Incentivising employees: Phantom scheme or esop?

Incentivising employees: Phantom scheme or esop?

As we receive more requests from entrepreneurs who want to incentivise valued employees in an optimistic effort to either attract top talent, retain top talent or even benefit their business’ BEE status profile, we realised that the motive behind such incentives are not always aligned to the type of incentive instrument that entrepreneurs request. In this blog, we aim to provide you with a basic distinction between two popular incentive instruments, namely the phantom share scheme (“Scheme“) and the employee share ownership plan (“ESOP“) to assist you in electing the best instrument for your valued employees.

PHANTOM SHARE SCHEME

Beneficiaries of a Scheme are awarded notional shares or units (not real shares but rather units giving participant employees the right to certain cash bonuses). The notional shares are linked to the issued shares in the share capital of the company. The Scheme is essentially a cash bonus plan under which the amount of the bonus is measured by reference to the increase in value of the shares in the issued share capital of the company. Such notional shares ordinarily grant the holder the same economic rights and privileges equal to all other actual issued shares in the company on a 1:1 ratio.

Therefore, instead of issuing authorised shares in the share capital of the company, notional shares are created and then awarded to participating employees (with or without vesting conditions). No shares are factually issued or transferred to the employees. Employees do not become actual shareholders of the company. This is illustrated in the fact that  they do not receive rights such as ownership rights in the company; rights to inspect records of the company; rights to attend shareholder meetings, nor voting rights – which would result in less control or decision-making influence from beneficiaries. Employees do however, have the opportunity to receive cash bonuses in the actualisation of certain events, such as when profits are declared by the company or any other “liquidity event”.

A Scheme is an excellent tool for attracting top talent and motivating employees who do not have a particularly long serving history with the company. In this respect, the Scheme allows shareholders to retain complete control and ownership of the company. The flexibility of the Scheme ensures that an employee receives a cash-in-hand benefit without enjoying other shareholders rights.

EMPLOYEE SHARE OWNERSHIP PLAN (ESOP)

An ESOP structure allows participating employees to acquire actual shares in the share capital of the company. By virtue of holding actual shares, such employees will become part owners of the company, they will have voting rights in the company (involving them in decision-making) and they will benefit financially when dividends are declared, as well as during an exit or other liquidity events. An ESOP, as opposed to a Scheme, is potentially an excellent instrument for incentivising long standing employees who have material interests in the growth of the company. Our recommendation is that ESOP shares should only be awarded to trusted individuals as holders acquire much more extensive rights, for example, the right to inspect sensitive company documentation and records.

CONCLUSION

While other complexities may influence your election of setting up and implementing either an ESOP or a Scheme, we recommend that the instrument selected should be guided by each entrepreneur’s true intentions.

Pre-incorporation contracts: Contract out of personal liability

Pre-incorporation contracts: Contract out of personal liability

Published: 7 December 2018

Why use pre-incorporation contracts?

A company has no legal existence until it is incorporated in terms of the Companies Act, 71 of 2008 (as amended) (“the Act“). As such, any agreement it purportedly concludes prior to such incorporation is invalid and unenforceable. Fortunately, section 21 of the Act ameliorates this position by rendering agreements concluded by companies not yet incorporated valid. These are commonly called pre-incorporation contracts or pre-incorporation agreements (“PIA“). This has meant that potential company founders are given statutory authority to enter into agreements in the name of a company that is still to be formed. This is of huge practical importance given that a company that has not been incorporated yet can already secure business premises, contract for urgent corporate opportunities and even secure supplier agreements before it is incorporated. Such PIAs have also been said to encourage investor confidence. However, it is important for founders to protect themselves by contracting out of personal liability if the company is not subsequently incorporated or does not ratify the PIA post incorporation, among other reasons.

Personal liability in terms of section 21: Can it be avoided?

Section 21(1) of the Act provides that the individuals concluding a PIA may “enter into a written agreement in the name of, or purport to act in the name of, or on behalf of” a contemplated company. According to Venalex (Pty) Ltd v Vigraha Property CC and others [2015] 2 All SA 645 (KZD) if the PIA is concluded in terms of the Act, the individual(s) will be acting as an agent of a company not yet incorporated. Such individuals will in turn become “jointly and severally liable” if the contemplated company is not subsequently incorporated or fails to fully ratify the PIA post incorporation. In other words, all agents will be liable for any loss suffered by the third party because of the company’s repudiation. This is an unalterable provision of the Act meant to protect the third party to the PIA and means that agents cannot avoid such liability when using section 21 PIAs.

The only way to escape such liability is to structure the written PIA in terms of the common law principle, stipulatio alteri or contract as a principal (not an agent) for the benefit of a third party. This form, unlike the statutory section 21 version, does not provide the third party with disproportionate protection against the party(ies) acting for the benefit of the contemplated company. In terms of the stipulatio, there are no harsh consequences of personal liability for the parties acting for the benefit of the company that is yet to be incorporated. If the contemplated company is not incorporated, or it rejects the PIA upon incorporation, the contract simply falls away, unless otherwise provided in the written PIA.

How to ensure you are using the appropriate type of PIA

Structuring the agreement to clearly reflect the intentions of the parties as to the type of PIA can be done in various ways. In the Venalex case the court’s analysis concluded that the individuals acting on behalf of the company were not acting as agents in terms of section 21 of the Act, but that they contracted as “principals for the benefit” of the company that is to be incorporated, in terms of common law.

A way in which to determine if a court will declare an agreement to be a section 21 PIA or a common law stipulatio, is by establishing when the parties intended the PIA to give rise to contractual obligations. For example, when a newly incorporated company in a section 21 PIA ratifies the PIA (completely, partially or conditionally), such ratification happens retrospectively. In other words, performance obligations in terms of the PIA will be interpreted to have arisen from the time that the agent entered the PIA, not when the company ratifies it. If the PIA is not ratified or rejected within three months after the company is incorporated, there will be deemed ratification. If the company is not incorporated, or the PIA is rejected by the company, the agents become personally liable (together with the company, if incorporated) to the third party for any loss suffered.

In terms of the common law stipulatio, a newly incorporated company will have an election of whether to accept the PIA or to reject it. If the company accepts the PIA, then obligations to such contract will only arise from the day of such acceptance, not when the principals concluded the contract for the benefit of the contemplated company. If the company is not incorporated or it rejects the contract upon incorporation, the principals acting for the benefit of the contemplated company are not held personally liable, unless otherwise stated by the PIA specifically, and the contract will simply fall away. Lastly, the common law does not indicate a strict time period for election (in contrast to the statutory section 21 PIA), in that the election simply needs to be made within “a reasonable time”, without sanctions if not made. The stipulatio PIA can never be deemed accepted without the newly incorporated company’s knowledge if it fails to make an election within a reasonable time.

Conclusion

In conclusion, the court has previously stated that it will look at the written agreement when it exercises its discretion in determining whether the parties have concluded a section 21 PIA or a stipulatio alteri PIA, in the absence of such express provisions indicating their preference. Therefore, it is important to state clearly which form of PIA you are concluding. For the commercial attorney representing the person contracting on behalf of a company to be incorporated, it is important to structure the agreement in terms of the stipulatio. On the contrary, an attorney acting for the third party must insist on a section 21 PIA, given that it offers greater protection to such third parties.

Key changes proposed by the draft companies amendment bill, 2018

Key changes proposed by the draft companies amendment bill, 2018

Published 30 October 2018

The current Companies Act, 71 of 2008 (“the Act“) succeeded in lessening multiple regulatory burdens under the old Companies Act, 61 of 1973 (“the Old Act“). On 21 September 2018 the Department of Trade and Industry (“the Dti“) released the draft Companies Amendment Bill, 2018 (“the Bill“) to initiate a formal process of changes to the Act. If the Bill is adopted, it will be the third time that the Act is amended, with the first two sets of amendments being implemented by way of the Companies Amendment Act, 3 of 2011 and the Financial Markets Act, 19 of 2012. According to the Dti, the Bill proposes changes that will bring the Act in line with the current international corporate trends and close identified gaps in the Act. In addition, the Bill jettisons certain cumbersome resolution requirements. We have selected a few key changes proposed by the Bill to discuss in a little more detail. The Bill is currently available for public comment until 20 November 2018. We encourage business and stakeholders to tender their comments to the Dti on or before the due date.

Key proposed changes

On what day does the amendment to a memorandum of incorporation (“MOI“) become effective?

The Bill makes it clear that all amendments to MOIs (excluding MOI amendments that change the name of the company) will take effect 10 business days after lodging your notice of MOI amendment with the Companies and Intellectual Property Commission (“the CIPC“). If the CIPC, after the 10 business days have lapsed, has not endorsed the notice of MOI amendment or failed to reject it with reasons, it will be deemed to be effective. Presently, under section 16 of the Act and as contained in the options provided on the CoR 15.2 Notice of Amendment of MOI form, the MOI amendment takes effect on the date that the CoR 15.2 form (together with supporting documents) is filed with the CIPC, the date on which the amended registration certificate is issued by the CIPC, when the MOI amendment includes a name change, (with an estimated turnaround time of 25 days in terms of the CIPC’s website) or such later date as is indicated on the CoR 15.2 form. The applicant may elect one of these options.

This change is welcomed as it shortens the CIPC’s turnaround time and places a duty on the CIPC to act expediently. However, care must be taken with the “deemed effect” when the CIPC does not provide feedback within 10 business days. The silence of the Bill seems to suggest that such “deemed effect” shall be incapable of being rescinded even if the CIPC, in hindsight, has valid reasons to reject the MOI amendment application. This can have long term negative effects on the company in that it will be governed by a defective MOI without knowledge, as no obligation is created on the CIPC to endorse or reject the MOI amendment after the 10 business days have lapsed.

Transparency regarding directors’ and prescribed officers’ remuneration

Stakeholders will be happy to know that the Bill proposes the amendment of section 30(4) of the Act. This section currently provides for the remuneration and benefits disclosure of “each director, or individual holding any prescribed office in the company”. The amended wording provides that each individual director or prescribed officer must be identified by name when reporting about their remuneration and benefits in the annual financial statements of the company. In addition, the Bill introduces a new section 30A in to the Act which outlines a format for a public company’s directors’ remuneration report, which must be compiled for each financial year and presented to shareholders at the annual general meeting.

These proposed changes should be welcomed as they strengthen transparency in South African companies.

Court’s power to validate the irregular creation, allotment or issuing of shares

Shareholders will not be happy to know that the Bill proposes empowering the courts, upon application by an interested person, to validate the irregular creation, allotment or issue of shares when it is just and equitable to do so. A similar provision existed in section 97 of the Old Act. Presently, shareholders or in other cases the board, if they have the power to authorise shares, may pass a resolution to retroactively authorise invalidly issued shares. Under section 38(3) of the Act, shares that are issued in excess of the authorised shares set out in the MOI (and not retroactively authorised) are a nullity.

This proposed change undermines the powers of the shareholders to govern the company by passing resolutions and decide internally whether to authorise invalidly issued shares or not. The discretion of the court is also far reaching in that no clear meaning can be ascribed to the terms “just and equitable”. The proposed change is therefore not welcomed as it limits the powers of the shareholders at the peril of the court’s wide discretion.

Regulation of share buy-backs

The Bill proposes tightening the regulation of share buybacks by requiring a shareholders’ special resolution to be adopted if shares are repurchased from a director or prescribed officer of the company, or a person related to such director or prescribed officer. In addition, the same special resolution will be required if the share buyback entails an acquisition of shares in a company generally, except for in identified circumstances. Such circumstances are where a pro rata (equal) offer is made to all shareholders (or to all shareholders of a particular class), or if the buyback is in the form of a transaction effected in the ordinary course on a recognised stock exchange on which shares of the company are traded. The present position under section 48(8) of the Act is that a shareholders’ special resolution for repurchasing shares is only required where the shares are held by a director or a prescribed officer of the company, or a person related to such director or a prescribed officer and where the buyback involves the acquisition by the company of more than 5% of the issued shares of any particular class of the company’s shares.

Fortunately, the Bill extends the circumstances where a special resolution is required. The implication of this is that any shares in the company that are repurchased must be approved by a special resolution (provided that the repurchase doesn’t fall into one of the exceptions), i.e. irrespective of whether they are held by a director or a prescribed officer of the company, or a person related to such director or a prescribed officer.

These proposed changes should be welcomed as they provide further protection for shareholders to vote on share buybacks. They also reduce regulations where it might be unnecessary to pass a special resolution for efficient operational reasons.

Financial assistance within a group

Lastly, the Bill proposes that shareholders’ special resolutions are no longer required where a company gives financial assistance to its own subsidiary. Under section 45 of the Act, such financial assistance must be authorised by the board and shareholders by passing a special resolution.

The shareholders will not be happy about this amendment since part of their voting power will be limited. In addition, “subsidiary company” is widely defined in the Act and it is unclear if “own subsidiary” will carry a narrower meaning. A decision to tender financial assistance to a subsidiary is material and shareholders should be given the opportunity to vote on it. Although, this proposed amendment lessens regulations it should not be welcomed since it takes away the right of shareholders to vote on this decision.

Conclusion

The identified proposed changes in the Bill which are meant to make the Act more compatible with international corporate trends are in relation to increasing corporate transparency. However, some proposed changes limit shareholders’ rights which will discourage investors and are arguably not aligned to international standards. The Bill provides much needed clarity about when an MOI amendment take effect. Lastly, the Bill lessens regulatory burdens for effective operational means in that resolution approvals are reduced. However, some of the Bill’s dropped resolution requirements, particularly in requesting special resolutions for actions of the company, and empowering the court to validate invalidly issued shares, may come at a cost to shareholders’ rights.

A cautionary note on fractional shares

A cautionary note on fractional shares

27 September 2018

What is a fractional share / “shareholder”?

A fractional share is less than one full share. This implies that ownership in a single share is given to more than one person, for example, one share is divided between party A and party B rendering each the holder of 0.3 and 0.7 fractional shares in a profit company, respectively. The Companies Act, 71 of 2008 (as amended) (“the Act“) does not expressly forbid or regulate fractional shares. However, party A and party B cannot qualify as “shareholders” in a company for purposes of the Act. In terms of the Act, a shareholder “means the holder of a share issued by a company”. Such holder of a “share” must hold “one of the units into which the proprietary interest in a profit company is divided”. In other words, for a holder of equity to qualify as a shareholder in terms of the Act, the holder must hold at least one share and not a fractional share. Henochsberg on the Act also notes that a share cannot be divided into fractions.

Voting rights

Shareholders are generally entrusted to vote on any matter to be decided by the company. Such voting rights are defined in the Act as “the rights of any holder of the company’s securities to vote” on the proposed matter. A “share” is included in the definition of “securities”.

However, fractional shares do not enjoy general voting rights in terms of the Act. This means that issued fractional shares risk creating administrative anomalies when having regard to the total votes exercised on a resolution.

Section 37(2) of the Act states that each issued share of a company, has associated with it one general voting right, except to the extent provided otherwise in the Act or the preferences, rights, limitations and other terms determined in terms of the memorandum of incorporation (“MOI“). For our purposes, this section seems to suggest that fractional shares do not enjoy general voting rights given that an “issued share” must be at least one unit. This would result in party A and party B not enjoying general voting rights in matters to be decided by the company. Furthermore, we submit that if 40 holders own 2.5 fractional shares each in a company, they, in terms of section 37(2), are only entitled to vote using the two full shares for their voting rights, resulting in the other 0.5 fractional shares (multiplied by 40), being forfeited. How is the company meant to deal with these anomalies, if not otherwise provided in the MOI?

In addition, section 37(3)(a) of the Act states that every issued share has an irrevocable right of the shareholder to vote on proposals to amend the preferences, rights, limitations and other terms associated with that share. Applying the same logic as above, it would mean that for any proposed changes to the MOI regarding fractional shares, the holders of fractional shares will not be allowed to vote on such changes to their shares, subjecting their rights to the peril of other shareholders (if not otherwise provided for in the MOI).

Rectifying fractional shares issued

The good news is that an existing company which has issued fractional shares may still rectify this position by increasing the number of authorised shares (if needed); cancelling the currently issued fractional shares and issuing such numbers of whole shares to ensure the equivalent shareholding percentages in the company. This can be done by way of capitalisation shares in terms of section 47 of the Act. Alternatively, the company can resolve to make payment considerations instead of issuing fractional shares. This way, parties maintain their whole shares and receive monies instead of their fractional shares entitlement.

It is evident from the above that fractional shares will create a plethora of administrative difficulties for any company, resulting in wasted time and additional legal expenses. These can simply be avoided by issuing whole shares instead of fractional shares. To avoid finding oneself in a situation where fractional shares become an “option”, a company simply needs to authorise enough shares (we normally recommend millions) to enable initial and future issues of whole shares. If your company has existing fractional shares in issue, please don’t hesitate to contact us to help you solve this headache.