The solvency and liquidity test in section 4 of the Companies Act, 71 of 2008, presents arguably one of the most important requirements of that Act. Without a company satisfying this test, it company cannot declare dividends, cannot provide loans and other forms of financial assistance to directors or to prospective shareholders to enable the latter to subscribe for shares in the company, to name but a few examples. Where directors act in contravention of the prohibition in considering whether a company may enter into a transaction, they may be held personally liable for damages or losses suffered as a result (see section 77(3)(e)).
A company would satisfy the solvency and liquidity test if, considering all reasonably foreseeable financial circumstances of the company at that time:
(a) The fair value of the assets of the company equal or exceed the fair value of its liabilities; 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 a distribution/dividend generally, 12 months following that distribution/dividend declaration.
The test is generally required to be applied by the board of directors of a company and in so doing the board must consider appropriate and satisfactory accounting records and financial statements of the company in coming to their conclusion regarding the company’s solvency and liquidity. Section 4(2)(b) of the Companies Act also introduces a ‘substance based’ approach, whereby the directors must consider a fair valuation of the company’s assets and liabilities (including any reasonably foreseeable contingent assets and liabilities and irrespective of whether or not these may arise as a result of the proposed transaction). The directors may further consider any other valuation of the company’s assets and liabilities that is reasonable in the circumstances.
The purpose of the test is to ensure that other stakeholders of the company are not prejudiced by certain transactions which have the ability to erode the value of the company to the benefit of only a select group of stakeholders. For example, only a solvent and liquid company may grant a loan to one of its directors to ensure that e.g. the shareholders are not prejudiced through an irrecoverable investment that the company has made. Similarly, creditors would be prejudiced if an insolvent or illiquid company is allowed to impoverish itself by distributing profits by way of dividends to shareholders, leaving the company unable to pay its debts.
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or ommissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)