'Unfriendly' insolvency laws

11 March 2011

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This article first appeared in Business Day

A CONTROVERSIAL provision prohibiting companies from trading “under insolvent circumstances” contained in the new Companies Act could have far-reaching consequences for companies that are financially compromised yet still viable, corporate law firm Deneys Reitz Attorneys warned.

Mark Kyle, a director at Deneys Reitz, said the prohibition was extremely wide and could apply to any company that was technically insolvent regardless of whether the entity was under any financial strain.

“At a time when the government is trying to project a business-friendly face and to foster job creation, it is hoped an appropriate amendment will be forthcoming which creates the type of certainty business requires to flourish,” he said.

He pointed out that trading “under insolvent circumstances” did not usually mean “commercial insolvency”.

It is a well-established principle under insolvency laws that a person is insolvent when their assets, fairly valued, are exceeded by their liabilities. So the words “insolvent circumstances” could refer to a company whose assets, fairly valued, are exceeded by its liabilities, fairly valued. This is often referred to as “technical insolvency”.

Mr Kyle said a company might be liquid and able to pay its debts when they fell due for payment. However, because of the way in which the company had been capitalised by its shareholders, through the provision of shareholder loans, it might be technically insolvent.

Hugh Bisset, a director at Deneys Reitz, said under the current Companies Act there was a punitive sanction against individuals who were party to carrying on a company’s business recklessly or fraudulently.

However, there was no prohibition on a company carrying on with business when it was actually insolvent. “There is a good reason for this, namely that shareholders very often choose to fund their companies by shareholders’ loans.”

But under the new Companies Act, Mr Kyle pointed out, it would be unlawful for a company that is technically insolvent to continue operating. A company would not be able to trade if its liabilities exceeded its assets despite a subordination of shareholders’ loans, he said.

“This will have severe and unfortunate consequences. It seems unlikely to us that the possible implications of this provision of the new act have been fully appreciated.”

Mr Kyle said that, if the legislation were implemented in its current form, without an amendment to the prohibition, it was certain that before long a matter would come before a court. The court would be faced with a choice between straining the meaning of "insolvent circumstances" to breaking point or finding that a viable company that was technically insolvent was trading unlawfully.

“This is an unsatisfactory state of affairs.”

“The law should create certainty for business.”

The government has confirmed that the legislation will come into effect on April 1, despite objections from several quarters. Deneys Reitz said it was hoped the government would amend the problematic provision.

The authors' concerns mentioned in this article, and shared by most of the academic world and the Law Society, were addressed by the amendment of the Act by deletion of the prohibition against insolvent trading.

Norton Rose South Africa (incorporated as Deneys Reitz Inc) joined Norton Rose Group on 1 June 2011.