Post Redemption Obligation(s): a real pain in the $%# for any preference share finance transaction – Part 3

Securing the post redemption obligation and the “costs” thereof.

By: Morne Mc Grath, tax specialist

In Part 1 we discussed the general principles applicable to preference share financing transactions and the concept of a post redemption obligation while Part 2 dealt with the calculation methodology and the impact of section 99(4) of the Tax Administration Act(“TAA”) on the quantum and final discharge date (termination date) of the post redemption obligation. In this Part 3 we will discuss how the potential post redemption obligation has traditionally been secured by the Borrower (Issuer) in favor of the preference shareholder and the cost implications thereof. `

Introduction

The presence of a potential post redemption obligation creates an investment/credit risk for the preference share investor if/when such an obligation materializes. The preference investor’s required return is calculated based on no tax risk in respect of the dividends to be received. Once SARS taxes the dividends the preference shareholder will incur an “unintended” obligation and need to make payment to SARS of the assessed amount. Once payment is made to SARS the preference shareholder will be “out of pocket” and exposed to the ability of the Borrower to satisfy the post redemption claim (credit risk). The intention of the security arrangements is therefore to ensure that the preference shareholder be fully indemnified for any loss of return.

“Conventional” security arrangements for the potential post redemption obligation.

The security arrangements for a potential future post redemption obligation are negotiated and contracted for at inception of the preference share transaction on a “forward-looking” basis. It is impossible to predict what may occur in the future in terms of possible “events” that could impact the tax status of the dividends, and the preference shareholder will therefore approach the post redemption claim on a “worse case” scenario (maximum post redemption amount) when negotiating the quantum and final discharge date of the post redemption claim. The security arrangements may include one, or a combination of, the following:

1. the Borrower to place an amount on deposit with an acceptable bank equal to the maximum post redemption amount (quantum) and cede the deposit to the preference shareholder as security. Over time, as the maximum post redemption exposure reduces, the deposit can also be reduced to retain a 1:1 ratio. The deposit will normally be made on the date the preference shares are redeemed and carry a “normal” interest rate.
2. the Borrower may cede assets (other than cash) to the preference shareholder as security for the potential post redemption obligation. Where the underlying assets of the Borrower consist of listed or unlisted shares, for example, one can expect a 2-3 times ratio requirement by the preference shareholder to address the volatility in value of the said shares. If the maximum potential post redemption amount is therefore calculated to be say R100m the preference shareholder will require shares with a value between R200m-R300m to be ceded as security.
3. the Borrower (Issuer) can provide an acceptable 3rd party guarantee for the maximum potential post redemption amount to the preference shareholder.
4. combination of the above.
5. The future cashflows may be the source of security for the post redemption obligation where other security alternatives are not available. In the case of a Borrower, where its main asset is a long-term contract that generates cashflows over a term of say 20 years (power purchase agreement for example), the preference share investor will structure the security arrangement on the basis of ensuring sufficient cashflow be generated from the contract, in the 7 year period between the redemption date of the preference shares and the final discharge date of the post redemption obligation to satisfy a potential post redemption claim.

Requiring the redemption of the preference shares at least 7 years prior to the termination of the long-term contract effectively translates to the repayment of the preference share finance in year 13. In a conventional project finance loan, the repayment of the loan capital would normally be structured between years 15 to 20 and the redemption of the preference shares in year 13 will put enormous pressure on the Borrower’s cashflow and potentially force it into a refinance transaction. The unfortunate and profound consequences section 99(4)(c) of the TAA has on preference share transactions, in the alternative energy industry, is highlighted in this security arrangement.

The “cost” of securing the potential post redemption obligation.

The “conventional” security arrangements discussed above unfortunately comes at a cost for the Borrower and should not be ignored as part of the finance instrument decision-making. The cost can be an actual financial cost, an opportunity cost, or a combination. “Vanilla” loans do not have the same complexities in terms of a “post repayment obligation” and the Borrower should therefore consider whether the cashflow benefit generated from using preference shares is sufficient to compensate for the cost and complexities of preference share financing when making its final choice of finance instrument.

The “costs” of the security arrangements is discussed in i-iv below:

• where the Borrower places an amount on deposit with a bank (and cedes it to the preference shareholder on the redemption date) the interest to be earned by the Borrower on the deposit is taxable and the rate on such a deposit is normally low. The cash used to make the deposit could have been used to repay other expensive debt, pay dividends or finance new projects with a higher rate of return.
• ??where the Borrower cedes non-cash assets such as shares (listed or unlisted) the preference shareholder will require over-collateralization (2-3 times cover) to cater for the volatility of the security (movement in value of shares). The shares that are subject to the cession is effectively sterilized up to the final discharge date of the post redemption claim in the sense that the Borrower cannot sell those shares nor use them as collateral to raise any new finance. The Borrower will therefore be exposed to some serious equity risk linked to these shares that have been ceded to the preference shareholder.
• ? a third-party guarantee as contemplated in 3 above normally comes at a cost as the guarantor will normally charge a fee and/or require collateral in exchange for issuing the guarantee.
• ??? a “security” arrangement as contemplated in 5 will have serious cashflow implications for the Borrower because of the shorter term of the preference share finance. The Borrower will have to look towards its shareholders for an equity injection or conclude refinance by way of a loan. The cashflow benefits of preference share finance is reduced because of the shorter term of the preference shares and the Borrower may run the risk of non-deductibility of the interest incurred if the preference shares are refinanced with a loan.

Conclusion

Part 3 highlighted the costs, complexities and inefficiencies of the way post redemption obligations are currently secured. In Part 4 we are going to try and define the problem statement at the heart of the post redemption obligation (and securing thereof) problem and discuss potential solutions or at least improvements to the current treatment.