Wednesday, 02 August 2017 13:52

How to Test Solvency

The Solvency Test

The Companies Act 1993 requires directors to focus on the financial state of the company and to consider whether the company meets the solvency test before permitting distributions and certain other actions by the company.

The statutory Solvency Test is set out at section 4 of the Companies Act 1993.  The Solvency Test requires that both the liquidity limb and the balance sheet limb of the test are satisfied immediately after a distribution or other action.  Distributions are widely defined and include the direct or indirect transfer of money or property and incurring a debt for the benefit of shareholders.

In making a distribution, directors who vote in favour of the distribution must sign a solvency certificate confirming that, in their opinion, the company satisfies the Solvency Test immediately after the distribution is made. The relevant date for assessing solvency is the date of the resolution and not the transfer date of funds.

Liquidity Limb

The company must be able to pay its debts as they become due in the normal course of business.

The nature of the business of the company must be taken into account. A liberal interpretation is to achieve the liquidity limb, debts are paid before creditors become threatening.

Balance Sheet Limb

There is a requirement that the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.

This limb causes some concern because of the complexity with assessing what the company’s assets and liabilities are and the basis they should be valued. It is necessary to look ahead to after the distribution has been made, to ensure that the assets will still exceed the liabilities.

This is often complicated when companies have kept poor financial records.

What Directors must consider when determining value

Directors should have regard to;

(i) the most recent financial statements of the company.

(ii) all other circumstances which the directors know or ought to know affect the value.

Directors may rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances. When assessing contingent liabilities, the likelihood of occurrence of the contingency and opportunity for the company to offset the contingent liability by way of a counter claim, may be taken into account.

The Solvency Certificate

Directors who vote in favour of a distribution must sign a solvency certificate. The certificate and procedure should address:

- the appropriateness of the latest accounts
- the existence of contingent liabilities and the likelihood of any contingency occurring
- whether any claims exist to offset the contingent liability
- any special trade factors or circumstances which “ought to be known” by the directors
- assessment of what valuations or estimates are necessary or appropriate

The certificate and procedure is a formal record to show that the directors have acted properly and considered all the appropriate matters in making their assessment.

Directors need to act in good faith and make proper enquiry and may rely on reports, statements and financial information prepared by staff, professionals, experts, and advisors who the directors believe to be competent so long as they have no knowledge that such reliance is unwarranted.

A company cannot issue a solvency certificate while it remains insolvent.

Application of Solvency Test

The Companies Act requires the Solvency Test to be considered for;

- dividends
- buyback of shares or reduction of equity
- financial assistance in connection with the purchase of the company’s own shares
- minority buyouts
- shareholder discounts / shareholder forgiveness of debt
- the unfair prejudice remedy
- amalgamations
- payment or guarantee of shareholders’ outside debt

Recovery of Distributions

If a distribution is made to a shareholder and the Solvency Test is not satisfied after the distribution is made, then the moneys may be recovered from the shareholder except where the shareholder receives the distribution in good faith without knowledge that the Solvency Test is not satisfied.

A director is personally liable for the repayment of the distribution if the director unreasonably fails to follow the statutory procedures S56(2)(a) and (c) or if the director signs the solvency certificate authorising a distribution when there were no reasonable grounds to believe the solvency test was satisfied S56(2)(b) and (d), or did not take reasonable steps to prevent a distribution once becoming aware, S56(3) and S56(4).

A director is only however liable to repay the company to the extent that the distribution is not able to be recovered from the shareholders. The Court may relieve a director from full liability under S56(5) if the Court is satisfied that the company could have by making a distribution of a lesser amount, satisfied the solvency test. Case Law has not established a strict arithmetical approach to this.

This reiterates the need for appropriate procedures to be established by a company and its directors to ensure distributions are not clawed back or that directors face personal liability.

Directors may be fined where they act in a false or misleading way and can be held liable and face up to 5 years imprisonment, or to a fine not exceeding $200,000.

In our capacity as liquidators of insolvent companies we are often required to consider if shareholder distributions should be clawed back, and/or if directors are liable for repayment of distributions. These potential director actions are good reason to understand the importance of the Solvency Test and procedures under the Companies Act 1993.

If you are an advisor to a company that is insolvent or fails the solvency test, then it is important to make your client aware of the following provisions of the Companies Act 1993 and the possible consequences.

Section 135: A director must not allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.

Section 136: A director must not agree to the company incurring obligations unless the director believes at that time, on reasonable grounds, that the company will be able to perform the obligations.

If you require assistance in establishing the appropriate compliance procedures for the Solvency Test or have any general questions on the Solvency Test or other aspects of the Companies Act 1993, please do not hesitate in contacting the directors or senior staff at McDonald Vague.

 

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:

  1. Trading solvency/liquidity - the company is able to pay its debts as they become due in the normal course of business; and
  2. 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.

The considerations

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 -

  1. The likelihood of the contingency occurring; and
  2. 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 -

  1. 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
  2. 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. 

Conclusion

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.