The Solvency and Liquidity Test
Section 4 of the Companies Act, No 71 of 2008 (“the Act”) outlines the solvency and liquidity test that should be applied by directors before expenses are incurred or profits are distributed.
How to apply the solvency and liquidity test
A company must consider all reasonably foreseeable financial circumstances to determine whether the aggregate of the assets of the company, fairly valued, equals or exceed the liabilities of the company, as fairly valued, at a particular time. If 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 12 months after the date that the test is applied, the company will pass the test.
The test must be based on the accounting records and financial statements of the company, which records must satisfy the requirements of sections 28 and 29 of the Act. The company must use a fair valuation of the company’s current and reasonably foreseeable future assets and liabilities. The valuation requirements of the assets and liabilities are not clearly defined and the Act merely prescribes that the valuation that is used for the assets and liabilities must be reasonable in the circumstances.
The solvency and liquidity test must be applied by the company in the following circumstances:
- When a company offers financial assistance for subscription of shares (section 44 of the Act);
- When a company authorises loans or financial assistance to directors (section 45 of the Act);
- When a company authorises distributions other than shares to shareholders (section 46 of the Act);
- When a company authorises the capitalisation of shares (section 47 of the Act);
- When a company or subsidiary company acquires its own shares (section 48 of the Act);
- In the event of an amalgamation or merger of companies (section 113 of the Act).
There are severe sanctions for non-compliance with the test which include personal liability of directors in terms of section 77 and 218 of the Act. The liability in terms of these sections does not only extend to actions taken by directors, but also include omissions by directors to vote against distributions in circumstances where the company did not satisfy the solvency and liquidity test.
A further sanction is that parties such as co-directors, shareholders and public officers may apply to court for an order to declare the director delinquent or to be placed under probation where a director failed to vote against a resolution despite the inability of the company to satisfy the solvency and liquidity test.
A company can however decide to allow liability insurance to be procured on behalf of the director and this aspect must be included in a company’s MOI. The solvency and liquidity test is an important principle introduced by the Act and directors should constantly be mindful thereof when controlling company funds.