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JOHN COHEN
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The Companies Commission can, by way of a compliance notice, order a company to stop carrying on business if it is unable to pay its debts as they fall due.

The provisions of the Companies Act of 2008 in regard to trading whilst insolvent.

When the new Companies Act 71 of 2008 was first published, one of the provisions that caused great concern was section 22(1)(b) which stated that a company must not -

trade under insolvent circumstances

It has come as a relief to many that in the Companies Amendment Act 3 of 2011 - which came into force at the same time as the new Companies Act itself - this provision has been deleted. In place of the deleted text, section 22(2) has been amended to provide that, if the Commission has reason to believe that a company -

is unable to pay its debts as they become due and payable in the normal course of business

then the Commission can issue a notice to the company to show cause why it should be allowed to continue carrying on business.

If the company then fails within 20 days to satisfy the Commission that it is indeed "able to pay its debts as they become due and payable in the normal course of business" the Commission can issue a compliance notice in terms of section 22(3) to the company requiring it to cease carrying on business.

Why did these provisions, in their original form, cause such concern, and how does the amended provision impact on businesses?

What does it mean to be "insolvent"?

The term "insolvent" has at least two meanings.

The first is what may be called "legal insolvency" or "balance sheet insolvency", which is the situation where the value of the debts of a business exceeds the value of its assets.

The second meaning of insolvency is commercial insolvency, which refers to the situation where the business cannot pay its debts as they fall due.

The commercial insolvency of a debtor is generally of greater concern to creditors than balance sheet insolvency.

Many individuals are insolvent in the balance sheet sense, without its causing the slightest inconvenience to them or the slightest concern to creditors.

For example - a young person starts his or her first job with little or nothing in the bank. With their first salary cheques, they buy a new car and new household appliances on credit.

They are now almost certainly insolvent in the balance sheet sense because they bought the car and the appliances new, and they are now second-hand and worth far less than the outstanding balance of the purchase price. Is this young person (or the finance house) concerned? Not in the least - this young person knows that his or her salary is enough to cover the monthly instalments. And as far as the finance house is concerned, all it cares about is that the monthly instalments continue to be paid on time. Whether or not the individual is solvent in the balance sheet sense is a matter of complete indifference.

Assume that, over the next several years, this young person buys a house to live in, and the house goes sharply up in value. He or she is now no longer insolvent in the balance sheet sense - the increase in the value of the house far outweighs what is owing on the appliances and the car.

But assume that this young person now loses their job; salary cheques stop and they are still struggling to find another job. They are now unable to pay the monthly instalments on the car and the appliances. Now, they (and the finance house) are worried, and with good reason, because this person is now commercially insolvent, even though he or she may still be safely solvent in the balance sheet sense.

Exactly the same applies to companies. There are many reasons why a company may - particularly in the early years of its business - be insolvent in the balance sheet sense, but able to pay its debts as they fall due. The company is therefore not "commercially insolvent". However, just as with the young person in the example given above, neither the company nor its bank or other creditors is likely to be greatly concerned at the balance sheet insolvency.

Section 22 in its original form and as now amended

The weakness of section 22(1) in its original form was that it said that a company must not "trade under insolvent circumstances" but did not make clear whether "insolvent" meant insolvent in the balance sheet sense or commercially insolvent.

If this provision bore the former meaning, and prohibited a company from continuing in business if it was insolvent in the balance sheet sense (even if it was not commercially insolvent), many companies throughout the country would have to close their doors. The consequences for the commercial sector (and indeed the national economy) would have been dire.

The amendment to section 22(2) now makes clear that this provision is concerned only with commercial insolvency and not with balance sheet insolvency. This is a great advance on the section in its original form.

Secondly, in terms of the amended provision, even commercial insolvency does not have an automatic impact on the company's right to carry on business.

The only consequence is that the Companies Commission "may" call on the company to show cause why it should be allowed to continue trading.

In its response, the company may well be able to provide a plausible and convincing reason why it should be allowed to continue trading despite its commercial insolvency. For example, the company may respond by saying that its major debtor has been slow in paying its invoices, but payment will be received shortly. Or, the company may say that it has experienced a sudden drain on its cash reserves because one of its depots burned down, destroying its trading stock, but that an insurance pay-out will shortly be made and the depot will be rebuilt.

As a general principle, but not a rigid rule, the law regards it as undesirable for a company that is unable to pay its current debts to be allowed to incur further debts. The issuing of a compliance notice by the Companies Commission requiring the company to stop carrying on business is a fast-track method of dealing with this mischief.

It also needs to be borne in mind that, for a company to incur a debt in circumstances where there are no reasonable grounds to believe that it will be able to pay when the debt falls due, constitutes reckless trading. In these circumstances, the court has the power in terms of section 424(1) of the Companies Act of 1973 (which remains in force notwithstanding the enactment of the Companies Act of 2008) to declare the responsible directors to be personally liable for the company's debts.

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