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The new Companies Act of 2008

The solvency and liquidity test - what it means and when it applies

The Corporate Laws Amendment Act of 2007 introduced a concept which has now been adopted in several provisions of the proposed new Companies Act of 2008, namely that of a solvency and liquidity test which the latter Act requires to be satisfied in a number of situations.

The difference between solvency and liquidity

Fundamentally, liquidity refers to a person's possession of or access to ready cash (as distinct from merely owning assets) with which to pay debts.

By contrast, solvency ordinarily connotes that, at a given point in time, the value of a person's assets exceeds his liabilities.

However, the word insolvent is used in at least two senses, namely balance sheet insolvency (where the value of a person's assets exceeds the value of liabilities) and commercial insolvency(where a person cannot pay debts as they fall due, irrespective of whether he is insolvent in the balance sheet sense).

It is possible to be liquid, yet insolvent in the balance sheet sense of the latter word.

For example, assume that I borrowed R10 million several years ago to buy shares whose value has now dropped to R3 million because of a decline in world stock markets. I still owe the bank the R10 million that I borrowed. My personal balance sheet may well show me as insolvent. But if I have a good salary, I may well be able to meet the loan repayments and my other debts as they fall due, and therefore be liquid despite being insolvent.

The converse is also possible - I could be solvent but illiquid. For example, my house is worth R7 million, and is fully paid for and I have minimal debts. But I have just lost my job, have no salary, and don't have enough ready cash to meet my monthly bills.

Creditors, generally, are not concerned with whether or not their debtors are solvent in the balance sheet sense, and are concerned only with whether they can pay their bills as they fall due.

All of the above holds true for companies as well as individuals.

However, there is this important difference. If a company is wound up on the grounds that it is unable to pay its debts, its shareholders and directors are not, as a general rule, personally liable to pay the company's debts, unless they have bound themselves as sureties for the company.

For this reason, a company's balance sheet solvency (and not just its liquidity) is a matter of concern to its creditors. If persons who supply the company on credit suspect that the company is heading for insolvency, they will not continue doing business with it except on a cash basis.

The solvency and liquidity test laid down in the Companies Act of 2008

The Companies Act of 2008 specifies the criteria that must be satisfied for a company to pass the statutorily defined solvency and liquidity test, and the circumstances in which the test is applicable.

Section 4 of the Act (as corrected by the pending amendment Bill) provides that a company satisfies the solvency and liquidity test at any given time if, considering all reasonably foreseeable financial circumstances of the company at that time -

(a) the assets of the company (or, if the company is a holding company, the consolidated assets) fairly valued, exceed the liabilities of the company (or, if the company is holding company, the consolidated liabilities), fairly valued, including reasonably foreseeable contingent assets and liabilities; and

(b) it appears that the company will be able to pay its debts as they become due in the ordinary course -

(i) for a period of twelve months after the date on which the test is applied; or
(ii) in the case where the company declares a dividend (or makes another kind of distribution) for a period of twelve months following that distribution.

The various provisions of the Act which impose the requirement of a solvency and liquidity test require that it be satisfied immediately after the transaction in question - in other words, that the transaction has not tipped the company into insolvency or illiquidity. And as noted above, the Act goes on to require that it must appear that the liquidity test, that is to say, the ability to pay debts as they fall due will also be satisfied for a period of twelve months thereafter.

The circumstances that require the application of the solvency and liquidity test

Section 22 of the Companies Act 2008 prohibits a company from trading in insolvent circumstances. Furthermore, the categories of transactions that will require that the solvency and liquidity test be satisfied include -

the provision of financial assistance to third parties for the acquisition of the company's own shares - for example, where the company lends money to a person to enable the latter to acquire the company's shares (section 44);

loans or other financial assistance to related parties, including subsidiary companies, holding companies and directors (section 45);

dividends or other "distributions" (as defined in section 1) to shareholders (section 46);

the issuing of capitalisation shares on terms whereby the recipient can choose whether to take the shares or to take cash (section 47);

share buy-backs - in other words, where the company buys back its own shares (section 48).

In each of these circumstances, the Act imposes a duty on each of the company's directors to apply his or her mind to the question whether, considering all reasonably foreseeable financial circumstances of the company at the time, the company will pass the solvency and liquidity test.

Directors and other persons who have a material influence in the management of the company therefore need to be constantly vigilant in regard to the following issues --

Is the company trading in insolvent circumstances?

Does a transaction that the company proposes to enter into fall into one of the categories, outlined above, which requires that the statutory liquidity and solvency test be satisfied?

If the answer is affirmative, have the directors taken account of the necessary information to enable them to make the requisite determination of the company's solvency and liquidity?

In making that determination, have the company's assets and liabilities been fairly valued when applying the solvency and liquidity test, and not just taken at book value, and has account also been taken of contingent assets and liabilities?

The "fair valuation" of the company's assets and liabilities that is required by the statutory solvency and liquidity test may be a complex exercise. It certainly requires more than just a cursory scrutiny by the directors of the company's balance sheet. Thus, the directors will need to ensure that the valuation takes account of, amongst other things, the value of the company's intellectual property, debts which have been incurred but are not yet payable, and the company's future liability under contracts that have not yet been performed.

The Act requires that, in circumstances where the solvency and liquidity test must be applied, it must "appear" that the company will be able to pay its debts in the ordinary course of business for a period of twelve months thereafter, or for twelve months after the company pays the envisaged dividend.

The directors are thus required, in effect, to carry out a prediction as to the company's continued liquidity for that extended twelve month period - a daunting requirement that some critics may say requires the directors to be clairvoyant. The Act is explicit in section 4(2) that the financial information to be considered by the directors in this regard (and clearly they will consider more than just financial information) must be based on the company's accounting records and financial statements, and therefore cannot be merely a hope or unfounded optimism.

The consequences for a director who fails to properly apply his mind to whether the company passes the solvency and liquidity test

In terms of the Companies Act of 2008 a director will be personally liable for any loss, damage or costs sustained by the company if the director acquiesced in the conduct of the business of the company in insolvent circumstances, or otherwise failed to vote against a resolution to which the solvency and liquidity test was applicable in circumstances where the company did not satisfy that test. (See section 44(6)(b);section 46(6)(b); section 48(7)(b).). Such personal liability extends not only to board members but, amongst others, also to members of management and others who significantly influence the management of the business of the company.

It is important to note that a director does not automatically incur this liability if, as matters turn out, the company is unable to satisfy its debts for the applicable twelve month period. The director will be liable only if it was reasonably foreseeable that the company would not be able to do so.

The court can also place such a director on probation in terms of section 162(7)(a)(i).

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