Definitions:
MOI – Memorandum of Incorporation
CIPC – Companies and Intellectual Property Commission
Target Company – Brooklyn
Company 2 – Durban
Company 3 – Pretoria
Company 4 – Mombasa
Company 5 – Lusaka
Ring fence – a virtual barrier that segregates a portion of an individual’s or company’s financial assets from the rest
Durban owns 60% of the issued share capital in Brooklyn (the target company). The rest of the 40% is held by a different company, Pretoria, making Brooklyn effectively owned by only 2 shareholders. There’s only 1 class of share with the same rights attached to it in issue according to the MOI of Brooklyn. The question is, should Durban who owns the 60% consolidate Brooklyn, as it would be considered a subsidiary?
This was the debate at a recent independent review of one of the venture capital companies we administer. The registered auditor was of the view that the target company should be consolidated into the company owning 60% and I was of the view that it shouldn’t.
The following sets out the rationale of why consolidation would not transpire, even though Durban owns majority of the share capital in Brooklyn. Durban was the company being independently reviewed.
IFRS Definition of Control
IFRS 10 sets out the following criteria for the purposes of consolidation:
An investor determines whether it is a parent by assessing whether it controls one or more investees. An investor considers all relevant facts and circumstances when assessing whether it controls an investee. An investor controls an investee when it is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.
An investor controls an investee if and only if the investor has all of the following elements:
- power over the investee, i.e. the investor has existing rights that give it the ability to direct the relevant activities (the activities that significantly affect the investee’s returns)
- exposure, or rights, to variable returns from its involvement with the investee
- the ability to use its power over the investee to affect the amount of the investor’s returns.
We both agreed that Durban met in part, criteria 1 and 2 and needed to establish if it met criteria 3 as well.
Can Durban use its power to affect the amount of its returns in Brooklyn?
To determine this, we needed to assess what rights existed in the MOI of Brooklyn, the composition of the board of directors of Brooklyn, transaction documents of the purchase of the shares in Brooklyn (and if a separate shareholders agreement existed), who controlled Durban and what rights existed to the shareholders of Durban as well, and we established this from Durban’s MOI.
- Brooklyn’s MOI
This was a standard MOI from CIPC with only one class of share giving the same voting rights to the shareholders who held those shares. There were no special rights granted to any shareholder. The shareholders had the same powers to also appoint the board of directors
- Board of Directors of Brooklyn
The board of directors of Brooklyn was made up of 3 of the directors of Pretoria, the company that owned the other 40%. They were all rightfully appointed by the shareholders. This was the first indication of who actually held control
- Transaction documents
We assessed if a separate shareholders agreement existed between the shareholders that would give rise to any special rights being granted to either. There was none. Further assessment of transaction documents revealed a ring-fencing of this purchase to a Class B of shares in Durban
Ring-fencing and control of Durban
To establish what gave rise to the ring-fencing of the transaction to Class B of shares in Durban, we had to undertake an exercise of assessing the governance documents of Durban and to do this, we looked at Durban’s MOI.
Durban had a custom MOI with various share classes, each with specific rights. The ones in issue were Class A and B. In effect, Class A shares were always issued at two-thirds (60%) of the entire share capital of the entity. Meaning, for every one share of any other class of share issued, two A shares would be issued. These were the management shares of the entity but did not grant the holder of these shares rights to any distributions nor dividends. This put the holder of the Class A shares to hold majority of the voting rights but have no claim as to the relevant, on-going economic benefits, except in the winding up of the company at which point they would share in the residual net assets after all investors had been exited and paid out. The rationale of this was to protect the holder of the management shares from the risk of being voted out, in order to continue to uphold regulatory requirements to protect the compliance of the company in line with the regulations it had to abide by.
The Class B shares in issue gave the right to the holders of these shares the right to be entered into the securities register as the registered holders thereof and gave rise to this being designated the “B” share portfolio. Any shares issued and funds raised in Class B gave each of the shares in issue the rights to vote on any matter concerning this portfolio. In effect, only the holders of A shares could vote together with the holders of B shares. Holders of other class of shares could not vote on any matter relating to the B portfolio. In particular, how investments concerning this portfolio could be conducted. It also gave the holders of these shares the right to participate proportionally in any distribution or dividends arising from the performance of the “B” portfolio.
Shareholding of Durban and control of Brooklyn
The shareholders of Durban were as follows:
- Class A shareholder (holding 100% of all class A rights) – Mombasa
- Class B shareholder (holding 76% of class B rights) – Pretoria
- Class B shareholder (holding 24% of class B rights) – Lusaka
With Pretoria holding 76% of the Class B portfolio, and the investment being ring-fenced to this share portfolio, it meant indirectly, Pretoria held 85.6% of the investment in Brooklyn as follows:
Directly held: 40%
Indirectly held: 76% x 60% = 45.6%
Total held by Pretoria in Brooklyn: 40% + 45.6% = 85.6%
Upon further analysis of the other Class B shareholder in Durban, Lusaka, holding the remaining 24%, it was revealed that the composition of the board of directors was the same directors who sat on the board of Pretoria. This therefore meant, the remaining 14.4% of the investment in Brooklyn was also controlled by the same board, making the entire Brooklyn investment, 100% controlled and directed by Pretoria.
Conclusion
Pretoria held control of the entire investment in Brooklyn. In essence and in line with IFRS 10:
- Power over the investee was held by Pretoria; 40% directly and 45.6% indirectly through the B portfolio in Durban
- Exposure, or rights to variable returns flowed 85.6% aggregated to Pretoria and 14.4% to Lusaka
- The ability to use its power over the investee to affect the amount of its returns was also largely held by Pretoria who controlled and directed Brooklyn’s activities and could give effect to the return that eventually flowed to Pretoria
With the establishment that Pretoria controlled 100% of the investment in Brooklyn, the auditor thereby agreed that Durban did not control Brooklyn and therefore, Brooklyn could not be consolidated into Durban.
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