Financially Distressed Companies – Some Critical Considerations

Under the Companies Act (2008) a company is in financial distress if –

• it appears to be reasonably unlikely that the company will be able to pay all of its debts as they become due and payable within the immediately ensuing 6 (Six) months; or
• it appears to be reasonably likely that the company will become insolvent within the immediately ensuing 6 (Six) months.

A company typically becomes insolvent if its liabilities exceed its assets.

If your company currently finds itself in financial distress, some actions or inactions may make matters substantially worse for the company and potentially create personal liability for the individual directors.

In this short article we list some critical cautions for your company to consider:

1. BE CAREFUL NOT TO TRADE IN INSOLVENT CIRCUMSTANCES:

• In terms of Section 129(7) of the Companies Act, if the board of a company has reasonable grounds to believe that the company is financially distressed, but the board has not adopted a resolution to place the company in business rescue, the board must deliver a written notice to each affected person (creditors, employees, shareholders and trade unions), setting out the financial distress circumstances of the company and its reasons for not adopting a resolution to place the company in business rescue.
• It may therefore become necessary / compulsory for your company to consider business rescue proceedings if your business becomes financially distressed.
• South African directors who fail to take action when trading in a company in financial distress may, in terms of Section 214 of the Companies Act (2008), render a director guilty of a criminal offence and be liable to a fine or imprisonment for a period not exceeding 10 years or to both a fine and imprisonment. Section 77 of the Companies Act (2008) furthermore provides that where a director knowingly carried on the business of the company recklessly or with the intent to defraud creditors or other stakeholders, such director may be held personally liable for any loss incurred by the company.

• Where a director fails to give the required notice in terms of Section 129(7) because he/she reasonably and honestly believes that he/she is acting in the best interests of the company, such director may be able to argue that any personal liability otherwise to be incurred by that director should be excused in the circumstances under Section 77(9) of the Companies Act (2008). Reliance on this section of the act, commonly referred to as the “business judgement rule” should, however, only be considered under guidance of an experienced legal team.

2. BE CAREFUL NOT TO CONFIRM INABILITY TO PAY BEFORE OBTAINING LEGAL ADVICE:

• Section 8 of the Insolvency Act (1936) sets out certain acts of insolvency that can be committed by a company, which includes the following:
  • a company offering to make any arrangement with any of its creditors for releasing it wholly or partially from its debts; and
  • a company giving notice in writing to any one of its creditors that it is unable to pay any of its debts.
• If a company commits an act of insolvency as described above, a creditor is permitted to launch an application for liquidation of the company. If your company is currently unable to pay a creditor, we recommend that you obtain legal assistance before communicating with the creditor in this regard.
• In this regard it should be noted that the obligation placed on company directors to communicate its financial distress to affected persons, including creditors, as set out in Section 129(7) of the Companies Act (2008), may unavoidably lead to the commission of a deed of insolvency by the company, confirming the company’s inability to pay its debts. It is therefore of utmost importance that directors of a company obtain guidance and assistance from its legal team before giving any notice related to the company’s financial distress.

3. BE CAREFUL NOT TO COMMIT A BREACH OF A CONTRACT BY REPUDIATING THE CONTRACT:

• Repudiation of a contract occurs where one party renounces their obligations under a contract. One example of repudiation is where a party openly states to the other contracting party that they are either unwilling or unable to perform their obligations under the contract.
• Repudiation is a form of a breach of contract. Once a contract has been repudiated, the aggrieved party may either elect to enforce compliance with the contract or accept the repudiation and cancel the contract, which would entitle such party to claim damages.
• For example, if a tenant communicates to a landlord that it will not make payment of rent for a particular month due to Covid-19 and the national lockdown, the tenant will clearly commit a repudiation of the lease agreement (unless the lease agreement has a force majeure clause that allows the tenant not to make payment of rent). The landlord, if he accepts the repudiation, will be entitled to cancel the lease agreement and claim damages from the tenant, which damages could include rent for the duration of the lease period.

4. BE CAREFUL NOT TO TRADE RECKLESSLY OR DEFRAUD CREDITORS:

• Any director, who allows his company to receive goods on credit from a creditor, knowing full well that the company is not in a position to make payment for such goods, opens himself/herself up to a personal liability claim. Such conduct would constitute reckless behaviour on the part of the director and may also include an intent to defraud the creditor who supplied goods to the company on credit.
• Section 77(3)(b) of the Companies Act (2008), as read with Section 22 of the Companies Act (2008), penalizes and holds directors personally liable for any loss incurred through knowingly carrying on the business of the company recklessly, with gross negligence, with the intent to defraud any person or for any fraudulent purpose.

For guidance and assistance in these unprecedent economically challenging times, feel free to contact our experienced team of lawyers to assist you in taking the right actions at the right time to protect your company and its directors.

To assist you in better understanding the legal framework that applies to financially distressed companies, our firm will publish a series of short articles on business rescue (including what it is and how the process works) as well as liquidations.

JACO WILLEMSE

ASSOCIATE