Solvency and liquidity test and good corporate governance practices when facing financial strain
To satisfy the solvency test, the assets of the company must exceed liabilities and the company will be able to pay its debts as they become due in the ordinary course of business for the coming 12 months.
When a company enters a phase of financial distress, the board of directors must meet on a regular basis to assess and monitor its financial position. The minutes of the meetings must be detailed evidencing that the board has debated and properly considered all issues tabled, and must be kept for record purposes. It is also advisable for the minutes to be checked by legal advisors prior to them being signed.
The company cannot incur debt in circumstances where a reasonable businessperson would realise (there is a very strong chance) that the company would be unable to pay creditors when due.
The board of directors should continually assess current and future liquidity needs and borrowing availability. It should also identify unencumbered assets that may be utilized in obtaining or increasing financing and non-core assets that may be sold to generate cash flow.
Restructuring can be defined very broadly and may include a rescue, reorganisation and/or refinancing of a financially stressed company.
Informal/consensual restructuring
An informal restructuring can involve rescheduling of debt, sale of business/assets, corporate reorganisations, or winding down of unprofitable group companies.
There are many reasons why a debtor may seek an informal restructuring rather than a formal process, which often signifies the end of the business. The informal restructuring discussions should be subject to confidentiality, so should not become public and hopefully the restructuring can be implemented without widespread knowledge of the debtor’s financial constraints.
If it became widely known that a company was in financial difficulties, this is likely to worsen the trading position of the company, for example, trade creditors seeking improved terms of business. The lenders to the debtor are also likely to prefer the position to remain private.
In order to be able to conduct an orderly informal restructuring, it may be necessary to enter into a standstill arrangement with those creditors party to the discussions whereby those creditors agree, on terms, not to take action against the debtor. If the debtor is facing considerable pressure from other creditors not party to the discussions/standstill, it may be necessary to move to a formal process to obtain a moratorium from all creditors to create the necessary time to agree to a restructuring.
In an informal restructuring, the directors and management remain in control, rather than the business being in the hands of a formally appointed insolvency or restructuring practitioner.
Because there are no prescribed rules of conduct in an informal restructuring, such processes can be more difficult to manage and often a specialist restructuring adviser, a chief restructuring officer (CRO) may be appointed by the debtor or suggested by lenders to assist with the process.
Early engagement with creditors and lenders is essential to build or rebuild trust with creditors. The debtor should provide detailed financials, a business plan and operational changes for creditors to review, revise and agree as the basis for the restructuring.
An informal restructuring may also result in a better return and outcome for creditors and shareholders. As such, the threat from the debtor that if the informal process is not followed and agreed, that a formal insolvency procedure will be inevitable should encourage creditors and the debtor to build consensus to the informal deal as the best solution.
Formal restructuring and liquidation processes
A company (or close corporation) is financially distressed if it appears:
Business rescue
If the board has reasonable grounds to believe that a company is financially distressed and there appears to be a reasonable prospect of rescuing the company, the board should pass a resolution placing the company under business rescue supervision.
Business rescue proceedings are formal proceedings aimed at facilitating the rehabilitation of a company that is financially distressed by providing for:
Business rescue proceedings can be initiated on a voluntary basis by way of a resolution of the board of directors of the company, or by way of an application to court by an ‘affected person’, this being a shareholder, creditor, a registered trade union representing employees or any employee of the company.
In addition to the general moratorium against legal proceedings, the business rescue practitioner may entirely, partially or conditionally suspend, for the duration of the business rescue proceedings, any obligation of the company under any agreement to which it is a party (excluding employment contracts).
Section 129(7) of the Companies Act requires that if the board of a company has reasonable grounds to believe that a company is financially distressed, but it has not adopted a resolution to place the company in business rescue, the board must deliver a written notice to each ‘affected person’ explaining why it has not adopted such a resolution.
A notice to affected persons of this nature may have devastating and far-reaching consequences and be hugely damaging to a company’s reputation and good will and may also amount to an event of default under the company’s major contracts, as well as possibly trigger cross-defaults.
It could also prompt a creditor to bring a business rescue application or even launch an application for the liquidation of the company. Creditors may also be unwilling to continue to supply goods and services on favourable credit terms and banks may withdraw facilities.
It is therefore important to avoid the need to give such a notice. In this regard it is critical for the board to consider the restructuring options available and whether the implementation of them would result in the company not being financially distressed, and therefore avoiding the need to issue a section 129(7) notice.
Section 155 Compromise
The board of directors of a company (irrespective of whether or not it is financially distressed) may propose an arrangement or compromise of its financial obligations to its creditors or a class of creditors.
Liquidation
In the very worst of circumstances, a board may need to consider liquidation. Companies may also face liquidation proceedings initiated by creditors.
The threshold for liquidating a company is essentially that it is unable to pay its debts as they fall due. Factual insolvency (i.e. liabilities exceeding assets) is not a ground for liquidating a company (although may be a factor considered by the Court in adjudicating an application).
Liquidation should only be considered if consensual restructuring and business rescue options have been exhausted. Companies should take legal advice if faced with an application for liquidation. In some instances, it is possible to convince the Court not to grant a liquidation application but instead to order the company to commence business rescue proceedings. If there is a viable business to be saved, business rescue may be a suitable alternative.
Directors’ duties and personal liability of Directors
Under circumstances of financial distress, directors need to be mindful of their duties, including their general statutory and common law duties and potential personal liability for reckless trading. There is no general obligation on a board of directors either to place a company in liquidation or to take steps to commence business rescue proceedings if a company is financially distressed. The board’s obligations must therefore be assessed in relation to:
The Companies and Intellectual Property Commission (CIPC) has issued a directive that it will not invoke its powers under section 22 (reckless trading) of the Companies Act, 2008 in the case of a company which is temporarily insolvent and still carrying on business or trading.
This is only applicable in circumstances where CIPC has reason to believe that the insolvency is due to business conditions which were caused by the Coved-19 pandemic. This practice note will lapse within 60 days after the declaration of the state of disaster has been lifted.
This article was drafted by Lyndon Norley, Head of Restructuring, and Bianca Masterton, Knowledge and Learning Lawyer for Dispute Resolution at leading African law firm, Bowmans.
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CPD webinar: 2 hours verifiable CPD per session - DEBT RESTRUCTURING AND CORPORATE REORGANISATIONS SERIES
For more information related to restructuring and business rescue options available to a company in times of financial distress, join us for our Debt Restructuring and Corporate Reorganisations Series presented in partnership with Bowmans starting on 25 August 2020 at 15:00.