The solvency test is not required to be met each day a company trades. It is required for certain transactions including distributions and dividends and requires the company to demonstrate it can meet two tests. These tests are the trading solvency/liquidity test and the balance sheet solvency test.
To satisfy the solvency tests, a company must be able to pay its debts as they become due in the normal course of business; and the value of its assets must be greater than the value of its liabilities (including contingent liabilities).
One objective of the solvency test is to control all transactions that transfer wealth from a company. In a liquidation context, where transactions have occurred when the company did not satisfy the solvency test, creditors may be able to recover from directors personally.
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The solvency test
The solvency test consists of two parts:
- Trading solvency/liquidity - the company is able to pay its debts as they become due in the normal course of business; and
- Balance sheet solvency - the value of the company's assets is greater than the value of its liabilities, including contingent liabilities.
The Companies Act 1993 requires that in some situations directors sign a solvency certificate. Sometimes this considers only the ability to pay debts as they fall due.
The situations requiring a signed solvency certificate are:
- Distributions by the company for the benefit of a shareholder, including a dividend, and incurring a debt to or for a shareholder's benefit, solvency to apply before and after distribution ;
- Share purchases;
- Share redemption options being exercised;
- Financial assistance to acquire share is offered by the company;
- An amalgamation; and
- 20 days prior to a Solvent liquidation.
Directors need to consider all circumstances that the directors know or ought to know that affect the value of the company's assets and liabilities. In the case of contingent liabilities consideration is required to be made on the likelihood of the contingency occurring and any claims the company may reasonably be expected to meet to reduce or extinguish the contingent liability.
Contingent liabilities to be factored in
Contingent liabilities can impact a solvency certificate and impact the validity of a distribution. If directors are aware of a contingency, action must be taken to determine projected costs and probable outcomes. Directors must be realistic when assessing solvency and take reasonable steps to obtain all information relevant to forming an opinion. The Courts have confirmed the solvency test should be applied with a sense of commercial reality.
Contingent liabilities can include obligations under guarantees, letters of credit, bills of exchange, current or pending litigation, eg. leaky building claims, performance bonds, leases, tax assessments, deferred purchase agreements and underwriting adjustments.
Section 4(4) of the Companies Act 1993 - Meaning of Solvency Test - says:
"In determining, for the purposes of this section, the value of a contingent liability, account may be taken of -
- The likelihood of the contingency occurring; and
- Any claim the company is entitled to make and can reasonably expect to be met to reduce or extinguish the contingent liability".
Risk of personal liability
Directors who do not fulfil their obligations under the Companies Act 1993 are subject to penalties and personal liability. The liability of a director will be determined by his or her involvement in the decision. Failing to vote on a board matter should be carefully considered as directors are collectively responsible for any decision made by the board.
Directors should ensure all workings support solvency certificates and contain all necessary information and support for decisions made. This detail can provide vital defence when a liquidator challenges a distribution made.
Directors should be aware that they should not sign a certificate as to solvency if there is doubt as to the existence of reasonable grounds for such belief. If they do not take reasonable steps, they can risk being held personally liable for any non-recovery of the distribution made to the shareholders.
Directors can rely on information and professional or expert advice, but only if they act in good faith, make proper inquiry or have no knowledge such reliance is unwarranted (Section 138 of the Companies Act 1993).
Section 56(3) of the Companies Act 1993 - Recovery of distributions - says:
"If by virtue of section 52(3) or section 70(3) or section 77(3), as the case may be, a distribution is deemed not to have been authorised, a director who -
- Ceased after authorisation but before the making of the distribution to be satisfied on reasonable grounds for believing that the company would satisfy the solvency test immediately after the distribution is made; and
- Failed to take reasonable steps to prevent the distribution being made, -
is personally liable to the company to repay to the company so much of the distribution as is not able to be recovered from shareholders".
Under Section 56, a distribution may be clawed back from the shareholders unless the shareholders received the distribution in good faith, without knowledge of the company's failure to satisfy the solvency test, and the shareholder has altered their position in reliance on the validity of the distribution and it would be unfair to require repayment in full or at all. As the tests are cumulative, failure to satisfy any of the above will likely result in clawback of distributions.
When can directors be held personally liable?
Directors can be held personally liable in the following circumstances:
- They fail to complete a solvency certificate when it is required;
- The procedure for authorising the relevant transaction has not been followed;
- Reasonable grounds for believing that the company would satisfy the solvency test did not exist at the time the solvency certificate was signed; or
- Between the date of approving the transaction and its date of execution, there has been a change in circumstances in relation to the company's ability to meet the solvency test but the distribution occurs anyway.
Apart from the obvious consequences of clawback, any director who signs a certificate knowing that it is false or misleading commits an offence and is liable on conviction to a fine not exceeding $200,000 or imprisonment not exceeding five years. A director who votes in favour of a distribution, but fails to sign a certificate to the satisfaction of the solvency test also commits an offence and is liable on conviction to a fine not exceeding $5,000. The risks are too high to not take reasonable care.
If a company is marginally solvent, directors need to take particular care to satisfy themselves, for certain transactions, that the transaction is properly authorised and that the company will meet the solvency test immediately after the transaction is implemented.