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The art of law - the courts do not rubber-stamp a directors' resolution that their financially distressed company is to embark on an attempted business rescue

Business rescue cannot be used simply to effect an informal winding up of the company

The business rescue provisions of the new Companies Act 71 of 2008 continue to come under scrutiny by the courts.

It is clear from the judgments included in the law reports that the courts by no means rubber-stamp applications for a company to enter the business rescue regime, and show that judges display a healthy scepticism as to the prospects of a successful business rescue where the proposed business plan is vague or unconvincing.

In this regard, it must be borne in mind that the business rescue provisions of the Act (see the definition of business rescue in s 128(1)) envisage a successful business rescue as achieving either of two possible outcomes - either that the company will be able to continue in existence on a solvent basis, or that the business rescue plan will secure a better return for creditors than would result from an immediate liquidation of the company.

A reasonable prospect of achieving either of these two objectives can serve as a basis for placing the company in the business rescue regime.

Employees, creditors and shareholders may pull in different direction

It is safe to assume that, in almost every case, the company's employees will be in favour of business rescue for, if the company is placed in liquidation, they will immediately lose their livelihood. On the other hand, if the company undergoes an attempt at business rescue, the employees will, at the least, be given a breathing space in which they can attempt to find another job - and perhaps decide to jump ship in anticipation of its sinking.

Creditors of a company, on the other hand, may be opposed to any attempt at business rescue, firstly, because a moratorium will be placed on their right to enforce payment of what they are owed (which may cause them, in turn, to suffer financial distress) and, secondly, because an unsuccessful attempt at business rescue may further deplete the company's resources (not least because of the hefty fee that will be charged by the business rescue practitioner) leaving even less for creditors when the company is liquidated.

Shareholders of a financially distressed company will often favour business rescue for, if the company is liquidated, they will be at the tail end of the queue of creditors, and will get a return of their share capital (or part of it) only if and when all the company's creditors have been paid.

The decision of the KwaZulu-Natal High Court in Finance Factors CC v Jayesem (Pty) Ltd [2013] ZAKZDHC 45, in which judgment was handed down on 22 August 2013, is an illustration of how hard it is to convince a court that there is a reasonable prospect for a successful business rescue of a financially distressed company where the business plan itself holds out only a vague hope of extended viability, or envisages little more than the sale of the company's assets.

The two avenues of entry to business rescue

It needs to be borne in mind that a company can enter business rescue by either of two procedures.

The first is that a company can enter business rescue voluntarily in terms of section 129(1) where the board of directors, believing on reasonable grounds that the company is financially distressed and that there is a reasonable prospect of rescuing it, pass a resolution that the company be placed under supervision.

The second method is that an affected person (as defined in the Act) can apply to court in terms of section 131(1) for an order that the company be placed under supervision so that business rescue proceedings can commence.

The right to challenge a directors' resolution to embark on business rescue

Where a company enters the business rescue regime by the first route, the Act gives any affected person the right to apply to court in terms of section 130(1) for an order setting aside the board of director's resolution that the company enter business rescue.

In the judgment under scrutiny in this note, the board had passed a resolution that the company enter the business rescue regime, and the company's major creditor (whose claim against the company totalled some R51 million, of which some R12 million was secured by a bond and was not disputed by the company) had applied to court for an order setting aside that resolution.

It seems clear from the timing of the board resolution that the board was trying to pre-empt judgment being taken against the company by its major creditor, and wanted to secure the benefit of the statutory moratorium that is triggered by business rescue proceedings.

The sole director of the company resided in the property that was its major asset

In essence, the sole director of the company (who was also a substantial creditor of the company to the extent of some R4.5 million) averred in the sworn statement required by section 129(3)(a) that the company was financially distressed (for which he blamed litigation against the company by its major creditor) but that it was not insolvent because the value of its assets allegedly exceeded its liabilities.

It was furthermore averred that the company would 'most likely' be able to pay all its creditors if it were placed under business rescue and allowed to continue trading, unhindered.

Significantly, the company's major asset was a substantial residence occupied by its sole director - who was also the author of the board resolution that the company enter business rescue.

It requires little reading between the lines of the judgment to appreciate that, if the company did not enter the business rescue regime, its sole director's place of residence was going to be sold out from under him. It is also significant that, although this residence was the company's major asset and the basis of the assertion that the company was not insolvent, the director had not committed himself to putting it up for sale to generate the funds to pay the company's creditors.

The company's major creditor applied to set aside the board resolution

The company's major creditor had applied to court for an order setting aside the resolution by the company's board of directors that it enter the business rescue regime. The challenge to the resolution averred that there was no reasonable prospect of rescuing the company, and the court noted (at para [18]) that the creditor bore the onus of proof in this regard, that had to be discharged on a balance of probabilities.

The central issue before the court was whether the creditor had indeed discharged this onus of proof by showing that there was no prospect, based on reasonable grounds, of a successful business rescue - bearing in mind that, as was noted above, there are two alternative successful outcomes to business rescue.

The company's major creditor pointed out the weaknesses in the business plan

The most obvious way in which a creditor can show that there is no reasonable prospect of rescuing the company is to point to deficiencies in the business plan put forward by the business rescue practitioner.

In the present case, the court described the business plan (see para [24]) as 'unclear and vague in many respects'.

In particular, the plan included no commitment to sell the company's immovable property (the property used as a residence by its sole director) and, on the contrary, assumed that the lease in respect of that property would remain in place for the next three years.

The court remarked in this regard (at para [26]) that -

'The business plan, without expressly providing for a sale and on what terms and within what time, and indeed postulating and proceeding on the assumption that the lease will remain in place for the next three years, does not disclose a reasonable prospect for rescuing the first respondent. All it will achieve and ensure is keeping the lease intact for the benefit of the lessee.'

The court went on to comment (at para [27]) that, even if the company's immovable property were to be sold in the course of business rescue, this would offer no more than 'an informal kind of winding up of the company', outside the provisions of the Companies Act.

In this regard, Koen J said that he agreed with the statement by Brand JA in Oakdene Square Properties (Pty) Ltd v Farm Bothasfontein (Kyalami) (Pty) Ltd [2013] ZASCA 68 in which the latter said that he did not believe that -

'this could have been the intention of creating business rescue as an institution. . . . I do not believe that business rescue was intended to achieve a winding up of a company to avoid the consequences of liquidation proceedings ...'

Koen J pointed out that, in the present case, the dispute over the contested portion of the major creditor's claim might lead to ongoing litigation and considerable delay, whereas if the company were simply liquidated, the creditor would submit its claim which would then be objectively scrutinised by a professional liquidator and either admitted or rejected. Liquidation proceedings, said Koen J, were better geared for this kind of situation.

In the present case, said Koen J, it was clear that the major creditor would vote against the proposed business plan, thus making it 'an exercise in futility' and such opposition was highly unlikely to be regarded by a court as unreasonable or mala fide.

Koen J pointed out that, if the company's properties were sold for the valuation amount of R17.5 million, which would suffice to pay off all the company's liabilities, the company would be left with so little that it would be unable to continue its objective of being a property-holding company. No purpose, he said, would be served in allowing a business rescue plan that would achieve this result.

It followed, said Koen J, that the board of directors' resolution that the company should enter the business rescue regime must be set aside. He noted that the court had the discretionary power in terms of section 130(5)(c) to order that the company be placed in liquidation, and he proceeded to make a provisional winding up order.

Overview

It is difficult to avoid the overall impression that this was a case in which a financially struggling company, whose sole director resided on a rental basis in the property that was its major asset (and who was himself a substantial concurrent creditor of the company) was trying to stave off a well-nigh inevitable liquidation of the company for as long as possible so that he could remain living in the property, on the basis of a vague business plan that, even if it were carried through, would have left the company a mere shell with no prospect of fulfilling its stated objectives.

The proposed business plan, in essence, foreshadowed no more than an informal liquidation of the company, but without the safeguards and disinterested professional administration of a liquidator.

It is clear from this decision that, for a court to uphold a decision by the company's board of directors that it should enter the business rescue regime, the proposed business plan - if aimed at restoring the company to viability - must envisage more than simply an informal winding up of the company and the sale of its major assets.

If there is no prospect that the company will be able to continue in business, then a formal liquidation is the optimal process for selling its assets and dealing with disputed creditors' claims.

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