South Africa: Whether The Solvency And Liquidity Test Provides Sufficient Protection To Creditors And Minority Shareholders

The Companies Act No. 71 of 2008 ("the 2008 Act") reproduces a change from the standard of preserving the capital structure, to preserving the solvency and liquidity test, in comparison to its predecessor the Companies Act No. 61 of 1973 ("the previous Act"). Formally, companies were prohibited to: a) provide financial assistance for the purchase or subscription of its shares; b) from purchasing is own shares; and c) to make payments to members, other than by way of dividends paid from company profits. In the 2008 Act, the highest standards of corporate governance are encouraged and directors are at risk for personal liability should their conduct be in breach of the 2008 Act. Fundamental transactions such as take-overs, receive grander consideration, with essential changes to the take-over provisions contained in the previous Act. This applies predominantly with regard to evaluation rights for uncooperative minority shareholders and minority shareholding. New rules narrate mergers and amalgamations, allowing two companies to merge into one entity, provided that the solvency and liquidity test is satisfied and certain consents are attained.

Section 4 of the 2008 Act lays out a solvency and liquidity test for directors of companies to apply when embarking on certain transactions or actions. The solvency and liquidity test adopts a two pronged / two legged approach to circumventing "a company trading recklessly in insolvent circumstances in that it requires not only that the company is liquid, namely that it is able to pays its debts as they become due in the normal course of trading but also that it is solvent."¹ The test is quite prevalent in the 2008 Act.

The solvency and liquidity test in the 2008 Act reads as follows:

Its noteworthy to mention that the 2008 Act endeavours to stipulate the required financial information to be considered for the solvency and liquidity test, "the provisions are not that clear, apart from requiring the board to consider accounting records and financial statements satisfying the requirements of the 2008 Act and that the board must consider a fair valuation of the company's assets and liabilities. This leaves a lot of room for interpretation as to what can and should be taken into account when considering the solvency and liquidity test."³

The solvency and liquidity test encompasses two idiosyncratic tests - solvency and liquidity - which necessitate the solicitation of several factors intrinsic to each test. "Solvency requires a snapshot test of whether the assets of the company equal or exceed the liabilities of the company."⁴ Liquidity on the other hand is more of an onward viewing test that involves the valuation of whether the company "will be able to pay its debts as they become due in the ordinary course of business for a period of twelve months after the date following application of the Test."⁵

The solvency and liquidity test becomes particularly pertinent when a company happens to go into liquidation proceedings or business rescue under Chapter 6 of the 2008 Act. It is then that the liquidator or business rescue practitioner of the company, has the opportunity to set aside any irregular dispositions or disbursements that were made by the company prior to going into liquidation or business rescue, and in many instances he will investigate whether certain distributions, financial assistance and similar corporate actions or transactions made by the company complied with the solvency and liquidity test.

The board of directors of the company must declare a distribution, and not the shareholders. The company's Memorandum of Incorporation and/or shareholders' agreement can place further requirements on the company in relation to declaring distributions, for example, a distribution must also be approved by a special resolution of the shareholders. This does not, however, change the fact that the distribution must first be proposed by the board of directors and ultimately be declared by the board of directors.

The solvency and liquidity test is not a test which the 2008 Act requires a company to commonly satisfy at all times – it is applied when a company proposes implementing certain corporate actions listed below:

• financial assistance for the subscription of securities (section 44 of the 2008 Act)
• loans or other financial assistance to directors (section 45 of the 2008 Act)
• distributions to shareholders authorized by the board (section 46 of the 2008 Act)
• capitalization of shares (section 47 of the 2008 Act)
• company or subsidiary acquiring company's shares (buy backs or buy ins) (section 48 of the 2008 Act)
• amalgamations or mergers (section 113 of 2008 Act)

"As best as I can make out, the sections of the 2008 Act, that refer to the call for the application of the solvency and liquidity test set out in section 4...To my mind, the solvency and liquidity test, as described in section 4, is a device or told for the purposes of implementing the provisions or satisfying the restrictions imposed in or by those sections."⁶

Section 113(1) of the 2008 Act provides a clear condition that companies may merge only if the merged company or companies satisfy the solvency and liquidity test. This was confirmed in the case of First Rand Bank Limited v Wayrail Investments (Pty) Ltd where Vahed J held that the solvency and liquidity test is a tool for the purposes of implementing a merger or satisfying the restrictions imposed in or by the provisions of section 113 of Act.⁷ The shareholder approval requirement ensures better protection for minority shareholders whilst preserving flexibility for companies to effect fundamental changes without allowing the dissenting shareholders to frustrate the merger.⁸

It is clear from the wording of section 4 that the solvency and liquidity tests are objective and that both legs must be satisfied, in the aforementioned corporate actions. For example section 85(4) (a) and (b) of the 2008 Act guarantees that a company that is insolvent or illiquid, or which will become insolvent or illiquid as a result of the share repurchase, cannot proceed with the transaction. In Capitex Bank Ltd v Qorus Holdings Ltd, the court held that in view of section 85(1) of the 2008 Act, "an agreement relating to the acquisition by a company of its own shares is no longer, in itself, illegal or unlawful, but that a payment made in contravention of the liquidity and solvency tests as embodied in s.85 (4)(a) and (b) would result in the illegality of the share repurchase agreement."⁹ The onus and responsibly in ensuring that the share repurchases does not result in the company becoming illiquid or insolvent lies with the directors of the company. If the share repurchase does render the company insolvent the directors will be held liable (jointly and severally). The company in South Africa, however, commits no criminal offence as it does in other jurisdictions; nor is it directly liable to its creditors or shareholders. "In South African law, the directors do not owe any fiduciary duty to the creditors of the company."¹⁰

In terms of section 46 of 2008 Act a company may not make a proposed distribution to its shareholders unless (i) the distribution is pursuant to an existing legal obligation of the company, or a court order, or the board of that company has, by way of resolution, authorised such distribution; (ii) it reasonably appears that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution and; (iii) the board of the company, by resolution, has acknowledged that it has applied the solvency and liquidity test as set out in section 4 of the 2008 Act and reasonably concluded that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution.¹¹

The rationale behind the application of section 46, read with section 4 of the 2008 Act, is to safeguard the minority shareholders and/or creditors of a company. Should the directors of the company not abide by the provisions of section 46 of the 2008 Act it will result in such directors encountering liability for the unlawful distribution, to the extent set out in section 77(3)(e)(vi) of the 2008 Act. In order to hold directors personally liable for the unlawful distribution, section 46(6) of the 2008 Act provides that the director/s of a company must have (i) been present at the meeting when the unlawful distribution was approved, or participated in terms thereof and (ii) failed to vote against the unlawful distribution, despite knowing that the distribution was contrary to the provisions of the Companies Act.¹² On the interpretation of the requirements of section 46(6) of the 2008 Act, it is clear that all the provisions must be satisfied in order to hold the director/s accountable for their actions in respect of the passing of the unlawful distribution. The said sections confirm that pursuant to a company and/or director of a company having been (or ought to be) assumed accountable, one would apply to court for an order putting aside the determination of a director, in order for a creditor and/or minority shareholder to find relief.

A company would be liable to creditors for damages if the company, as a result of the unlawful distribution, is insolvent and illiquid. "Outstanding claims by the creditors against the company may lead to (i) the company being declared insolvent and leading to the institution of insolvency proceedings, in which case the liquidator would likely use section 218(1) to declare the unlawful distribution void, or (ii) the company applying to the court in terms of section 77(5) (a) for an order to set aside the decision of the board and reverse the distribution."¹³ It is uncertain in terms of section 46 of the 2008 Act where the liability of the directors (jointly and severally), exists in circumstances where the directors did not intentionally contravene the 2008 Act, or failed to utilise the solvency and liquidity test, pursuant to the unlawful distribution which then resulted, the company now being insolvent and illiquid. Even though the 2008 Act is silent on this scenario, directors should still be held liable and to rely on not having knowledge, should not be an acceptable excuse for the failure to apply their minds adequately. The 2008 Act sets out the duties of directors very clearly and directors should be au fait with their respective duties. The duties canvased in the 2008 Act are central to the overall achievement of a company and as a result the shareholders in countless occurrences rely on directors to make decisions and maintain the company in good order. Directors should acquaint themselves with the provisions of the 2008 Act.

In light of the aforesaid the solvency and liquidity test is reckoned to be a key safeguard for creditors, especially when one looks at merging companies as the companies would be prohibited from amalgamating or merging should either of the constituent companies fail to satisfy the said test.

The 2008 Act does not contain many offences that carry criminal sanction; however the personal accountability of directors has been increased in a categorised form. Directors (board members by definition) may be held personally accountable (jointly and severally) to the company for various acts and omissions as set out in the 2008 Act.

Unambiguously, section 218 (2) of the 2008 Act sets out that any person who contravenes any provision of the 2008 Act could be liable to any other person for any loss or damage suffered as a result of the contravention.¹⁴ A director may be held accountable to a company for any loss suffered by the company while trading under insolvent circumstances and may also be held liable to any third parties who have had dealings with the company and suffered loss as a result of the director's actions. It is therefore prudent that all directors apply their minds to the solvency and liquidity test when embarking on any of the actions set out above.

In Ex parte De Villiers NNO: In re Carbon Developments (Pty) Ltd¹⁵, it was held that the liquidity element fits in well with the representation a company is said to make when it incurs debt, which is, that it reasonably expects to be able to pay as and when the debt becomes due.¹⁶ Initially, the previous Act encompassed no specific time or period at which the solvency and liquidity test had to be met. This resulted in significant improbability in the application of the said test. The legislature espoused the time period from the United Kingdom and as a result the 2008 Act introduced the 12-month requirement to furnish directors with more certainty when applying the solvency and liquidity test, as a result affording protection to the creditors. Conversely, some academics challenge that the time period may disadvantage the creditors that have clearly conceivable longer-term commitments that are not payable within the said period.

Section 41 of the 2008 Act protects the interests of minority shareholders in that special resolutions are required for certain transactions within the company namely share and option issues to directors or other specified persons.

There is an interchange headed for the legalisation of company law and the formation of bodies for the operative implementation of the body of law. Nevertheless, minority shareholders and other stakeholders, such as employees, will have better safeguard, authorities and recourse under the 2008 Act including the ability to bring class actions. The application of the solvency and liquidity test "is in fact one of the primary forms of creditor protection"¹⁷ and as a general restriction on distributions adequately protects the interest of creditors.¹⁸

CONCLUSION

It appears that section 46 of the 2008 Act administering distribution and acquirement does not sufficiently protect the minority shareholders and creditors as the previous Act did. In terms of the 2008 Act, the board have more power, which is also attached to liability (jointly and severally). In terms of the 2008 Act shareholders (minority) and creditors are protected by the solvency and liquidity test, to a degree, as there can be no transaction/acquisition until both legs of the test is satisfied. As the 2008 Act is clear in its requirements that a company ought to be solvent and liquid before any dissemination is made and that it must remain solvent and liquid after the acquirement, as a result creditors are guaranteed that their liabilities will be fulfilled when they are due.

On the other hand shareholders are not as secure as the creditors. Shareholders (minority) are excluded in the assessment making of whether or not to acquire for example company shares. The shareholders (minority) are not afforded the chance to determine if the acquisition will be beneficial or not even though the business deal possibly will have an adverse effect on their interests. This may boost misapplication of the power of acquisition/re-purchase and some shareholders may participate in disobedience so as to increase or shift control of the company. The directors have unequivocal power in this matter and the shareholders are left to rely on the fact that the directors have to act bona fide and for the unsurpassed interest of the company or else be held liable (jointly and severally). The creditors and the shareholders (minority) can seek comfort in the fact that the 2008 Act places liability on directors if the transactions/acquisitions are in contravention of section 46 and 48 of the 2008 Act and they did not vote in contrast to it. There are some shortcomings in the legislature but as a whole the 2008 Act does provide for more protection for creditors and to an extent the minority shareholders, insofar as the liability imposed on directors and the two legged solvency and liquidity test.

Footnotes

1. Dingley Marshall 'The Solvency and Liquidity Test under the new Companies Act' available at https://www.dingleymarshall.co.za/the-solvency-and-liquidity-test-under-the-new-companies-act-2008/

2. The Companies Act, 71 of 2008 s4 (1)(a)(b)(i)(ii)(2)(a)(i)(ii)(b(i)(ii)(c)

3. Dommisee Attorneys 'Companies Act, 71 of 2008 Series Part 7: Distributions – A Few Important Points To Consider' available at https://dommisseattorneys.co.za/blog/companies-act-71-2008-series-part-7-distributions-important-points-consider/

4. Deal Makers 'Thorts – Debt vs Equity: the solvency and liquidity test' available at http://www.inceconnect.co.za/article/thorts---debt-vs-equity-the-solvency-and-liquidity-test

5. Ibid

6. First Rand Bank Limited v Wayrail Investments (Pty) Ltd 2012 SA 684 ZAKZDHC at paragraph 34

7. Ibid

8. Cassim et al Contemporary Company Law 2ed (2012); 691

9. Capitex Bank Ltd v Qorus Holdings Ltd 2003 (3) S.A. 302 (W) at 308I-309A.

10. F.H.I Cassim et al 'The Capital Maintenance Concept and Share Repurchases in South African Law' available at https://www.bowmanslaw.com/insights/the-capital-maintenance-concept-and-share-repurchases-in-south-african-law-by-f-h-i-cassim-and-rehana-cassim-2/

11. Ibid at 2

12. Ibid

13. Deal Maker 'Thorts - Ignorance is bliss, or is it' available at http://www.inceconnect.co.za/article/thorts---ignorance-is-bliss-or-is-it--2019-10-04

14. Ibid

15. Ex parte De Villiers NNO: In re Carbon Developments (Pty) Ltd (in liquidation) 1993 (1) SA 493 (A).

16. Ex parte De Villiers NNO: In re Carbon Developments (Pty) Ltd (in liquidation) 1993 (1) SA 493 (A) 504.

17. Van der Linde K "The regulation of conflict situations relating to share capital" 2009 South African Mercantile Law Journal 48

18. Van der Linde "Aspects of the Regulation of Share Capital and Distributions to Shareholders" (2008 thesis SA) 367 and 385

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