Solvency and liquidity test: Companies Act raises the bar

2011-07-05 00:00

THE concept of capital maintenance has been done away with in the new Companies Act.

Instead a company is required to satisfy the so-called “solvency and liquidity test” before it may:

• pay a dividend to its shareholders

• make any other distribution to its shareholders, for example write off a debt owed to the company by its shareholders

• lend money to its directors

• lend money to any person for the purpose of acquiring that company’s shares

The above actions also require a host of other requirements, including notice to shareholders and to trade unions in the case of loans to directors.

So what is the solvency and liquidity test?

Basically the company’s assets must exceed its liabilities and it must appear that the company will be able to pay its debts as they become due, for a period of 12 months.

Generally the test will be an accounting exercise as the act stipulates how the various values are to be calculated and what assets and liabilities are to be taken into account.

As for the declaration of dividends the solvency and liquidity test has to be applied twice:

• A company may not make any distribution unless it reasonably appears that the company will satisfy the test immediately after the distribution.

• The board has acknowledged that it has applied the test and has reasonably concluded that the company will satisfy the test after the distribution.

Note the subtle distinction between the two applications of the test.

Note also that a director will be liable if he or she failed to vote against a board resolution approving a distribution contrary to the provisions of the Companies Act.

A company is defined as being “financially distressed” and will be subject to the business rescue provisions of the new act if it fails a test very similar to the solvency and liquidity test, but in this case for a period of six months.

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