THE SOLVENCY AND LIQUIDITY TEST

Oct
20

THE SOLVENCY AND LIQUIDITY TEST

DISTRIBUTIONS AND THE SOLVENCY AND LIQUIDITY TEST PART 1

The solvency and liquidity test[1] (“the test”) is a new concept which was introduced into the Companies Act [2](“the Act”) and applies to distributions, share repurchases, financial assistance, mergers and acquisitions as well as cash payments in lieu of capitalisation shares.

Prior to making one of the above transactions the board of directors must acknowledge that it has applied the test and has reasonably concluded that the company will satisfy the test immediately after completion of the transaction. The duty of the board of directors has become onerous as at the time when the transaction is approved and when the transaction occurs is not immediate in practice. A result of the delay in the two steps will cause the resolution acknowledging the test to lapse.

The test will lapse if the distribution has not been completed within 120 business days and a new assessment must be done[3]. The continuous re-assessment of the test may be unnecessary and it may be more practical to only re-consider the test just before the transaction is completed.

The test is made up of two elements, namely solvency and liquidity. The solvency aspect of the test is a balance sheet test and one can easily look at the financial records of a company to determine if their assets exceed their liabilities, the second part of the test is a cash flow examination. The difficulty experienced by companies is that when applying the test they will need to foresee that the company will be able to pay its debts 12 months after the test has been considered and the test must again be satisfied immediately after a distribution has been completed. The Act uses the term “foreseeable” and “foresee” on numerous occasions but fails to elaborate on an accurate manner to determine a company’s future financial position.

Section 46 of the Act specifically deals with distributions[4] and expands on the manner in which the board of directors must pass the resolution approving the distributions.[5] A resolution must be passed authorising the distribution as well as one indicating that the board of directors has acknowledged having applied the test and has reasonably concluded that the test can be satisfied after the distribution is complete. The Act goes further and states that once the resolution has been adopted the distribution must be fully carried out[6]. A distribution may be carried out at a later date when the directors who passed the resolution authorising the distribution are no longer part of the company.

Section 46 (a)(ii) states that the first board resolution was to authorise the distribution, later on in section being 46 (a)(c) the board must by resolution acknowledge the solvency and liquidity test. Therefore, there should be two resolutions passed by the board of directors, one for the authorisation and a subsequent resolution for the acknowledgement.

The next problem which may arise in respect of the resolutions is the liability of the directors. The question may arise as to who will incur liability at a later stage if the resolution acknowledging the test is re-passed. The directors who authorised the distribution may differ to those who acknowledged the test as only the resolution acknowledging the test will need to be re-passed if the 120 business days have lapsed.

Section 77 of the Act deals with the liability of directors and prescribed officers and extends liability to persons who are not only directors in the strict sense. When dealing with liability for any loss, damage or costs sustained by the company[7] the Act narrows the liability to directors only. In order for a director to incur liability he would have had to be present at a meeting, participated in the making of a decision and failed to vote against the resolution approving the distribution.[8] However Section 77(3)(vi) only refers to a director incurring liability for the approval of the distribution and fails to mention liability for the acknowledgement of the test.

Section 77 read in conjunction with Section 46 expands on liability. The liability in respect of the failure to vote against the resolution will only arise, if immediately after making the distribution contemplated in the resolution( referred to in section 46) the company does not satisfy the test and it was unreasonable at the time of the decision to conclude that the company would satisfy the test .[9]

Section 46(6)[10] of the Act cross referenced with section 48(7)[11] of the Act refers directly to a director’s liability being associated directly to the “approval” which authorised the transaction and no mention is made to the liability for the acknowledgement of the test. From a reading of the Act it is clear that the directors who initially authorised the distribution should act with a greater degree of care and skill due to the liability which could be imposed on them.

 

Michelle Van Heerden

[1] S 1 defines “Solvency and Liquidity” as meaning “(1) For any purpose of this Act, a company satisfies the solvency and liquidity test at a particular 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 member of a group of companies, the aggregate assets of the company, as fairly valued, equal or exceed the liabilities of the company or, if the company is a member of a group of companies, the aggregate liabilities of the company, as fairly valued;

and (b) it appears that the company will be able to pay its debts as they become due in the ordinary course of business for a period of—(i) 12 months after the date on which the test is considered; or (ii) in the case of distribution contemplated in paragraph (a) of the definition of ‘distribution’ in section 1, 12 months following that distribution.

(2) For the purposes contemplated in subsection (1)—(a) any financial information to be considered concerning the company must be based on—(i) accounting records that satisfy the requirements of section 28; and

(ii) financial statements that satisfy the requirements of section 29;(b) subject to paragraph (c), the board or any other person applying the solvency and liquidity test to a company—(i) must consider a fair valuation of the company’s assets and liabilities ,including any reasonably foreseeable contingent assets and liabilities,

irrespective of whether or not arising as a result of the proposed distribution, or otherwise; and(ii) may consider any other valuation of the company’s assets and liabilities that is reasonable in the circumstances; and(c) unless the Memorandum of Incorporation of the company provides otherwise, a person applying the test in respect of a distribution contemplated in paragraph (a) of the definition of ‘distribution’ in section 1 is not to be regarded as a liability any amount that would be required, if the company were to be liquidated at the time of the distribution, to satisfy the preferential rights upon liquidation of shareholders whose preferential rights upon liquidation are superior to the preferential rights upon liquidation of those receiving the distribution”.

[2] The Companies Act 71 of 2008.

[3] n 2 Section 46(3).

[4] S 1 defines “Distribution” as meaning “a direct or indirect—(a) transfer by a company of money or other property of the company, other than its own shares, to or for the benefit of one more holders of any of the shares of that company or of another company within the same group of companies,

whether—(i) in the form of a dividend;(ii) as a payment in lieu of a capitalisation share, as contemplated in section

47;(iii) is consideration for the acquisition—(aa) by the company of any of its shares, as contemplated in section 48;or(bb) by any company within the same group of companies, of any shares of a company within that group of companies; or (iv) otherwise in respect of any of the shares of that company or of another company within the same group of companies, subject to section 164(19); (b) incurrence of a debt or other obligation by a company for the benefit of one or more holders of any of the shares of that company or of another company within the same group of companies; or (c) forgiveness or waiver by a company of a debt or other obligation owed to the

company by one more holders of any of the shares of that company or of another company within the same group of companies, but does not include any such action taken upon the final liquidation of the company”.

 

[5] n 2 Section 46.

[6] n 2 Section 46(2).

[7] n 2 Section 77 (3).

[8] n 2 Section 77 (e).

[9] n 2 Section 77 (4).

[10] (6) A director of a company is liable to the extent set out in section 77(3)(e)(vi) if the director— (a) was present at the meeting when the board approved a distribution as contemplated in this section, or participated in the making of such a decision in terms of section 74; and (b) failed to vote against the distribution, despite knowing that the distribution was contrary to this section.

 

[11] (7)A director of a company is liable to the extent set out in section 77(3)(e)(vii) if the director— (a) was present at the meeting when the board approved an acquisition of shares contemplated in this section, or participated in the making of such a decision in terms of section 74; and (b) failed to vote against the acquisition of shares, despite knowing that the acquisition was contrary to this section or section 46.

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