The Legal Implications of the Economic Realities of Artificially Manipulating a Decrease/Increase of Earnings Per Share - If Any

Although probably oversimplified, calculating "earnings per share" or the "earnings-per-share ratio" entails the activity of dividing the net profit of a company by the number of its issued shares. The economic reality is that companies may use innovation and creativity to lawfully engineer a better earnings-per-share ratio in order to attract more shareholder investments. Neither the Companies Act of 1973 nor that of 2008 makes any provision for the maximum or minimum amount of capital required to float a company, or the minimum number of shares that should be issued. This depends solely on the promoters' discretion of the number of shares that must equal the capital amount. It is therefore possible that the promoters may excessively exercise their discretion when deciding on the authorised share capital, and later tailor-make or financially engineer the share capital structure of the business to make it attractive to shareholders or future shareholders. After all, the law does not prohibit statutory financial engineering. The purpose of this article is therefore to consider section 75 in the Companies Act of 1973 - or its equivalent (section 36(2)) in the Companies Act of 2008 - and the topic of statutory approval for an artificial decrease or increase in the number of issued shares. Possible methods of preventing or limiting artificial increases in earnings per share are also suggested.


Introduction
Neither the Companies Act of 1973 nor that of 2008 makes any provision for the maximum or minimum amount of capital required to float a company, or the minimum number of shares that should be issued. This depends solely on the promoters' discretion of the number of shares that must equal the capital amount. 5 It is therefore possible that the promoters may excessively exercise their discretion when deciding on the authorised share capital, and later tailor-make or financially engineer the share capital structure of the business to make it attractive to 3 Smullen and Hand Dictionary 148. 4 Bannock, Baxter and Davis Dictionary 107. 5 Cilliers et al Corporate Law para 16.20. The rules of the JSE require shares to be issued for at least R1 per share -see Amalgamated Packaging Industries (Rhodesia) Ltd 1963 1 SA 335 (SR); Ex Parte Rietfontein Estates Ltd 1976 1 SA 175 (W); Companies Act 61 of 1973. shareholders or future shareholders. 6 For example, the earnings per share are calculated by dividing retained profits (net profit) by the number of shares issued. 7 Similarly, a shareholder of a listed company could divide the market price per share of a listed company by the earnings per share in order to calculate the investment attractiveness of a listed share, which is known as the "price-to-earnings ratio ". 8 This article considers possible methods of preventing or limiting artificial increases in earnings per share. 9 The word "artificial" in this instance is not meant in the sense of an artificially inflated turnover, but rather to denote the artificial engineering of the number of issued shares to increase the earnings-per-share ratio, without an actual increase in the company's turnover or in the net profits through normal business operations. The word "artificial" should therefore be understood in the context of clever financial engineering of the number of shares issued to the shareholders of the company. 10 First, however, it is important to consider the capital rule philosophy in South Africa pertaining to section 85 of the 1973 Companies Act as it was amended in Act 37 of 1999, and its significant contribution to the field of the maintenance of share capital in the 2008 Companies Act. 6 Walsh Key Management Ratios 82. The excess cash will increase the "total assets" as disclosed in the balance sheet. The return on total assets ratio will thus produce an indication of ineffective asset utilisation by the management to produce sales/turnover. A promoter is not required to have any business background or financial qualifications to float a company. 7 Benade et al Entrepreneurial Law 150. Although the company's constitution is a public document, the issue price par value is of no importance. This is clearly evident from the philosophy pertaining to no-par value shares. If an unlisted public company issues 20 million shares at 1c each, the earnings per share would be less than in the case of 10 million shares at 2c each.  In terms of these rules, the company may acquire its own shares (as a method to decrease the number of issued shares), if the financial ratios in section 85 have been adhered to. 11 The ratios as disclosed by section 85 as amended in Act 37 of 1999 are those most widely used in the financial industry to determine the financial position of a company before the company is allowed to acquire its issued shares, particularly the liquidity (cash in hand) and solvency ratios (assets exceed liabilities). The purpose of the "new" capital rules was to benefit the shareholders of the company without any prejudice to the company's creditors should the company decide to acquire its own shares. 12 However, it has become increasingly obvious that the acquisition of own shares has quite the opposite, positive effect by influencing the earnings per share directly. This has interesting implications in the light of section 85's requirement for creditor protection through the solvency and liquidity ratios.
Before section 85 was amended in Act 37 of 1999, section 85 had no liquidity or 11 Companies Amendment Act 37 of 1999; Pretorius et al Company Law (6 th ed) 121; Brews Takeover Regulation 28, 142. 12 Section 85(4) of the Companies Act 61 of 1973: "A company shall not make any payment in whatever form to acquire any share issued by the company if there are reasonable grounds for believing that -(a) the company is, or would after the payment be, unable to pay its debts as they become due in the ordinary course of business or (b) the consolidated assets of the company fairly valued would after the payment be less than the consolidated liabilities of the company." solvency ratios as requirements to support or validate a buy-back of company shares. 13 Yet there are also certain drawbacks to these ratios as statutory requirements. As the balance statement of a company discloses the financial position of that company only on a specific date, 14 an accountant can choose a date to "window-dress" the balance statement favourably so as to comply with the statutory ratios of section 85 as amended in 1999. 15 On the other hand, the balance sheet presents only a snapshot of the company's financial affairs on a specific day, and remains relevant until the next financial year-end (a twelve-month period). To neutralise the latter circumstance, one can argue that an auditor should instead disclose the weighted average cost of capital in relation to the internal rate of return in the company's balance sheet. If the internal rate of return is less than the weighted average cost of capital, this would imply that the company is unable to pay its debts as they become due, and should consequently not be allowed to acquire any of its shares. 16 Nevertheless, due to the difficulties associated with the correct calculation of an (1) For any purpose of this Act, a company satisfies the solvency and liquidity test at a particular time if, considering all reasonably foreseeable financial circumstances of the company at that time -(a) the company's total assets equal or exceed its total liabilities; and (b) it appears that the company will be able to pay its debts as they became due in the course of business for a period of -(i) 12 months after the date on which the test is considered. 19 The time period included in this section has implicitly introduced the relationship between the internal rate of return and the weighted average cost of capital. Even though it is not a requirement to disclose this relationship in any financial statement to determine whether the company will actually be able to comply with the twelvemonth time period, it is at least a continuous requirement up to the next financial year-end. If the internal rate of return is less than the weighted average of the cost of capital, we can assume that the company will not be able to service its debts as they become due -thereby breaching the twelve-month time period. 20 If it is able to pay its debts for a period longer than twelve months, this implies true company liquidity. 21 On the other hand, the requirements in section 4 or 85 can be avoided by making use of section 75 or its equivalent (section 36(2)) in the 2008 Act. Section 75 or section 36(2) requires no liquidity or solvency ratios nor a twelve-month time period as requirements to support or validate the decrease or increase in the number of issued shares. Due to the latter, the following question is posed: is the decrease or increase of issued shares an intra vires act? 19 Section 4(1)(b)(i) of the Companies Act 71 of 2008 also refers to 12 months. 20 Atkinson Financial Collapse 46: "Notwithstanding the apparent success of the use of ratio analysis in the prediction of company failure, it should be noted that some researchers comment that, while ratios of failed firms were found to be significantly different from those of non-failed firms, the ability of such ratios to predict failure was not so conclusive." In this regard, the internal rate of return should be calculated and compared to the weighted average cost of capital. If the internal rate of return is less, the forecast value of the company would be less than that of a company able to create a greater internal rate of return. 21 Black, Wright and Davies In Search of Shareholder Value 23: "We raise capital … sell it at an operating profit. Then we pay the cost of the capital. Shareholders pocket the difference." The greater the liabilities, the greater the weighted average cost of capital, and consequently, the less the profits. Also see Delport Verkryging van Kapitaal 205.

The old philosophy (1887)
One of the cornerstones of company law is the matter Trevor v Whitworth. 22 The Trevor case laid down a very important principle in 1887, although perhaps similar in part to section 48 of the Act of 2008, 23 when Lord Herschell stated the common-law principle that a company 24 is not allowed to buy-back its own shares unless a buyback is regulated in its constitution so as to allow for an intra vires act. 25 This "old" rule as stated by Lord Herschell required no true liquidity/solvency to legitimise the buy-back of shares. It required only an intra vires act to support or validate any buy back of shares, or else the transaction would be ultra vires and void in the common law. 26 Before it was amended in 1999, section 85 did not require an intra vires act to support or validate a buy-back of shares. On the other hand, section 75 required authorisation in the articles of association to decrease or increase the number of issued shares. If no authorisation was provided for in the articles of association, the decrease or increase constituted an ultra vires act. The same intra vires act is not per se a requirement in section 36(2) of the 2008 Act. 27 However, neither section 85 before it was amended (and after its amendment) nor section 75 seems to have been adequate in protecting the creditors of a company, since an ultra vires act could be set aside by the company in terms of section 36 of the 1973 Act . 28 In the 2008 Act, section 218 (2) simply states that any person who contravenes any provision of the 2008 Act is liable to any other person for any loss suffered, and section 218(1) continues that only a court has the power to declare an ultra vires act 22 Trevor void or voidable. Consequently, the following paragraphs consider whether section 85 as was amended or its equivalent in section 4, in economic reality, indeed offers sufficient protection for creditors stemming from any buy-back of shares. 29

The new capital rules introduced in 2008 and the need for a reason as a requirement to legitimise a buy-back of shares
As stated above, the legal aspects of section 85 were not adequate to conclude whether the creditor or the company would be prejudiced due to a buy-back of shares, 30 as it was possible for management to "window-dress" the balance sheet. 31 Irrespective of an intra vires act, the acquisition or buy-back depended on the balance sheet and whether the liquidity or solvency ratios had been met.
Interestingly, the Trevor case 32 considered a reason as an ancillary requirement to legitimise the acquisition or buy-back of shares. In that matter, Lord Herschell enquired as follows: "What was the reason which induced the company in the present case to purchase its shares?" 33 One such possible reason could be the prevention of a hostile takeover. Hostile takeovers have been covered in depth in law literature. The reason for the latter statement is simply that, in economic reality, directors are also shareholders of a company, whose shares bear a direct relation to their own interests. Thus, if a director is advancing the interest of a company, he or she is also advancing his or her own interest in that company. 38 Through additional allotment, the earnings per share will decrease, which makes for an easy argument against the additional allotment of shares. Besides the latter, section 85 or section 48 requires no valid reason for such a buy-back, and whether or not a buy-back contravenes the proper-purpose doctrine falls outside the scope of this article. 39 However, it should be noted that any artificial increase in earnings per share to attract possible investors/shareholders should be interpreted as being improper. 40 Section 52 of the 2007 Bill also does not prohibit any artificial increase in earnings per share. It states the following: Shares of a company that have been issued and subsequently re-acquired by that company, must be returned to the same status as shares of the same class that have been authorized but not issued. And the 2008 Act also does not prohibit any artificial increase in earnings per share.
Section 35(5)(a) states: Shares of a company that have been issued and subsequently acquired by that company, as contemplated in section 48, must have the same status as shares that have been authorized but not issued.
Similarly, section 48 (3) In the following paragraphs, the focus shifts to the financial position of a company as a reason not to allow for a buy-back of shares or a decrease in the number of issued shares in terms of section 36(2).

Financial obligations
The equity or shareholders' fund is calculated by deducting liabilities from assets as disclosed in the balance sheet of the company. The book value of a share is determined by dividing the equity by the number of issued shares. This method is used for both par and no-par value shares in order to determine the book value of a company's shares, 41 and can be illustrated as follows: 41 Marx Investment Management 131-151. There are five different methods to calculate the value of a share, and a specific method serves a purpose in a specific circumstance, ie for a business to be valued as a going concern or not.

Number of shares Equity Book value
100 R100 R1 per share *(100/100 = 1) In the Rabinowitz case, 42 the court used the book value and not the market price of the shares to determine their value. Although this may be correct, it should be noted here that the market price of a share is not a confirmation of the value of the company as a going concern, 43 but is merely used to calculate the current value of a listed share-capital company. This approach to calculating value is known as the market capitalisation of a listed company. 44 The following serves to illustrate this: this indicates grounds for a possible takeover bid, for example to acquire the company for R50 when the book value of its shares is R100 (see the table above).

Number of shares
Similarly, if the book value is less than the market cap, it indicates that the price listed for the shares is overvalued. In order to increase the book value of the shares the board of directors will largely focus on reducing the company's debt or liabilities.
As the debt decreases, the equity of the company will increase, since the amount of the liabilities deducted in the income statement will be less. Therefore, equity in the balance statement will increase. To illustrate this, the debt-to-equity ratio -which is also important to obtain a holistic view of the book value of shares -is used to spot artificial increases in earnings per share or book value per share. 46 Instead of altering the debt-to-equity ratio, for example by paying off the debt, the board of directors can use section 48 to alter the capital structure of the issued shares, and consequently artificially raise the issued shares' book value. Although capital or cash is required to fund the acquisition, this can easily be avoided by using section 36(2) of the 2008 Companies Act, which also alters the capital structure of 45 The market cap is calculated as the number of issued shares multiplied by the listed price per share. shares without any cash in return for shares. 47 Thus, section 36(2) is the focus of the following paragraph.

Altering the book value of shares without a buy-back
Section 75 of the 1973 Companies Act provides for altering the composition of the number of issued shares in relation to the share capital of the company. 48 Section 75(1) states as follows: Subject to the provisions of sections 56 and 102 a company having a share capital, if so authorized by its articles, may by special resolution-(c) consolidate and divide all or any part of its share capital into shares of larger amount than its existing shares or consolidate and reduce the number of the issued no par value shares; (i) convert any of its shares, whether issued or not, into shares of another class.
Section 36(2) of the 2008 Companies Act states as follows: The authorisation and classification of shares, number of authorised shares of each class and the preferences, rights, limitations and other terms associated with each class of shares, as set out in the company's memorandum of Incorporation, may be changed only byan amendment of the memorandum of incorporation by special resolution of the shareholders or the board of the company, in the manner contemplated in subsection 3 except to the extent that the memorandum of incorporation provides otherwise.
If the company has made use of section 36(2), the number of issued shares will be altered legally to "shares of larger amount", for instance 500 at R1 each converted into 250 at R2 each. To a potential investor, the result will indicate higher earnings per share (net profit divided by fewer shares), 49 producing a promising book value per share in the balance sheet. 50 The following

2649
The above also applies to earnings per share. Equity increases through company profitability, as was discussed earlier and was illustrated by the debt-to-equity ratio.
For example, if net profit is R1 000, earnings per share would be R4 per share (1 000/250). Compare this to 500 issued shares, which would work out to earnings per share of R2 per share (1 000/500). If a company is listed on the stock exchange and the listed price per share is R8, R8/R4 per share equals 2, compared to R8/R2 per share, which equals 4. In economic reality, the former simply is more investmentattractive.
Not only does section 36(2) influence the earnings-per-share ratio, but it affects other financial ratios as well. Section 36(2) can be utilised to alter the composition of the share capital of a company by converting certain shares into redeemable preference shares. Although the earnings-per-share ratio will be unchanged by the alteration, the return-on-equity ratio will be affected. 51   The following represent some guidelines as to which companies should ideally be allowed to buy back shares, and which not. The same rationale should be applied to the use of section 36(2). 53 Walsh Key Management Ratios 182. The stock market price of a share, divided by the book value of a share, must produce the same ratio when dividing the return on equity through the earnings yield.

A company experiencing fewer net profits than in previous financial years
A company that experiences fewer retained profits along with increased liabilities will command less financial leverage to conduct business continuously, 54  increased risk. The increase in liabilities should therefore increase the value of shareholders' equity at the same time. However, if the ratio/balance between debt and equity is increased beyond a prudent level -although this may indicate an increased earnings yield or a stronger return on equity -it will serve to reduce the total company or shareholders' value in the long term. than R0,5. The R1 is called "artificial investment attractiveness".

A company with a marginal or high growth rate
An increase or growth in the top line (the turnover) will increase the company's additional current assets (for example cash) with which to conduct business continuously. 57 It is therefore very important to understand in what way the company financed the increase (the growth) in turnover. 58 If the company did so by means of increased liabilities, its profitability may be negatively influenced if the anticipated increase in the top line is not achieved, resulting in a decrease in net profit. This would constitute a poor financial position like that in paragraph 5.1 above. On the other hand, marginal or high growth achieved through current assets will lead to net profits that are linear to the increase in the top line.
An increase in liabilities and a decrease in profitability will be an indication that the growth and profits are not in equilibrium and, consequently, the earnings per share will decrease. The board of directors must therefore adjust the growth rate of the company to yield favourable profitability results, as evidenced by the earnings-pershare ratio. Unless these circumstances are achieved, this type of company should also not be allowed to acquire its own shares as a method of artificially increasing the value of its shares. The same approach will be used to determine days to the payment of accounts and account payments received. After calculating all the days, these must be added up and the accounts paid deducted, indicating the number of days on which there must be sufficient cash. This number of days divided by sales, multiplied by 365, as well as the predetermined growth in sales will express the amount of cash necessary to sustain the cash-flow cycle.
The following section serves to explain the concept of artificial increases in more detail, before it is illustrated with reference to a case law example.

6
Linearity between assets, profits and growth as a requirement to allow a buy-back of shares

The concept
Establishing whether assets, growth and net profit are in equilibrium, or linear to each other, requires a simple financial calculation or mere common sense. 59 For example, if the current assets (cash) are being used adequately to produce an increase or growth in the top line, the direct result should be an increase in net profits or equity reflected in a promising earnings-per-share ratio.
On the other hand, if a company increases its liabilities to finance a buy-back of its own shares, this will affect the profitability of the company negatively. 60 Under such circumstances there will be greater pressure on the current assets to increase not only the top line 61 but to ensure that the additional liabilities deducted in the income statement will disclose favourable net profits. In an economic reality, the possibility arises that the current assets will not be sufficient to maintain previous profitability results owing to the additional burden of financing. 59 Rappaport Creating Shareholder Value 18. The cost of equity is 12%. To illustrate the 12% in practice, consider the following: The turnover of a company is R200. An increase/growth of 10% will increase the turnover to R220 (R15 investment). If the company invested R30, sales/turnover must be increased by 20% in order to create equity value. If sales increased by only 10%, although earnings per share may be higher, the value of the equity is less. This is because the amount of cash invested is neither equal to the growth rate nor at least 20%.

Case law example of non-linear assets, growth and profit
In the Rosslare case, 62 the assets, growth and profit of the company must be assumed not to have been in balance, owing to the fact that the company had redeemed a liability through allotting additional shares. The asset concerned was a block of flats in which a member/shareholder could occupy a flat without paying rent. The plaintiff argued that the occupation of a flat was in fact a reduction of the capital of the company. The court held that this was not so.
It must be respectfully stated that the case seems to have been decided incorrectly.
To illustrate why, the following liability example is again used. A liability places pressure on the top line/turnover of a company to produce sufficient net profits. If a liability is reduced, it follows that there will be increased net profits, evidenced by an increased earnings-per-share ratio. The increase in net profits stemming from the reduced liability will increase the earnings-per-share ratio. 64 Applying this logic to the case cited above, the occupation of a flat requires rent (growth) to be paid, and will consequently increase the top line linearly to net profits, which implies an increase in earnings per share. If rent is not paid, the asset or flat is not linear to the top line and, consequently, there is no increase in earnings per share. It is well understood that if rent is not paid, it dilutes the value of the lease agreement, and thus also the value of the shares of the company as a going concern.
Top line or additional 63 600 shares would have increased its earnings per share, as these 63 600 would not have been taken into account when calculating earnings per share. 70

Conclusion
The Companies Act of 1973 did not make any provision for a maximum or minimum amount of capital required to float a company, or for a minimum number of shares to be issued. 71 It is therefore possible for the promoters to excessively exercise their discretion when deciding on the authorised share capital, and later tailor-make (by buying back shares) or financially engineer the share capital structure in accordance with the business potential of the company, in order to generate an attractive earnings per share, especially in respect of listed companies.
This has not been altered by the Companies Act of 2008. Besides the latter statutory regulation, as was discussed earlier, it is consequently proposed that trafficking in shares (such as the buy-back of shares) must be prohibited if the purpose of a buyback is to artificially increase the company's investment attractiveness. 72 In addition, the buy-back of shares could easily be avoided by making use of section 36(2), which requires no solvency/liquidity ratios or any authorisation required in the memorandum of incorporation to amend the number of issued shares. 73 All that is required is a special resolution to amend the number of shares.