20.2 THE SOLVENCY AND LIQUIDITY TEST
4. Solvency and liquidity test.—
(1) For any purpose of this Act, a company satisfies the solvency and liquidity test at a particular time if, considering all reasonably foreseeable financial circumstances of company at that time—
(a) the assets of the company, as fairly valued, equal or exceed the liabilities of the company, as fairly valued; and
[Para. (a) substituted by s. 2 (a) of Act No. 3 of 2011.]
(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 contemplated in paragraph (a) of the definition of “distribution” in section 1, 12 months following that distribution.
(2) For the purposes contemplated in subsection (1)—
(a) any financial information to be considered concerning the company must be based on—
(i) accounting records that satisfy the requirements of section 28; and
(ii) financial statements that satisfy the requirements of section 29;
(b) subject to paragraph (c), the board or any other person applying the solvency and liquidity test to a company—
(i) must consider a fair valuation of the company’s assets and liabilities, including any reasonably foreseeable contingent assets and liabilities, irrespective of whether or not arising as a result of the proposed distribution, or otherwise; and
(ii) may consider any other valuation of the company’s assets and liabilities that is reasonable in the circumstances; and
(c) unless the Memorandum of Incorporation of the company provides otherwise, when applying the test in respect of a distribution contemplated in paragraph (a) of the definition of “distribution” in section 1, a person is not to include as a liability any amount that would be required, if the company were to be liquidated at the time of the distribution, to satisfy the preferential rights upon liquidation of shareholders whose preferential rights upon liquidation are superior to the preferential rights upon liquidation of those receiving the distribution.
[Para. (c) substituted by s. 2 (b) of Act No. 3 of 2011.]
The solvency test is at a point in time, in fact after the distribution is made, and the liquidity test must be completed for a period of 12 months following the distribution which is a prediction of the company’s cash flows over the ensuing 12-month period. The 12-month period in Section 4(1)(b) is also new. It gives Directors more certainty when applying the solvency and the liquidity test. It is also designed to protect creditors and make sure that the company survives after the distribution. The Directors must make a prediction of the company’s cash flow for the period of twelve months into the future. This predication can be based on trading conditions in previous years. As we know this is quite a complicated exercise and should be conducted properly with all the necessary accountant’s skill. Accfin has a software program called Cash Flow Forecaster which will help with this exercise.
Section 4 (1) requires an arithmetical calculation. Section 4 (2) contains some vital rules as to the method of making this calculation. All financial information concerning the company must be considered and must be based on the Accounting Records and Financial Statements. In making this determination the Board must consider a fair valuation of the company’s assets and liabilities including any reasonable foreseeable contingent assets and liabilities irrespective of whether or not arising as a result of the proposed distribution or otherwise and may consider any other valuation of the company’s assets and liabilities that is reasonable in the circumstances. This gives the Board some degree of flexibility into determining the value of assets or liabilities.
This in fact creates a severe difficulty in that none of the financial records are forward looking but are based on the historical records of the company. In order to do this properly it’s just not good enough to look at the historical books. The directors must look at the future budgets and cash flows and funding plans that reflect the future forecasts of the business. The directors must view very carefully their capital expenditure budgets required. If this is not done then how can the liquidity test be carried out properly?
At this stage there are no standards to govern how these tests should be done, therefor the board would need to apply a high degree of skill in carrying out these tests and in the situation of private companies the directors will be leaning on their accounting firm’s skill if they even realise what the risks are. Surely this is an opportunity for the accounting firm but could also be a huge risk.
In order to safeguard the creditors of the company before the company can make any distribution as defined, the board of directors must apply the solvency and the liquidity test and acknowledge by way of Directors Resolution that it has reasonably concluded that the company will satisfy the solvency and liquidity test immediately after the distribution is made. These two aspects of the solvency and liquidity tests and the acknowledgment must be met whether a distribution is pursuant to a board resolution or an existing obligation or a court order.
The solvency and liquidity test are very important and there are seven instances where the directors have to ensure that the solvency and liquidity tests are carried out: -
· S44 – financial assistance and
· S45 – loan to directors, prescribed officers or related and inter-related companies.
· S47 - capitalisation shares with a cash alternative
· S48 – buyback of shares
· S113 – amalgamation and mergers
· foreign transfers to register a company in South Africa
· distributions mostly dividends
In terms of the solvency test the assets must be fairly valued and the assets must be valued at a specific point in time just after the distribution has taken place. This means that the assets can be revalued over and above what the balance sheet says. Properties held can be looked at, at their current market value and intangible assets undervalued on the balance sheet can be brought in at their fair value.
Failure by Director to comply with these tests could render the director personally liable under s 77 (2) for any loss sustained by the company and could render that director liable to be placed under probation.
The board must acknowledge that it has applied the solvency and liquidity test and must have reasonably concluded that the company will satisfy it. They acknowledge this by passing a director’s resolution to this effect.
The liquidity test is met “if it reasonably appears that the company will satisfy the solvency and liquidity test, and the board has acknowledged that it had applied the solvency and liquidity test”