According to the old saying, you should always ‘Expect the Unexpected!’ If so, wouldn’t that make the unexpected expected?
According to the old saying, you should always ‘Expect the Unexpected!’ If so, wouldn’t that make the unexpected expected?
As a company director or business owner you need to plan for the worst and hope for the best. Forecasts and predictions can help you plan for expected outcomes, but how do you prepare for the unexpected? This may take the form of a ‘Contingency Liability.’ If you know of a possible issue that may affect your company, what plans can you put in place to mitigate or minimise the risk?
Examples of contingent liabilities include guarantee obligations, letters of credit, current or pending lawsuits, leases, tax assessments, performance bonds, hire purchase agreements and underwriting adjustments.
A popular printing company’s motto is: “On time or it’s free.” There’s an example of a contingent liability. What’s the likelihood an order will be late? What’s the likely cost of covering that free printing? That company needs to have procedures and systems in place to ensure projects are managed and completed before the agreed deadline or they’ll give away all of their work.
The Solvency Test
One method for company management to take stock of all their contingency liabilities is to run a Solvency Test, which is explained in section 4 of The Companies Act (1993).
A business will pass the solvency test if it can pay its debts in the normal course of business, and if the value of the company’s assets is greater than its liabilities, including contingent liabilities. The solvency test aims to control transactions that transfer wealth from a company.
You don’t need to run the solvency test each morning before starting work. A signed solvency certificate to show the test has been passed is only necessary before and after paying shareholder dividends, purchasing shares, a company amalgamation or merger, and twenty days prior to liquidation proceedings.
If the company bought, sold, or paid out shares without passing a solvency test, the directors may be personally liable to creditors. That’s why it’s essential to have working documents outlining the reason for each decision. They will be vital if a liquidator challenges a transaction and its impact on your business.
How can you avoid personal liability?
Complete solvency tests when required, and follow the proper procedure. It may sound obvious, but many company directors have gone bankrupt after wanting a deal to go through so badly they were willing to take shortcuts. If it backfires, you’re not protected and can face a $200,000 fine or five years in prison!
If circumstances change between signing the certificate and the transaction taking place and you do nothing, you may still be held personally liable.
Finally, if you have any doubts about whether your company can pass a solvency test, don’t sign the certificate. Sometimes the truly unexpected happens, but if you can show you acted in good faith and prove you took all reasonable measures to minimise risk, you may avoid personal responsibility. The risks are too high to not take proper care.
If your business is solvent, but only just, you will need to take extra care before and after certain transactions to expect the unexpected and ensure you can pass a solvency test.
If your company is experiencing financial difficulty, download our free guide for NZ Companies to discover your different options.