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The solvency and liquidity test in business rescue.

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The 1973 Companies Act has as a central tenet the maintenance of capital. This tenet informed the basic approach to the way share capital was structured, and was the reason why shares could not be subscribed for at a discount and why a company could neither acquire its own shares nor provide financial assistance in their acquisition. The primary purpose was to protect creditors of the company by preserving share capital and reserves and restricting distributions to situations where assets exceed liabilities.

Without thin capitalisations rules and with the permitting of no par value shares, the tenet was undermined even before the Act came into force. This was done by issuing shares of no par value with low capital value and financing the business through shareholder loans. Creditor reaction was to often insist that such loans be subordinated and to insist on specific loan terms that sought to preserve both balance sheet solvency and operational liquidity.

The Companies Act of 2008 (the Act) seeks to replace this ineffective regime with the introduction of the “solvency and liquidity” test, the “business judgement” test and the codification of the duties of directors and advisors. It also introduces the concept of “Business Rescue” for periods of distressed liquidity should the directors invoke the provisions contained in Chapter 6 of the Act.

This series of articles considers the inter relationship of these measures. The most important of these is the solvency and liquidity test set out in Section 4 of the Act. The test provides that for a company not to be considered financially distressed:

  1. The assets of the company (fairly valued) equal or exceed the liabilities (fairly valued), and
    1. 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 12months after the date on which the test is considered or
    2. In the 12 month period following a distribution

Interestingly the Solvency and Liquidity test appears to cover a combination of the two types of insolvency; the first being technical insolvency whereby the company’s assets (fairly valued) are exceeded by its liabilities. The second type of insolvency, referred to as commercial insolvency, is referenced by a company’s inability to meet its debt requirements as they fall due, irrespective of the nature of its balance sheet.

In applying the Solvency and Liquidity test a Board of Directors (the Board) or its advisors must consider all reasonably foreseeable financial circumstances at the time of performing the test. Therefore the Board would consider the company’s financial information based on accounting records that comply with Section 28 and financial statements that comply with the requirements of Section 29 of the Act.

This creates a difficulty in that none of these records and statements are forward-looking and the Act is silent of what reasonable information would be required to support the business judgement test when considering whether or not the company is in financial distress.

The Board, in applying the Solvency and Liquidity test, would need access to the forward looking budgets, cash flows and funding plans that reflect the future forecast of the business. If these are absent how could the requirements of the solvency and liquidity test be met?

There are no standards that guide the preparation of the financial forecasts and or the reasonableness of the assumptions used in compiling these forward looking statements. Therefore the Board will need to bring to bear high levels of skill and care in the evaluation process.

The Board, or any other person applying the solvency and liquidity test to a Company, must consider the fair value of the assets and liabilities including any foreseeable contingent assets and liabilities. It may also consider any other valuation of the assets and liabilities of the company that is reasonable in the circumstances.

The recognition and valuation of assets and liabilities must conform to any of the standards set by the Act. Often intangible assets such as brands and trademarks are not recognised on the balance sheet or taken into account in the valuation of companies but they can have a profound effect on the solvency element of the test. Thus, the valuation of the intangible, unrecognised assets may be appropriate in the circumstances. In particular, self-generated assets, prohibited under International Framework Reporting Standards (IFRS), may be considered in the solvency and liquidity test.

Chapter 6 of the Act (Business Rescue) introduces the concept of “financially distressed” in Section 128(f)(i). This builds on the principals of the solvency and liquidity test as set out in Section 4. The test requires directors and advisors to consider financial distress when it seems reasonably unlikely that the Company will pay all of its debts as they become due and payable in the immediately ensuing six months or it is reasonably likely that it will become insolvent in that period.

The Section implies that the solvency and liquidity test must be continuously evaluated by the Board and the officers of the Company. It must therefore be a key consideration of the risk and finance committees of well governed companies.

In considering the voluntary commencement of business rescue, section 129(b) requires that there must appear to be a “reasonable prospect” of rescuing the company. The impact of a voluntary commencement of Business Rescue proceeds is that a Business Rescue Practitioner is appointed by the Board of Directors and all claims against company at the date of commencement are held in abeyance. The intention here being that the Practitioner, and the existing Board are provided with ‘breathing’ space during which to administer the operations of the business to the best advantage of the creditors and shareholders.

The BRP is expected to present a plan that maps the route for the company’s return to solvency and liquidity and the rescue of the business. In the alternative, the plan may allow for an outcome better than liquidation. At all times in the process, the BRP needs to keep the solvency and liquidity test foremost in his or her mind while navigating the complex business, legal and financial issues that arise in business rescue.

Where the Board recognises the likelihood of imminent distress and considers there is a reasonable prospect of rescuing the business but chooses not enter into business rescue the Company is required to provide the notice of distress to creditors and affected parties. The Board must also provide reasons for not entering into Business Rescue. This is a new level of protection for Affected Parties and allows creditors an insight into the affairs of companies before they default on payment.
It is unusual to see this notice of distress and directors may well be at risk in these circumstances even if they have very good reasons to believe that the company will overcome its solvency and liquidity challenges within the ensuing six months. The Act does not allow elective compliance and the wording of section 129(7) is mandatory.

It is in applying the “business judgement” test to determine whether there is a “reasonable prospect of success” of the corporate action proposed in the Business Rescue Plan that Directors, their advisors and the Business Rescue Practitioners (BRPs) face their greatest challenge. Their reputations, careers and personal liability are exposed unless due care and diligence is evidenced in the decision.

The meaning and interpretation of these key elements of the Act will, no doubt, be litigated. That litigation is most likely to arise in the course of business rescue. In court initiated business rescue good practice already insists on an independent expert to give their opinion on the reasonable prospect of success before granting the application. The introduction of a special court could almost certainly anticipate that creditors and affected parties will challenge both the commencement of business rescue or liquidation on this test on a more frequent and timely basis.

BRPs need to carefully assess the information provided to the Board that informed their opinion that rescue had a reasonable prospect of success; that the basis of the valuation of assets and liabilities used in the test was appropriate; the quality of the financial records and financial statements and the forward forecasts. The forward-looking work papers that identify the distress should also conform to some agreed standards and some standardised formats.

Section 150 of the Act specifies details of the information expected to be included in the Business Rescue Plan along with the time horizon required. It does not, however, specify a format for this information. Accountants would expect that the cash flow statement should conform to IFRS, however IFRS allows two formats in which cash flow information may be presented. In practice, it is more often the simple cash payment plan that is provided. This may be an area where accountants can play a meaningful role in business rescue by supporting practitioners who may not have the skills set to produce plans that comply with IFRS. I would submit that the professional bodies need to apply their minds to providing guidance on these matters.

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