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Liquidity and Solvency: How Does The New Liquidity And Solvency Test Affect Your Company?
The introduction of the new Companies Act, 2008 (the Act) introduced various new and modified applications of existing concepts within the corporate law framework. The following article is the first of a series of articles aimed to highlight the significant areas of the Act that may affect companies within South Africa.
Even though the concept of liquidity and solvency already existed within the previous Act, the specific guidance provided within the new Act placed significant emphasis on the application and practical implications of this area of the Act. The purpose of this article is to consider certain frequently asked questions pertaining to the solvency and liquidity test (the test) and is not intended to be exhaustive.
When should a company consider the test?
A company must perform the test when:
- providing financial assistance for the subscription of its own securities (Section 44);
- providing loans or other financial assistance to directors and to a related or inter-related company (Section 45);
- making distributions (Section 46);
- offering cash payment in lieu of issuing capitalisation shares (Section 47);
- acquiring own securities or subsidiary acquiring holding company securities (Section 48); and
- when a decision is made to amalgamate or merge a company with another company (Section 113).
What is the solvency and liquidity test?
The test consists of the following two elements:
- the company will be able to settle its debts when they become due in the ordinary course of business for a period of 12 months after the test is considered or, in the case of distributions, 12 months after the distribution is made. (This part of the test can be performed in various manners. It is however recommended that the method selected focus on the ability of the company to generate cash flows that will be used to settle its debts); and
- the assets of the company, fairly valued, equal or exceed the liabilities of the company, fairly valued.
What information should be used for the liquidity and solvency test?
Step 1: The tests should be performed by obtaining the information as provided in the:
- Accounting records (Section 28); and
- Financial statements (Section 29).
Step 2: When evaluating the financial information obtained in Step 1, a company should remember that not all components presented were necessarily measured at their fair value. The Act also requires the company to consider the fair values of any reasonably foreseeable contingent assets and contingent liabilities. When considering the test, the company must therefore take any steps necessary to ensure that they are able to consider the fair values of these assets and liabilities (and the reasonably foreseeable contingent assets and contingent liabilities) for the purpose of applying the test.
The Act also indicates that a company may also consider any other valuation of the company's assets and liabilities that is reasonable in the circumstances. When relying on such an “other valuation”, the Board should proceed with caution especially in light of the fact that a misapplication of the test could in many instances result in personal liability for the directors (Section 77). It will be necessary for the Board to be able to demonstrate why such a valuation is reasonable in the circumstances.
What are some of the other practical issues that should be considered when performing the test?
The test is performed when required by the Act for each company based on company financial information (i.e. not based on group financial information).
Directors should also be reminded that they will need to refer to the company's Memorandum of Incorporation (Memorandum) to identify any additional restrictions that may apply. For example, if the company's Memorandum contains a clause stating that a dividend may only be paid out of profits, the company may find itself in a position where it may be able to justify satisfying the solvency and liquidity test (based on the fair value of assets and liabilities), but that the additional restriction in the Memorandum would prevent the payment of the dividend as the company may not have sufficient profits to pay the dividend.
What are the consequences if a company performs one of the listed actions and it does not satisfy the test?
The directors that were present at a meeting where a decision was made and who failed to vote against this decision could be held personally liable in terms of Section 77 of the Act.
In terms of Section 218(2), any person may also now hold any other person liable if he or she suffered loss or damage as a result of the later person not complying with the provisions of the Act. One should also be mindful that the Act now also appears to allow for class action, which means that groups of aggrieved parties may now institute action against the company, a director, prescribed officer or any other official where they can show loss or damage as a result of non-compliance. asa
Author: Cobus Grove CA(SA) is an Associate Director: Professional Practice Group at Ernst & Young.
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