and redemptions, financial assistance must be implemented through designated statutory modes. A company may give financial assistance under—
• s 76(1)(a) with the written consent of all shareholders ;
• s 76(1)(b) as special financial assistance in compliance with s 78;
• s 76(1)(c) as financial assistance not exceeding 5% of shareholders’ funds pursuant to s 89; or
• s 107(1)(e) with the unanimous written consent of all entitled persons.
Financial assistance under any of the three s 76 modes must comply with s 76(2) and s 76(3). These sections, which have direct counterparts in ss 60 and 69 of the regimes for buybacks and redemptions, require the board to resolve and certify that the assistance is in the best interests of the company and the terms and conditions are fair and reasonable to the company. Where the unanimous consent of the shareholders cannot be obtained under s 76(1)(a), the board may provide special financial assistance under s 76(1)(b) or a limited amount (5%) of financial assistance under s 80. For special financial assistance, the board must, in compliance with s 78, resolve and certify that the assistance is of benefit to those not receiving assistance and that the terms and conditions are fair and reasonable to those shareholders. The board must also cause the company to distribute a disclosure document which, pursuant to s 79, sets out the terms of the assistance and the text of the required resolutions. Under s 80, which is obviously designed for employee share schemes, the board may authorise financial assistance not exceeding 5% of shareholders’ funds without the resolutions required by s 78. Like the other transactions subject to s 107, financial assistance can be provided with the unanimous written consent of all entitled persons without compliance with the resolution, certification and disclosure requirements applicable to the other statutory modes. Reversing the previous common law rule, s 81(1) provides that a failure to comply with the rules and financial assistance does not affect the validity of the transaction. However, s 81(2) preserves the common law liability of participants as constructive trustees or otherwise. Also, failure to comply with the certification and disclosure requirements amounts to an offence punishable by fines up to $5000.
Financial assistance as problematic under the s 76 modes. The financial assistance proposed for the example is problematic under any of the three s 76 modes. There is no difficulty satisfying the threshold requirement under s 76(1)(a), ie unanimous shareholder consent. However, under any of the s 76 modes, the board must certify that the assistance is in the best interests of the company. Under the circumstances, it not obvious how assistance can serve the interests of the company inasmuch as the company gains nothing from either the guarantee or security given in respect of P's indebtedness to V or a third party. Indeed, the company is worse off to the extent of the contingent liabilities represented by the guarantee and security. The only possible argument is that, were the assistance not provided, the transaction between V and P would not proceed and the company would have to be liquidated. However, this is a dubious rationale for the assistance on at least two grounds. First, it presupposes that a one person company has interests distinct from those of its sole member. Secondly, the counterfactual liquidation assumption has little persuasive power. It is equally plausible that, were the assistance not provided, the parties would structure the transaction as a sale of assets or the purchaser would find a more solvent buyer for the obviously healthy business. Even if liquidation were to occur, this can hardly be said, under the circumstances, to contravene the interests of the company. Liquidation would result in full payment of the company’s liabilities and a substantial dividend for V. In view of these benefits to all parties with a stake in the company, it is not apparent how liquidation would injure the company’s interests. Whilst the requirement for certifications and resolutions borders on the absurd in the one person company, it cannot be safely ignored. As illustrated by the judgment in Waller v Paul discussed in chapter XX, should the company fail and be wound up, the liquidator will seize upon non-compliance with formality requirements as a ground for making P personally accountable for debts of the business under s 301 and V liable as constructive trustee.
Financial assistance under s 161. Certain forms of financial assistance will also be subject to s 161. That section authorises the board to cause the company to grant four types of benefit to directors:
benefits for services as a director or in any other capacity,
compensation for loss of office,
guarantees for debts incurred by the director.
The board must resolve under s 161(1) and certify under s 161(4) that the benefit is fair to the company. The particulars of the benefit must be entered in the interest register under s 161(2). This section obviously provides authority for common forms of assistance. For instance, it authorises the company to lend P funds that P can then use to pay V for the shares, or to repay a third party loan used to finance the acquisition. In the example, s 161 authorises the proposed company guarantee of P’s debt incurred to V or the third party lender. However, the provision provides no authority for the proposed use of company assets as security for either V’s debt or the company guarantee. Whilst s 76(6) expressly anticipates the provision of security as financial assistance to a shareholder, this form of assistance appears ultra vires under s 161 when given to a director. As applied to financial assistance, the fairness requirement in s 161(1) is subject to the same difficulties as raised above in connection with the best interest requirement under s 76. Failure to comply with these requirements entails civil liability under ss 161(5) and 161(6) and may constitute an offence.9 However, this liability is not congruent with that incurred for failure to comply with the rules on financial assistance.
Financial assistance under s 107 recommended. In view of the difficulties arising under ss 76 and 161, it will be advisable to implement the assistance under s 107(1). The threshold requirement, unanimous written consent of all entitled persons, is easily met. In most cases, the only entitled person will be the single shareholder of the company. As the financial assistance is a specific transaction, it falls under s 107(5) and is not subject to the withdrawal right under s 107(6) that, as discussed in chapter XX, causes so much difficulty in connection with buyout agreements. The s 107 assent will probably enable the parties to avoid the apparent limitation in s 161 upon the company’s authority to provide a security over the company’s assets. Section 107 also enables the parties to avoid the resolution/certification requirements in s 76 and s 161 and the associated civil and criminal liabilities for non-compliance. However, the director remains responsible for compliance with the general duties under ss 131 to 137. Of particular significance is s 131(1)—
A director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company.
At first blush, the proposed financial assistance poses the same problem under s 131(1) as it did under s 76(2). As the company receives nothing in exchange for the guarantee and security, it is hard to argue that it is in the best interests of the company. There are, however, some potentially significant differences between s 131(1) and s 76(2). First, the best interests obligation under s 131(1) is a subjective one, whereas this is not clear in relation to the counterpart obligation under s 76. Secondly, there is no direct counterpart under s 131(1) to the fair and reasonable requirement under s 76 or the fairness requirement under s 161. Thirdly, financial assistance proceeds under s 131 without regard to the certification requirements and the criminal penalties for non compliance.
Financial assistance subject to solvency test. Whether provided under s 76 or s 107, financial assistance is subject to the double solvency test. This represents a major change from previous law. The 1955 Act forbade financial assistance in order to protect creditors. However, the exceptions to the prohibition were not subject to the capital maintenance rules applicable to dividends, reductions of capital or redemptions. The 1993 Act allows financial assistance but requires compliance with the same capital maintenance rules that apply to distributions. Further, the solvency test is modified in two important respects for application to financial assistance. The rationale for the application of and the modifications to the solvency test in the case of financial assistance are evident when one analyses the potential impact of the transaction upon the company’s creditors. Consider the most blatant form of financial assistance in the circumstances of the example.
Example. P causes the company to lend her $30,000 for the purpose of funding the purchase of shares from V.
This loan represents a double threat to creditors. On the one hand, it reduces the cash that would otherwise be available for payment of debts in ordinary course. In this regard, the loan exposes them to the same risk as a dividend of $30,000 and implicates the trading limb of the solvency test. On the other hand, unlike a dividend, the $30,000 loan results in the company’s acquisition of asset of notionally equal value, ie the repayment obligation of P. However, this asset is of questionable worth in the event of liquidation. The financial position of P is usually linked to that of the company. The same lack of personal assets that called for the assistance in the first place will leave P dependent on returns from the company to repay the loan. These returns will cease as soon as the company becomes financially distressed. In the event of the company’s insolvency, the loan will be a worthless asset. In the unlikely event that P has any own funds or own property, these will be taken by company creditors in satisfaction of P’s obligations under the usual guarantees of the firm’s debts. The financial assistance loan will, just like a dividend, have resulted in a diminution of the company’s net assets, the problem that drives the balance sheet limb of the solvency test.
Financial assistance as equivalent to a buyback. An additional or alternative rationale for application of the solvency test can be found in the functional similarity of financial assistance and the purchase of own shares. The Greene Committee was of the view that financial assistance amounted to a circumvention of the then common law proscription of share buybacks.10 This concern is also reflected in the 1993 Act which, whilst it abolishes the prohibition of financial assistance, regulates the transaction by means of rules very similar to those applicable to share buybacks. The functional comparability of buybacks and financial assistance is easily illustrated by reference to the example. Up to this point, the discussion has presumed that the change in control would be implemented by a purchase of shares financed by a company loan. However, as noted at the outset of the previous chapter, the same result can be achieved by means of an issue/buyback scheme. V and P would enter an arrangement pursuant to which V causes the company first to issue P shares for $20,000 and then to purchase V’s shares for $50,000. As the only difference to the financed share sale, the company has not acquired a loan receivable asset. Were the transfer of control implemented in this manner, the buyback feature clearly involves a distribution subject to the double solvency test. A purchase of own shares poses exactly the same risk for creditors as a dividend. Creditor protection would be seriously undermined if a share repurchase could be restructured as a financially assisted purchase of shares without regard to the solvency test.
Modification of the solvency test for financial assistance. Sections 77(b) and 108(5) modify the solvency test in two respects for its application to financial assistance. First, in the balance sheet limb, the asset component excludes all amounts of assistance given by the company in the form of loans. In the absence of this change, financial assistance in the form of loans would have no impact on the balance sheet as it would entail a reduction in cash which would be offset by an equal increase in loan receivables. The modification is warranted in view of the linkage, discussed earlier, between the financial affairs of P and those of the company. The loan receivable asset will be rendered worthless by the company’s insolvency, the very situation which drives adoption of the balance sheet limb, ie, to insure that in the event of business failure the company is left with assets sufficient to pay creditors. As the second modification, the liabilities component in the balance sheet test includes the face value of all outstanding liabilities whether contingent or otherwise incurred in connection with the giving of financial assistance. This change is particularly important in connection with guarantees and security arrangements. Where, as in our example, the company guarantees and/or provides security for V's debt, that security and guarantee would qualify as contingent liabilities under generally accepted accounting practice. In the application of the balance sheet test, the value of the liabilities could be discounted under s 4(4) by reference to the possibility that the contingency would not occur. The modified rule prescribes any such discount. This modification is warranted for the same reason as the first one. Due to the linkage between the financial fortunes of P and those of the company, liquidation of the company—the event anticipated by the balance sheet test—makes all but certain that the security and guarantee will be enforced. This would not be the case where the company had secured or guaranteed the obligation of a person whose financial fortune was wholly unrelated to that of the company. As a matter of creditor protection, the modifications to the solvency test should apply to all inside debt at least in closely held companies. A loan to a director to pay a family medical bill poses the much same risk to creditors as one to purchase shares in the company. This rationale explains the regulation of inside debt found in many overseas statutes.11
The proposed assistance under the balance sheet test. The solvency test poses, at least initially, an obstacle to the implementation of the proposed financial assistance.
Example. It is proposed that P put $20,000 of own funds towards the purchase, borrow either from V or a third person the remaining $30,000 and cause the company to guarantee that indebtedness and to secure it by a second-ranking debenture over the company's assets.
The one modification to the solvency test requires that the contingent liability represented by the guarantee be taken at face value of $30,000. The other modification prevents the company's right of indemnification under that guarantee being counted as an asset. In connection with the balance sheet limb, the issue arises whether the security represented by the second-ranking debenture counts as a liability, presumably a contingent liability. Secondly, if it does so qualify, is it counted separately from the contingent liability represented by the guarantee? An arrangement which takes security over company property but does not impose a personal liability on the company [ie the essence of nonrecourse lending] should surely be viewed as a liability in view of the legal obligation relating to the property and the relative certainty of the economic sacrifice.12 Accordingly, even in the absence of the guarantee, the security should be treated as a $30,000 liability in the balance sheet test. Under the circumstances, the security is not a nonrecourse one inasmuch as it secures the company's guarantee. Where a security is ancillary to a personal obligation, the two are treated as a single liability. Accordingly, the proposed financial assistance will, for purposes of the balance sheet test, increase the company's liabilities from $80,000 to $110,000. As this exceeds the $100,000 figure for the company’s assets, the proposed financial assistance will, ceteris paribus, cause the company to contravene the balance sheet test. This will expose P to liability under s 56 in her capacity as both director and shareholder.
Revaluation of assets and the balance sheet test. A revaluation of the company’s assets is the obvious solution to this difficulty. The proposed assistance will satisfy the balance sheet test if the assets are valued at $110,000 or more. The valuation of assets is a decision that lies with the board under s 128. Under the circumstances, a revaluation of the assets from $100,000 to $130,000 would be entirely defensible. The best evidence of value is the price actually agreed upon by a willing buyer and willing seller in an arms-length sale. In the absence of an actual sale, the standard is applied on a hypothetical basis, ie by an inquiry as to the value at which a willing but not anxious vendor would sell and a willing but not anxious purchaser would buy under the circumstances with reference to transactions in respect of similar properties.13 However, in the present situation, there is an actual transaction that can serve as the basis for the revaluation. V and P have contracted, at arms length, for purchase and sale of V’s shares at a price of $50,000. This represents the parties‘ estimate of the going concern value of the company's net assets. Given that the parties accept the company’s liabilities at their face value ($80,000), this means that they have ascribed a value of $130,000 to the assets. Provided that the sale is truly an arms-length one under which no party suffers an information disadvantage, the revaluation is relatively immune from challenge. Should the parties wish to obtain further comfort, ie with a view to an eventual claim by the liquidator under ss 137 and 300, they should seek the opinion of an independent valuer. In the presence of an arms-length sale of the shares, they are likely to find an opinion that supports a revaluation of the assets to the desired level.
The proposed assistance under the trading test. The application of the trading limb of the solvency test varies with the nature of the financial assistance. In the example, the financial assistance can take the form of a loan to P who would use the proceeds to pay the price owing for the shares under her contract with V. Alternatively, the company can guarantee and/or secure a third party loan to P who would use the proceeds to pay V. The two transactions are treated identically under the balance sheet limb. However, this is not true in relation to the trading limb. The company loan alternative involves a cash outgoing that impairs the company’s present ability to discharge its debts in ordinary course. In contrast, financial assistance in the form of a guarantee and security, as they entail no cash outgoing, do not implicate the trading limb. On the other hand, enforcement of the security or guarantee will inevitably cause the company to default on its obligations to other creditors. However, it seems clear from s 76(5) that the solvency test applies at the time the security and guarantee are put in place rather than as of the time when they are enforced.
The sequencing of dividends and financial assistance. In some common situations, the impact of the financial assistance rules depends on the sequence of the various steps in the payment component of the sale and purchase.
Example. In the share sale scenario, suppose that the parties have agreed on a price of $30,000 for the shares in V Ltd. On execution of the agreement, P will pay $5000 out of her own funds. An additional $10,000 is due in a fortnight. P intends to fund that payment of a dividend in the same amount. The balance of $15,000 is due one year hence and P’s payment obligation is to be guaranteed by the company and secured by a charge over its assets.
In this case, the operation of the financial assistance rules, triggered by the guarantee and security, may depend on whether the assistance is implemented before or after authorisation of the dividend. Suppose the dividend occurs first. Provided that the $10,000 outgoing does not impair the company’s ability to pay its current debts, the dividend leaves the company in compliance with the solvency test. After the dividend, the company’s books will shows $90,000 in assets funded by $80,000 in liabilities and $10,000 in shareholder funds. However, once the dividend is paid, the company cannot, without a revaluation, provide the proposed financial assistance. That assistance will, with the modifications to the balance sheet limb in ss 77(6) and 108(5), increase the company’s liabilities to $95,000 and leave its assets at $90,000. Now suppose the order of the dividend and assistance is reversed. Provision of $15,000 in financial assistance complies with the balance sheet limb as it increases the liabilities to $95,000 but leaves assets at $100,000. Now P must determine whether a $10,000 dividend will contravene the solvency test. This depends on the state of the company’s assets and liabilities. For accounting purposes, the books will show the contingent liability represented by the guarantee and security. The books may also show as a contingent asset the company’s indemnification right against P. We know that, for purposes of applying the solvency test to financial assistance, the contingent liability must be counted at its face amount and the contingent asset disregarded.
A troublesome issue. The issue is whether these modifications continue to apply when the solvency test is applied to the subsequent authorisation of a $10,000 dividend. If they do apply, the dividend will contravene the balance sheet limb because it will decrease the assets to $90,000 that is less than the $95,000 in liabilities. The dividend cannot proceed unless the board revalues the company’s assets. On the other hand, if the modifications do not apply in the dividend determination under s 52, then the contingent liability can be valued with regard to factors such as the likelihood of the contingency’s occurrence and the enforceability of contingent asset. The board could well decide that, whilst the contingent asset has a zero value, there is no more than a 40% chance that the guarantee will be enforced. Accordingly, the board would discount the contingent liability to $6,000. In this scenario, a $10,000 dividend would leave the company with $90,000 in assets and $86,000 in liabilities. The dividend could be paid without a revaluation of the company’s assets. As a matter of statutory interpretation, the answer is relatively clear. The modifications in ss 77(6) and 108(5) are only stated to apply to the decision to grant financial assistance. Further, ss 77(7) and 108(5A) provide that the modifications do not limit or affect the application of s 4(4). Finally, there is nothing in s 4 that requires that the modifications be carried forward on the books of the company for other applications of the solvency test. This is of course a rather dubious result. A reordering of the two transactions does not effect their combined threat to the company’s creditors, particularly where, as in the example, the two transactions can be implemented within minutes of each of other.
Creditor protection in the asset sale. The rules on financial assistance seek to protect creditors from the risks, described earlier, which arise when company assets are used to finance a transfer of shares in the company, particularly a controlling parcel. The presence of these rules and the draconian consequences of non-compliance under the 1955 Act undoubtedly contributed to the fact that the asset sale became the preferred vehicle for the transfer of an undertaking. As the rules do not apply to financed asset sales, one might reasonably assume that this alternative does not pose the same threat to creditors as the financially assisted share sale. However, this is not the case. The effect of a financed asset sale on company creditors varies according to the treatment of the company’s debts, particularly the secured ones. All of the company‘s existing security agreements will contain a covenant pursuant to which any transfer of assets requires the prior written consent of the secured party. The secured party will, more often than not, refuse to consent unless the debt is paid in full. As a result, many asset sale transactions anticipate that the assets will be sold free of all encumbrances at their book value plus whatever premium is paid for goodwill. This is the position adopted by the REINZ/ADLS standard form that provides that the vendor warrants good title to all the assets.14 In the transaction posed by the example, the price would be $130,000. The purchaser will finance the acquisition by means of own funds and borrowings against the clean titled assets. In this situation, the asset sale poses little or no risk to the existing creditors of the company as the proceeds are more than sufficient to discharge the $80,000 of liabilities.
Possible impact on creditors. In an alternative scenario, however, the parties agree to the sale of assets subject to all existing encumbrances. P will assume primary liability for payment of the company’s obligations, particularly the secured ones. Under this scenario, the business would be sold at a price of $50,000, the same as that paid in the share sale transaction. Purchaser P would invest $20,000 of her own funds and finance the balance with an extension of credit, either from V Ltd or a third party, which would be secured by the unencumbered value of the company’s assets. This alternative exposes the company’s creditors to precisely the same risk as the share sale alternative discussed above. However, it can be implemented without regard to rules applicable to financially assisted share sales. Nevertheless, unsecured creditors probably fare better in financed asset sales than financed share sales. They benefit, incidentally, from practice under the negative pledge clauses in security agreements over the assets. In most situations, the secured creditor will consent to the transfer only on the condition that their debt is paid in full. As reflected by the REINZ/NZLS standard form, this results in a sale of assets free of any encumbrances. The sale will be priced at a figure that produces, in the case of a successful business, proceeds sufficient to pay both the secured and unsecured creditors.
Doubts about the solvency test. This discussion casts some doubt upon the efficacy of the solvency test as applied to financial assistance. The balance sheet limb will pose a obstacle whenever, as in the example, the price of the shares exceeds the sum of own funds which P can invest in the transaction and the balance sheet entry for shareholder funds. However, in such a case, the fact of a concluded sale will support an asset revaluation that brings the transaction into compliance with the balance sheet limb. So long as the assistance takes the form of a guarantee or security, it will not run afoul of the trading limb. In short, as applied to the most common forms of financial assistance, the solvency test turns out to be completely nugatory. P has used company assets to finance her purchase of control. If the company succeeds, P will reap the rewards. If the company fails, it is extremely unlikely that the assets will realise anywhere near the appraised value and the loss will fall on the company creditors, in no small part because of the additional secured indebtedness involved in the financial assistance. Whilst the trading limb may pose a more significant barrier to assistance in the form of a company loan, the loan alternative is a purely theoretical one for the typical cash-strapped closely held company.
Sections 135 and 136 as constraints on financial assistance. One must also consider whether and to what extent financial assistance is constrained by the rules on trading and obligations under ss 135 and 136—
Section 135. Reckless trading. A director of a company must not—(a) Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company's creditors; or (b) Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company's creditors.
Section 136. Duty in relation to obligations. A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.
As traditionally construed, the rule in s 135 does not represent a significant constraint on the implementation of the proposed assistance. Section 135 is the successor to s 320(1) of the 1955 Act. Both provisions apply to conduct in the form of "carrying on" a business. It was generally accepted that s 320(1) was primarily concerned with the director who, in the face of insolvency, continues to operate the business.15 In this situation, as the shareholder's funds will have been exhausted, the business is being continued at the risk of the creditors. So interpreted, the section has little significance for specific transactions put in place while the business is solvent. However, it is relevant to note that a number of recent lower court decisions have, without discussion of the point, applied s 135 in cases which did not involve the carrying on of an insolvent business operation.16
Section 136 as applicable. Section 136 represents a potentially more significant constraint on some forms of financial assistance. It would not apply to loan assistance as that does not require the company to incur an obligation. However, s 135 would catch assistance in the form of a guarantee secured over the company’s assets. In that situation, s 135 will be contravened where the director does not have reasonable grounds for her belief that the company would be able to perform the guarantee when required to do so. Like the trading limb of the solvency test, the section is concerned with the company’s ability to pay its debts. As the provision is forward-looking, it clearly applies to contingent liabilities. However, s 136 looks further into the future than the trading test. That test looks at the ordinary course of business which is probably no longer than one financial period. Section 136 looks to the performance date of the particular obligation that may be years away. Also, the trading test and s 136 are concerned with the performance of different debts. The trading test addresses debts other than the debt that is being incurred, while s 136 addresses the incurred debt. Should s 135 be contravened, the director can, in the event of liquidation, be ordered to pay compensation under s 301.17
Section 136 as contravened by the proposed financial assistance. In the example, short of sufficient own funds, P must finance $30,000 of the purchase through an extension of credit from V or a third party. P proposes to cause the company to secure that credit by a guarantee and debenture over the company’s assets. Section 136 forbids P from proceeding unless she believes on reasonable grounds that the company will be able to perform the guarantee when it is required to do so. The provision clearly establishes a subjective/objective standard. P cannot comply with the provision simply by resolving that she honestly believes the company can perform the guarantee. The belief must be based on reasonable grounds which, in well established precedent under the predecessor to s 136, turn on the facts which P knew or should have known at the time of the decision.18 The background facts known to P will include the following:
The company’s assets will have been recently revalued, eg to $130,000, so that the proposed assistance does not contravene the balance sheet test. The assets are represented by $80,000 in liabilities and $50,000 in shareholder funds.
The provision of the financial assistance will add to the company’s debts a contingent liability of $30,000 in the form of the guarantee and associated security as well as a contingent asset represented by the company’s indemnification claim against P.
As all the company’s assets are already subject to one or more securities, the security for the guarantee will be a second or third ranking one.
The guarantee and security will be enforced only in the event that P defaults on the underlying obligation owed to V or the third party lender.
Having just agreed to buy the business, P will have access to historical and forecast financial statements that show that the company’s prospects are good at least in the near term. She will not have committed the company to any new venture or project that jeopardizes those prospects.19
There is nothing in these facts to put P on notice that the company, given its prospects and debt/equity ratio, would not be able to perform the guarantee if required to do so. However, there is one additional fact which changes that.
P intends to fund the loan repayments out of returns from the company in the form of salary or dividends.
So long as the company prospers, P will not default on her loan obligation. Contrariwise, if the company fails, default is inevitable. P will know or be held to know that the company will be required to perform the guarantee only in the event that the business ceases to be profitable. In light of this additional factor, it is very questionable whether P can harbour the belief required for compliance with s 136. If the business fails, it is almost certain that the company will be unable to perform the guarantee. Further, in that situation, there is little chance that the security interest provided by a second or third ranking debenture will yield more than a few cents on the dollar.
The two critical factors under s 136. Of the facts relevant to the reasonable grounds standard in s 136, two are particularly significant. These are (i) the use of company returns to service the loan obligation and (ii) the low priority of the security given for the guarantee. Given the other circumstances, the absence of either of these two factors would allow P to proceed with the transaction under s 136. For instance, even if the guarantee was triggered by the financial collapse of the company, P could reasonably believe in performance of the obligation where the security was a first ranking debenture. Where P serviced the loan from an outside source, enforcement of the guarantee would be triggered by a disruption of that income stream. This would be as likely to occur while the company was prospering and able to discharge the guarantee. Unfortunately, the two critical factors are present in most cases where a buyer resorts to a financially assisted share purchase as the acquisition vehicle.
Identity of the board. In the example, the transfer of the business by way of a share sale involves a number of discrete steps, one of which is the provision of financial assistance. That assistance involves execution of the loan documents, guarantee and security agreements along with whatever resolutions and certifications are required under the 1993 Act. The other steps include execution of the contract for purchase and sale, completion of the share transfer, entry of the transfer in the share register, V’s resignation from the board of directors of V Ltd and P’s appointment to the board. Except for execution of the sale agreement and the share transfer, the other steps require action by the board. However, it is the financial assistance component that particularly exposes the board to liability. The identity of the board which approves the financial assistance will depend on the sequencing of the documentation associated with the various steps. The composition of the board can be altered as the first step, the last step or at some intermediate step in the sequence. For instance, after execution of the sale agreement but before execution of the share transfer, V could appoint P as director of the company and then resign from the board. P would then be responsible for causing the company to undertake all the other steps in the transaction including the provision of financing assistance. At the other extreme, with P’s consent, V could remain director of the business after entry of the share transfer, cause the company to provide the assistance and then resign from the board whereupon P would appoint herself as director. Given the liability associated with the provision of financial assistance, the parties must be advised about the sequencing issue and its legal significance. In light of this advise, V will prefer to resign from the board as early in sequence as possible and P will prefer to ascend to the board as late in the sequence as possible. The issue is not so much one of principle as a matter of negotiation. For instance, where P cannot obtain outside finance and proposes to resort to company assets, V can and should insist on resigning from the board before implementation of the financial assistance.
Financial assistance as a dividend or fringe benefit. The financial assistance discussed in this chapter comprises a tripartite arrangement. In one common variant, it consists of a debt owed by P to V, the company's guaranty of and security for that debt, and the company's right of indemnification under law or contract against P. As between P and the company, another feature of the arrangement is the benefit that P derives from guarantee and security given by the company. The combined guarantee and security as well as the security standing alone may qualify as a dividend under s CF 2(1)(e)—
The making available by the company … of any property of the company for the benefit of any shareholder of the company to the extent that the value of the benefit enjoyed by the shareholder exceeds the amount or value of any consideration provided to the company by the shareholder for provision of the benefit.
This corresponds to the approach of the 1993 Act which treats financial assistance as a distribution, ie a benefit delivered to a member for which the company receives nothing in return. It is difficult to view the company's entitlement to indemnification, whether arising by law or contract, as consideration of equal value for purpose of s CF 2(1)(e). The dividend is a non-cash one and can carry attached imputation credits. The situation is not so clear where the financial assistance is confined to a guarantee by the company of P’s debt to V. The guarantee alone, even though it represents an economic benefit to P, does not qualify as a dividend under s CF 2(1) as it does not involve a distribution, disposition, making available or payment of company property. On the other hand, it could qualify as fringe benefit under the residual category in s CI 1(h): any benefit of any other kind whatever, received or enjoyed by the employee. While there is an issue whether the benefit is provided to P in her capacity as an employee, this may be resolved in the circumstances by the presumption in s CI 2(2). If so, the company is liable for fringe benefit tax at the rate of 49% on the value of the benefit. The fringe benefit would be valued under s CI 3(10) at the amount which a commercial institution would charge for such a guarantee.
Financial assistance under the accrual rules. Financial assistance also implicates the accruals regime. The debt owed by P to V clearly represents a financial arrangement under s EH 22. The guarantee and security given by the company to V qualifies as financial arrangement if the company is paid for the guarantee but otherwise not.20 The company's right of indemnification, whether it arises by contract or law, is a debt comprising a financial arrangement under s EH 22. Timing of income and deductions associated with P's payment of her debt to V will depend upon whether the parties qualify as cash basis holders. Remission of the debt will require a base price adjustment under s EH 45 and result in gross income for P under s EH 47(2). Under s EH 54, written-off debt will generally be a nondeductible capital loss for V, ie unless V is in the business of holding or dealing in such financial arrangements and is not associated with P. A base price adjustment by V is also required where the company pays the debt under the guarantee or V realises the security. The company is not in the business of giving guarantees. Accordingly, the company's payment will be a non-deductible capital expenditure under BD 2(e) if the guarantee is not a financial arrangement. If the guaranty qualifies as a financial arrangement, the payment will be deductible under s EH 47(4) to the extent of the income derived by the company from the fee or other consideration received. Similarly, payment of indemnification by P to the company will require base price adjustments by both parties. The negative outcome for P will not be deductible under s EH 47(4). For the company, the payment will be income under s EH 47(3) but will be reduced to zero under s EH 47(4) by its non deductible payment made under the guarantee.
A common practice. In situations such as the example, it sometimes happens that P arranges for the company to pay the instalments owing to V.21 The payments are usually debited to P’s current account. The payments are often made on an informal basis, ie unaccompanied by a board resolution which authorises and identifies the nature of the payment. Under these circumstances, it is not clear, for tax law or company law purposes, whether the payment represents salary, an advance or a dividend. As discussed in chapter XX, very different legal requirements and tax consequences attend these alternative characterisations. For instance, P’s liability to the company is increased by an advance not by remuneration or a dividend. Whereas any dividend must comply with the double solvency test under s 52, a salary payment or an advances need meet only the fairness requirement in s 161 unless the company provides the benefit under a s 107 assent. The failure to comply with these company law requirements entails both criminal and civil liability which varies from one alternative to the next. For example, whilst P has a fair value defense under s 161 in relation to unauthorised salary or advances, there is no comparable defense in relation to liability under s 56 for receipt of an unauthorised dividend.
Tax consequences also divergent. There is similar variation in the tax ramifications of the various alternatives. As a dividend, the payment is non-deductible to the company, taxable to P and subject to the rules of the imputation regime. As an advance, the payment is not deductible by the company and not assessable to P. However, the difference between the interest charged to P and the prescribed rate will comprise a deemed dividend or fringe benefit, according to whether P is a shareholder or a shareholder-employee under s CI 2(2). As salary, the payment is deductible by the company and assessed as gross income to P. If characterised as performance under the guarantee, the payment is a non-deductible capital expenditure for the company. If the company also remits its indemnification claim against P, this can give rise to gross income either as a dividend under s CF 2(1)(b) or by reason of a base price adjustment under s EH 47. Unless properly advised, P will be tempted to treat the payment as a deductible expense on the company’s return but not recognise any gross income on her own return. As this treatment is not appropriate for any of the alternatives, it will place either the company or P in default on their tax obligations.
A dubious reform. The 1993 Act reforms but, on the whole, probably does not appreciably improve the quality of the law governing financial assistance. On the positive side, the statute corrects the two most serious flaws under the 1955 Act. It abolishes the rule in Skilton and replaces the prohibition of financial assistance with regulation linked to the capital maintenance regime. These changes give effect to the creditor protection policy underlying the concern with financial assistance transactions and the functional equivalence of such transactions with other distributions. However, the reform does not significantly advance the interests of either creditors or shareholders. Even as modified, the solvency test does not represent a significant constraint. Common forms of assistance do not implicate the trading limb and any difficulties arising under the balance sheet test can be dealt with by an asset revaluation keyed to the purchase price. The modifications to the solvency test, whilst probably warranted as a matter policy, make outcomes depend upon arbitrary sequencing factors and unsettle the operation of the test in subsequent transactions.
The most significant flaw in the financial assistance regime concerns its relationship to other features of the statute. In the context of closely held companies, many forms of assistance qualify as director benefits under s 161 which entails financial and non-financial constraints quite different from those applicable under s 76. As discussed in the following chapter, this makes s 161 into a vehicle for circumvention of the rules on financial assistance. As a second problem, the fiduciary obligation generalised in s 131 will, if taken seriously, block kinds of assistance which, otherwise possible under s 76 as well prior law, pose little or no threat to creditors. As the third difficulty, the duty in relation to obligations under s 136 will, applied to common forms of assistance, pose a more significant financial constraint and provide greater protection for creditors than the solvency test. Indeed, as demonstrated by USA experience,22 the rules in s 131 and 136 probably render redundant a separate regime for financial assistance. As regards the sale and purchase of small businesses, the complexities of the current regime will undoubtedly perpetuate the bias in favour of the asset sale alternative.
1 A Borrowdale CCH Company Law and Practice Commentary (1999) para 16-685 [mortgage of shares].
2 The pledge, legal mortgage and equitable mortgage will all qualify as a security agreement which leaves the creditor with a security interest, even in the legal mortgage where the creditor has taken title to the shares. Personal Property Security Act 1999 s 16 (security agreement),.s 17 (security interest). The security interest attaches when, pursuant to ss 36 and 40, the debtor has rights in the collateral, value is given by the creditor and either the collateral is in the possession of the secured party or the debtor has signed a written security agreement. The attached security interest is perfected under s 41 when a financing statement is registered or the secured party takes possession of the collateral. Unlike the more modern overseas versions of this legislation, the statute does not contain a separate regime for attachment and perfection of security over securities. Cf eg UCC (1998 rev ed) s 9-314 [perfection by control for security interests in investment property].
3 Barnaby v Curtis (1988) 4 NZCLC 64,637 (HC) [loan as financial assistance].
4 Belmont Finance Corporation v Williams Furniture Ltd (No 2)  1 All ER 393 [sale of assets at overvalue]. Under the l955 Act, parties sometimes went to great lengths to avoid the prohibition against financial assistance in s 62. For examples of complex schemes held to comprise financial assistance, see eg Euro-National Corporation Ltd v NZI Bank Ltd (1991) 5 NZCLC 67,453 (HC), Securities Commission v Honor Friend Investment Ltd (1991) 5 NZCLC 67,512 (HC) and Equiticorp Industries Group Ltd v R (1995) 7 NZCLC 260,873 (HC).
5 Report of the Company Law Amendment Committee (HMSO Cmd 2657 1926) p 14.
6 Report of the Company Law Amendment Committee (HMSO Cmd 1749 1962) para 173.
7 Skelton v South Auckland Blue Metals Ltd  NZLR 955 (SC) [transaction void], Belmont Finance Corporation v Williams Furniture Ltd (No 2)  1 All ER 393 (CA) [constructive trust liability].
8 R v Worn unreported HC (T135-91, 7 May l992) affd unreported CA (CA121-92, 26 June 1992) [financial assistance]; Quin “Section 229A Crimes Act” 1996 NZLJ 330 [considering the scope of s 229A in commercial transactions].
9 Whilst failure to comply with s 161 does not, as such, constitute an offence, noncompliance removes the transaction from the exception provided by s 143(a) from the rules on self-interested transactions and expose the director to the penalties provided by s 140(4).
10 Trevor v Whitworth (1887) 12 App Cas 409 (HL).
11 See eg Gesetz betreffend die Gesellschaften mit beschraenkter Haftung 1892 (Germany) s 33a(1) [subordination of inside debt in insolvency proceedings]; Canada Business Corporations Act 1974-74 s 42 [prohibiting financial assistance to shareholders and directors for any purpose except where it would satisfy the solvency test].
12 But see Applying GAAP and GAAS (Mathew Bender l999) para 13.04 [In the case of leveraged leases, the lessor nets the nonrecourse acquisition debt with the receivable represented by the expected rental payments. Thus, the nonrecourse debt does not appear as a balance sheet liability.]. On LEXIS, this publication is available in GAPGAS file in the ACCTG library.
13 Holt v Holt (1987) 3 NZCLC 100,096 (HC) affd (1987) 3 NZCLC 100,107 (CA).
14 Agreement for Sale and Purchase of a Business (2ed Real Estate Institute of New Zealand & the Auckland District Law Society 1995) cl 6.1.2.
15 Re Casual Capers Ltd (1983) 1 NZCLC 98,590 (HC) and discussion in Chapter 11.
16 Re Wait Investments Ltd  3 NZLR 96 (1997) (HC); see earlier Nimbus Trading Co Ltd (1983) 1 NZCLC 98,762 (HC).
17 Unlike s 320 of the 1955 Act, s 135 does not include an enforcement provision. Noncompliance with s 135 amounts to a breach of duty for purposes of s 301 which authorises the Court to make a payment order against the director. Alternatively, as the s 135 duty is one owing to the company under s 169(3), it could be enforced by the liquidator under the general powers conferred by s 260 and the Sixth Schedule.
18 Re Petherick Exclusive Fashions Ltd (1987) 3 NZCLC 99,946 (HC).
19 Re Bennett, Keane & White Ltd (1988) 4 NZCLC 64,317 (HC).
20 McElwee v CIR (1997) 18 NZTC 13,288 (HC).
21 Porirua Concrete Products Ltd v Reeve (1983) 1 NZCLC 98,706 (HC), Barnaby v Curtis (1988) 4 NZCLC 64,637 (HC).
22 US v Gleneagles 565 FS 556 (MD Pa 1983) affd sub nom US v Tabor Court Realty 803 F 2d 1288 (3d Cir 1986); Blackwood “Applying fraudulent convenyance law to leveraged buyouts” 1992 Duke L J 340.