EXPLAINER | How liquidation works

  • The coronavirus lockdown has devastated the business sector and many businesses, big and small, have to make some tough decisions about their ability to continue or not.
  • It is important to understand the difference between factual insolvency and commercial insolvency.
  • Make sure you do the right thing by your creditors to avoid committing any offences.

The coronavirus lockdown has devastated the business sector and many businesses, big and small, have to make some tough decisions about their ability to continue or not.

An understanding of the law of insolvency can provide much clarity on the available options for companies that find themselves in financial difficulties.

Katherine Timoney, an associate at Gillan & Veldhuizen, explains that the Insolvency Act was developed to create a consolidated set of rules for how an insolvent's assets are dealt with. It is aimed at ensuring that the interests of all parties are protected and that all creditors are treated fairly.

The Companies Act and the Close Corporations Act incorporate the provisions of the Insolvency Act when dealing with corporate insolvency to ensure that insolvent individuals and companies do not try to circumvent the system in order to get money to one creditor rather than another.

The Insolvency Act states that, if you are in financial difficulty, there are certain things you should avoid doing, such as giving away assets or choosing which creditors you would prefer to pay. This could include "collusive dealings" before declaring insolvency, which would have the ultimate result of disadvantaging any creditors.

Timoney further cautions that businesses facing insolvency may be tempted to dispose of or conceal assets, especially in the current climate.

"If you or your business is in financial difficulty, it is important to do the right thing by your creditors so as to avoid committing any offences," warns Timoney.

Factual and commercial insolvency

Juliette de Hutton, a partner at the law firm Bowmans, says it is important to understand the difference between factual insolvency and commercial insolvency.

Factual insolvency is where liabilities exceed assets. Commercial insolvency is where the business is unable to pay its debts as they fall due.

Factual insolvency does not of itself require directors to take action. Many companies are factually insolvent for prolonged periods.

However, when a company is unable to pay its debts as they fall due, it needs either to take urgent steps to improve its liquidity - for instance taking out a loan or obtaining funds from an investor - or it needs to seriously consider either liquidation or business rescue.

De Hutton explains that business rescue is only an option where funds are available for ongoing trading and where there is a viable underlying business.

"If the directors of a company do not take urgent steps to address an inability to pay debts, they may fall foul of reckless trading provisions in the Companies Act. Reckless trading may result in a director being held personally liable for the debts of the company and can also attract criminal sanction," she explains.

"In order for a director to have traded recklessly, they must have been grossly negligent or displayed reckless disregard for the consequences of their actions. Errors of judgment alone do not necessarily result in reckless conduct."

A typical reckless trading scenario is where a company continues to carry on business and to incur debts when, in the opinion of "a reasonable businessperson standing in the shoes of the director", there would be no reasonable prospect of the creditors receiving payment when due.

When a company or business goes into liquidation, a liquidator is appointed to take control of the assets and to realise (sell) them. The proceeds will then be applied to satisfy creditors' claims in the legal order of preference.

Any secured creditors are paid from the proceeds of assets secured in their favour. An example would be where a bank that has registered a mortgage bond over a property owned by the company would be paid from the proceeds of sale of the property.

Proceeds from assets that are not secured are used first to pay employees, and then to pay the SA Revenue Service any amounts that are outstanding. The remaining funds (if any) are shared equally among the rest of the creditors.

Various fees and costs must also first be deducted from the funds available before creditors are paid.

Intellectual property

Bernadette Versfeld, a Partner at Webber Wentzel, points out that business rescue and liquidation have consequences for intellectual property (IP) as well.

IP describes "an umbrella of rights" which fall into two categories: registered and unregistered. The registered IP of a business may include patents, while the unregistered IP may include copyright, trade secrets and "know-how".

"Intellectual property is often overlooked when a business is compelled to seek business rescue or liquidation, but it may form a valuable asset, requiring decisions to be made on whether to sell it or maintain it," says Versfeld.

"It is a misconception that IP loses value upon liquidation. IP is critical to the operation of any business, especially if it is technology-based, for example one that relies heavily on software."

Frequently, valuable registered IP will remain in the name of a liquidated business at the Companies and Intellectual Property Office.

"It is critical to appreciate that after liquidation, it is no longer possible to secure ownership of this IP, so whatever IP the business owns must be investigated and appropriately dealt with, before the liquidation process is finalised," she suggests.

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