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Should Creditors Rely on the Solvency and Liquidity Threshold for Protection? A South African Case Study

Published online by Cambridge University Press:  24 February 2015

Richard S Bradstreet
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Abstract

Many jurisdictions internationally have adopted some form of solvency-based threshold to protect creditors from opportunistic or abusive distributions being paid from corporate capital. When a legislative “test” for distributions involves an enquiry that is too heavily based on a company's balance sheet, and thus on the integrity of the financial reporting standards underpinning its preparation, the utility of such thresholds becomes questionable on a similar basis to that on which the effectiveness of the capital maintenance doctrine has been challenged. Even the addition of a “liquidity” threshold that shifts the emphasis away from a company's balance sheet appears to presume that a corporation's financial health can be accurately determined from its financial statements. This article explores the difficulties involved in so-called “solvency-based” thresholds for distributions and considers other sources of creditor protection that may be more reliable.

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Type
Research Article
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Journal of African Law , Volume 59 , Issue 1 , April 2015, pp. 121 - 149
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Copyright
Copyright © SOAS, University of London 2015 

INTRODUCTION

Since the creation of the limited liability corporation, there has been a substantial risk for creditors who finance the business of incorporated entities. In this commercial context, legislators bear responsibility for facilitating an environment conducive to commercial enterprise by, inter alia, protecting debt financiers sufficiently so as not to discourage their participation.Footnote 1 A particularly important task is the regulation of a corporation's capital. The modern trend of corporation statutes is to do so by applying a test based on a company's solvency: a company will be prohibited from making distributions from its capital if it is not “sufficiently” solvent. In many jurisdictions, the requisite level of solvency will be determined by the application of a legislative “solvency test”, which in some instances also involves a liquidity “limb” in order to consider a shorter-term conception of solvency.

South Africa has recently reformed its company law, incorporating a test for distributions based on both solvency and liquidity, largely following contemporary trends in corporate finance law internationally. Even before the most recent and drastic reforms, South Africa had adopted a similar test by a legislative amendment in 1999.Footnote 2 By incorporating this test, a prominent scholar on legal capital has remarked that “South Africa can be justly proud that even before the Company Law Reform process was launched early in the first decade of the twenty-first century, the existing Companies [legislation] had already gone through amendments to its legal capital provisions since its original enactment and embraced many of the principles of the 1984 revision of the Model Business Corporation Act.”Footnote 3

The American Model Business Corporation Act (MBCA) referred to has been celebrated as an invaluable reference for the legislative reform of any corporation statute. Even prior to its revision, one author called the act, in its unrevised form, “a magnificent work” and wrote: “I cannot remember when in recent years I have experienced such sheer pleasure from reading a legal text as I did from the Model Business Corporation Act Annotated”.Footnote 4 Others, however, “would not anoint the MBCA with the self-congratulatory accolades that accompanied (promoted?) the publication of the Model Business Corporation Act Annotated in 1961”.Footnote 5

Whatever the opinions of various authors may be, it is widely accepted that the solvency (and liquidity) standard as a benchmark for capital distributions is more satisfactory than the old regime of capital maintenance, and it appears that South Africa, in a recent and drastic reform of its companies legislation, has drawn inspiration from the MBCA's formulation of the test.

The South African corporate landscape was overhauled by the Companies Act 71 of 2008 (Companies Act 2008),Footnote 6 which has not only made significant changes to the available structures for corporate undertakings, but also (with regard to corporate finance in particular) abandoned the idea of par value shares in favour of a “no par” system of capitalization of profit companies. In the explanatory memorandumFootnote 7 to the new provisions, as well as the policy document on guidelines for corporate reform,Footnote 8 this shift has been described as one that replaces par value shares and nominal capitalFootnote 9 with a “capital maintenance regime based on solvency and liquidity”,Footnote 10 although reference to the old capital maintenance doctrine may be misleading.Footnote 11

Although developed with the protection of creditors as its objective,Footnote 12 the doctrine of capital maintenance has been strongly criticised as a rule based on arbitrary considerations that fails to achieve its purpose of creditor protection.Footnote 13 The solvency and liquidity regime, referred to in the explanatory and policy documents noted above, is an attempt to afford protection more effectively to creditors in a similar context. Whereas capital maintenance was essentially about maintaining what is referred to as the “legal capital” by restricting a corporation's power to reduce its capital, the standards of solvency and liquidity have similarly been introduced to restrict the power of the corporation to reduce its capital, but without reference thereto. This is because the concept of “legal capital” is essentially little more than a figure on a corporation's balance sheet and is, as such, subject to manipulation. The capital maintenance doctrine, based on the concept of legal capital, has been criticised on this basis when used to determine the permissibility of making distributions to shareholders. This “legal capital” figure cannot afford protection to creditors when what it represents is unclear, and the solvency and liquidity standard is an attempt to afford better protection to creditors by more effectively limiting a corporation's power to dispose of assets from the same pool to which creditors will have to look for settlement of their claims.

Even though the legislature's recent attempt to overhaul South African company law, embodied in the Companies Act 2008 (which draws significantly from the MBCA), may be considered one of the most “advanced” in its treatment of corporate distributions, it is not clear whether creditors should place total reliance on a solvency-based threshold in determining a company's financial health. This article attempts to outline the problems inherent in regulating capital “distributions” and ascertain whether (and to what extent) the solvency and liquidity test has provided a solution, by drawing on recent developments in South Africa and considering alternative sources of creditor protection. Reference will also be made to the regulation of distributions by the MBCA and Delaware General Corporation Law (DGCL), the latter being considered one of the most (if not the most) permissive corporation statutes in the world,Footnote 14 which interestingly has chosen not to follow the MBCA's approach to regulating distributions.

BACKGROUND: CREDITOR PROTECTION

Solvency-based thresholds for distributions have replaced the doctrine of capital maintenance, which was based on so-called rules of “legal capital”Footnote 15 and has traditionally been seen as a mechanism aimed at protecting the interests of creditors from abusive conduct. An assessment of the new solvency (and liquidity) regime should thus first begin with an analysis of the principles underlying the capital maintenance doctrine in order to expose the difficulties inherent in the previous system and properly assess the effectiveness of the new one in more efficiently addressing the same mischief for which the concept of capital maintenance was conceived in the first place.

In the context of corporate financing generally, it is important to recognize the role of creditors, who (along with shareholders) comprise the two categories of investors who will set in motion the commercial endeavours that, when viewed collectively, not only constitute the bulk of a country's economy, but also turn the cogs of a country's economic development. The protection of creditors ultimately serves not only the interests of the broader economic good of society, but also the debtor's own interests, in that an unwilling creditor is an unavailable source of debt finance, which would be useful to enable or enhance a corporation's profit motive. Where a change in approach to creditor protection amounts to the complete replacement of one mechanism for another, it becomes important to reassess the protection of creditors’ interests in order to ensure that this important group is not discouraged from making financial contributions to a company.

Chin and Wong identify a number of inherent disadvantages faced by creditors when they extend credit, two of which are most pertinent in this context. First, contrary to the assumption of market analysis that all parties have perfect information about the market, an asymmetric balance of information is always the case when we remember that creditors are not members of the company.Footnote 16 Secondly, the “incentive from within the company to gamble with the creditors’ monies and engage in the riskier ventures than what has been represented to the creditors”Footnote 17 increases the risk faced by creditors, and is exacerbated in instances where the company's management holds a majority of shares,Footnote 18 and by the asymmetric balance of information.

Legislation dealing with corporate finance must seek to balance the conflict of interest that will necessarily arise whenever a company with shareholders incurs debts. Essentially, this conflict relates to the money paid into the company by shareholders in return for shares. This “proprietorship investment”Footnote 19 by holders of equity serves to provide security for holders of debt, in that creditors (whether or not “secured” in the technical sense) will be happier to extend credit to a company that appears to possess sufficient capital for the settlement of debts on liquidation.

Creditors, as outside investors vis-à-vis the shareholders, are not privy to the internal management of the company. The body of shareholders governs the affairs of the limited liability company by voting at general meetings and appointing representatives (the board of directors) to manage the company on a day-to-day basis. The shareholders, furthermore, enjoy limited liability, and (subject to the restrictions imposed on them by the company's constituent documentFootnote 20 that regulates the shareholders’ position among themselves)Footnote 21 are entitled to act in their own selfish interests.Footnote 22 Although directors are subject to fiduciary duties, these duties are owed to the company, rather than its creditors. “As the creditor sees it, hungry goats have been set to watch the cabbages.”Footnote 23

“As liabilities connected with the running of the company are externalised, it [becomes] necessary to avoid opportunistic behaviour on the part of shareholders, which is doomed to increase when insolvency is drawing near”,Footnote 24 and there should, accordingly, be legal rules in place to prevent such conduct on the part of the “internal” equity financiers, thereby protecting the “external” debt financiers.

Manning and Hanks distinguish four ways in which this conflict of interests manifests itself in practice.Footnote 25 First, and most obviously, whereas creditors will prefer a larger amount of assets to be held by the company, against which they will have a stronger claim than shareholders, the shareholders will want to be placed as little as possible at risk of being subject to such claims by creditors. Secondly, whereas shareholders will often welcome additional investments of debt in the company by further creditors, such additional obligations will encumber the company's same limited asset pool, and ultimately dilute the pro-rata share that concurrent creditors will be able to expect upon liquidation of the company in the event that it becomes over-indebted. Thirdly, whereas the creditors would prefer that their claims are settled prior to shareholders receiving any return on investment, the shareholders will expect a return when the company makes a profit. Fourthly, the payment of dividends to shareholders is directly against the creditors’ interests in so far as it reduces the company's capital.

Against the backdrop of creditor protection, the choice of the comparative law surveyed will be clearer. The MBCA will be relevant to the discussion to follow by virtue of its very nature as a “model” statute. South Africa's Companies Act 2008 provides a recent example of a complete overhaul of a state's corporation laws, which appears to have adopted the MBCA's solvency and liquidity model in relation to distributions. Conversely, Delaware has opted not to overhaul its corporation statute, and the DGCL still regulates methods of “capital reduction”, but now imposes a threshold based purely on solvency, which is to be applied to such reductions. Delaware also has a reputation for being a haven for incorporation and has a vast jurisprudence of case law dealing with corporate matters,Footnote 26 which makes the DGCL particularly relevant in the context of a discussion dealing with balancing the rights of a company with those of its creditors.

LEGISLATIVE REGULATION OF SHARE CAPITAL

The system of shareholding in a company is not only a method to raise capital, but is also a “mechanism for limiting the liability of members, apportioning the rights and interests of members, and reducing the exposure of creditors to risk”.Footnote 27 As such, it is an important consideration in assessing any corporation statute's approach to balancing the rights of creditors and shareholders. Regulated share transactions may be divided broadly into the categories “capital formation” and “capital reduction”.

Formation of share capital

The importance of a company's capital from a creditor's viewpoint stems from the fact that “creditors are limited to making claims against assets that are held in the name of [the] firm itself, and have no claim against assets that the firm's shareholders hold in their own names”.Footnote 28 For the purposes of this discussion, therefore, it is only important to consider the legal nature of a company's shares in so far as this will have a bearing on the calculation of its distributable capital. This amount may be directly ascertainable by looking to the “legal capital” amount in the company's financial records, or indirectly so by means of solvency and liquidity calculations derived from such records. The discussion pertaining to the formation of share capital will therefore be limited to the legal nature of shares and any other requirements associated with reducing “legal capital” by distributions or otherwise.

Reduction of capital

There are a number of reasons for a company to reduce its capital, including converting capital reserve in order to render it distributable by way of dividends to shareholders, returning surplus to shareholders where assets exceed business needs, restructuring by the repurchase of stock and redemption of certain classes of stock, reconciling “book capital” with company assets, and refinancing in order to reduce expenses.Footnote 29 This is therefore an important area for regulation, and legislation governing corporations will aim to deal with this area in a way that protects both the holders of equity (shareholders) and the holders of debt (creditors) in respect of companies incorporated and governed under the applicable statute.

The precarious position of creditors as outsiders of the corporation means that they are not party to internal decision-making that affects the way in which the company regulates its own operations, and will therefore often have to rely on the protection afforded them by the relevant corporation statute.

“To protect creditors adequately and, at the same time, secure flexibility in corporate capitalization is a nice problem for the legislator. Where this problem has been faced squarely admirable statutes have resulted; but the great majority of corporation acts offer the creditor little security in the reduction situation. Uniformly, and perhaps necessarily, the statutes make reduction dependent upon a vote of the shareholders, the very group against which creditors require protection.”Footnote 30

A legislature may utilize any combination of three main regulatory strategies that exist to protect the interests of creditors in relation to the maintenance and reduction of corporate capital generally:Footnote 31 mandatory disclosure rules in relation to financial performance; detailed legal capital rules; and broad solvency-based standards underpinned by personal liability attaching to directors or controllers.Footnote 32 South Africa's recent corporate law reform represents a significant shift away from the second, towards the third.

The notion of “adequate” capital to make a distribution

The conflict of interests associated with the debt financing of a corporation gives rise to the necessity of providing creditors with some form of protectionFootnote 33 and this protection has in the past been provided by the so-called rules of “legal capital” or “capital maintenance”. Legislation based on principles of legal capital has typically required that a company have an “adequate” amount of capital before making any distribution from its capital funds.

Jurisdictions that embrace rules of legal capital subscribe to what is commonly referred to as the doctrine of “capital maintenance”. The aspect of the capital maintenance doctrine that remains of paramount importance is the idea that creditors should have somewhere to look to for the settlement of their claims. For this reason, rules that aim to guard a company's capital, protecting it from menacing shareholders, have preserved its relevance conceptually in spite of its theoretical difficulties.

As mentioned in the introduction, the idea of capital maintenance is simply aimed at ensuring that “the issued share capital of a company, whatever this amount may be, is maintained, in the sense that the company may not return or repay its issued share capital to its shareholders except where authorised by [law]”.Footnote 34 Although the rationale behind this is “the protection of creditors from the abuse of limited liability by directors and shareholders … the reality is that very few creditors would rely on the company's issued share capital as an indicator of its credit-worthiness”.Footnote 35

Rules of legal capital: Concretized conclusions from the capital maintenance doctrine

The rules based on the concept of capital maintenance may all be seen as restrictions on the distribution of a company's capital. A company is obliged to maintain its issued share capital because the courts have, in the past, regarded this capital amount to be a “guarantee fund or a permanent fund intended for the payment of claims of the creditors of the company”.Footnote 36 The general principle, under which a creditor should be “entitled to look to that capital as his security”,Footnote 37 was formulated by Boshoff J as: “[w]hatever has been paid by a member cannot be returned to him and no part of the corpus of the company can be returned to a member so as to take away from the fund to which the creditors have a right to look as that out of which they are to be paid. The capital may be spent or lost in carrying on the business of the company, but it cannot be reduced except in the manner and with the safeguards provided by the statute.”Footnote 38

Rules that restrict a company from making capital distributions are numerous and often overlap conceptually due to the fact that they all serve essentially the same function. As a basic premise, these rules can be broadly divided into those that relate to the payment of dividends by the company and those that relate to various share transactions. This distinction may be blurred when one deals with both such transactions under a wider conception of a “distribution” according to modern trends.

Rules relating to share transactions

Shares, being the units of capital contributions by members, will naturally be subject to regulation in that the real substance of any share transactions will ultimately be the capital of the company in question, and share transactions provide an alternate means of draining a company's capital. Consequently, there arises potential for prejudice to creditors where the capital structure is altered, where redeemable preference shares are redeemed, and where a company provides financial assistance for the purchase, or purchases, of its own shares. Effective legislative restrictions on such transactions to ensure the maintenance of legal capital would need to be by means of prohibitions with mandatory procedures for approval by stakeholders, or provision for judicial oversight as specific exceptions.

Rules relating to payment of dividends

Flowing directly from the capital maintenance doctrine, the payment of dividends out of share capital and the payment of interest on shares out of share capital were both prohibited. In South Africa, the former prohibition has its roots in the English case of Re Exchange Banking Company, Flitcroft's Case,Footnote 39 which laid down the rule at common law, the scope of which was later curtailed by section 90 of the Companies Act 1973, as amended in 1999.Footnote 40 Section 79 of the Companies Act 1973, similarly, created an exception to the latter prohibition by specifying certain circumstances in which interest payments may be made out of share capital.Footnote 41

More indirectly, “[t]he fact that a company is a separate entity is of significance in determining what profits are available for dividend purposes”.Footnote 42 A holding company, thus, may only distribute its own profits in the payment of dividends, and not the profits reflected in the “consolidated accounts of the holding company and its subsidiaries”.Footnote 43 A further rule of capital maintenance that has emerged in this regard is the prohibition on subsidiary companies being members of their holding companies. Any analysis of less rudimentary rules of legal capital or distributions in the context of groups of companies will be superfluous for the purposes of this article. Emphasis will be placed on the broad principles that underlie the rules, and these are sufficiently evident in the doctrine of capital maintenance.

Utility of maintaining “legal capital”

The so-called rules of legal capital essentially boil down to what is more commonly referred to as the doctrine of “capital maintenance”. The doctrine itself is unnecessarily complex,Footnote 44 and many of the rules that it embodies have “outlived their usefulness”.Footnote 45 Legal capital essentially refers to the company-specific capital amount that ought to be maintained by the doctrine of capital maintenance. This concept is, however, more elusive than would appear at a cursory glance.

The rules of legal capital offer what may be referred to as a “financial cushion”Footnote 46 in the form of the net assets of a company, serving to provide advance warning when the danger of liquidation is foreseeable.Footnote 47 The protection of creditors’ interests is intrinsically linked with the doctrine of legal capital, particularly in the case of limited liability companies,Footnote 48 where creditors are restricted to bringing a claim against the assets of the incorporated entity, the shareholders behind it being absolved from any liability in excess of their capital contributions made in the purchase of shares.Footnote 49 Legal capital rules assist in curbing “opportunistic behaviour” by shareholdersFootnote 50 by insisting on the “maintenance” of the company's capital. Shareholders will thus be unable to undermine the primacy of creditors’ claims against the company by stripping away corporate assets.

Traditionally, the “aggregate of the amounts reflected in a company's capital accounts”Footnote 51 (ie the issued share capital) has been treated as the level of capital demarcating the company's capital fund.Footnote 52 It is this fund that the rules of legal capital serve to protect by prohibiting the return of the capital contained therein to shareholders, thus ensuring that this amount is “reserved for business purposes and for creditors”.Footnote 53 Capital in excess of the amount constituting the “corporate reservoir of [net] assets”Footnote 54 in the capital fund (ie capital surplus) would not be subject to the same prohibitions and would therefore be distributable without impairing the full capital fund.

There is still much academic debate surrounding the doctrine of capital maintenance,Footnote 55 although the general consensus seems to be that it is a relic of the far less nuanced approach taken to company law in the days of its early development. Those who continue to defend the doctrine argueFootnote 56 that creditors will be protected by the preventative protection that it offers, including the prevention of the “plundering” of a company (particularly following a takeover), and that legal capital “has the same effect as a covenant with all the creditors [thus being] of value to weaker creditors who cannot negotiate covenants for themselves [and also for all creditors in that] it avoids the transaction costs involved in negotiating contractual protection”.Footnote 57

Arguments against the utility of capital maintenance stem from the conceptual failures of the legal capital concept that underlies it and the rationale that creditors can protect themselves, or that their protection should be afforded in insolvency law, rather than company law.Footnote 58 Reasons advanced includeFootnote 59 the crudeness of poorly designed legal capital rules, the costs that they impose being disproportionate to their benefits, their distortion of corporate finance decisions, and the fact that their “intended protective effect is nullified by the efforts of astute legal and financial professionals who, with relative ease, can devise schemes to bypass the rules”.Footnote 60

Another practical problem with having a rule against diminishing corporate capital would arise when a corporation raises more capital than it needs: such a corporation ought to “be able to refund unneeded capital to its stockholders [and thus] a strict non-invasion rule might be too strict”.Footnote 61

Thus, although a company's capital fund may have relevance to creditors in theory, in practice it does not provide any real assurance of an ability to repay debts owing to such creditors. Furthermore, in the light of the potential for this amount to be misrepresented or manipulated by clever accounting methods, the doctrine of capital maintenance can hardly be said to provide much reliable protection to a company's creditors. It is therefore not surprising that capital maintenance has been referred to as “a religion with few converts”.Footnote 62 It is submitted that the shortcomings of the doctrine at a conceptual level constitute sufficient reason to seek an alternative approach to achieve the doctrine's purported creditor-protectionist goals on a less fictitious basis.

Theoretical basis of a solvency-based standard

Solvency-based standards require a company's board of directors “to take a view on the company's solvency and liquidity and to assume personal liability for that view”.Footnote 63 Although the drafting of solvency tests may differ in different legislation, they typically require that directors certify that, not only is the company solvent at the time of the “pay-out” from the capital fund, but also that it will remain solvent for some time thereafter.Footnote 64

The problem with the solvency test for long-term creditors in particular is that, since directors cannot be expected to soothsay far into the future, the interests of long-term creditors may be overlooked in a calculation of a more immediately foreseeable future position of solvency.Footnote 65 Directors cannot therefore be expected to assume personal liability for the state of affairs that ensues, potentially even after they have ceased to be directors.Footnote 66 Creditors whose claims will outlast the limited “time horizon”Footnote 67 set for the solvency test will therefore naturally be apprehensive about solvency-based standards.

The solution to this problem of “optional short-sightedness” in the determination of solvency may lie in requiring directors either to take long-term liabilities into account or to rely more specifically on an “accounts-based balance sheet test of an excess of assets over liabilities” in their assessment.Footnote 68 Neither of these, however, is ideal, in that the former leaves wide discretion for directors and the latter overlooks the problem that “financial statements drawn up under accounting rules that were not designed with creditors’ interests primarily in mind are not necessarily a reliable yardstick”.Footnote 69

Hanks suggests that there is no need to have a solvency test based on both equity and solvency, since any reliance on the balance sheet harks back to capital maintenance and would not be useful in protecting creditors.Footnote 70 This is because a liquidity test does not, as would a purely solvency-based one, assume that “all liabilities are due and payable currently”.Footnote 71 A liquidity test (based on “equity insolvency”) is therefore premised on the idea that an inquiry based purely on “balance sheet insolvency” would not be sufficient on its own.Footnote 72 Each element is discussed separately in the section below dealing with the solvency and liquidity approach.

Appropriateness vis-à-vis capital maintenance doctrine

An example of the global shift away from the traditional approach to capital maintenance towards various approaches based on solvency and liquidity testsFootnote 73 may be found in the corporate law reform of many American states that have chosen to follow the regulatory capital approach taken by the Revised Model Business Corporations Act.Footnote 74 This reflects a general sentiment that solvency and liquidity is a more accurate benchmark for assessing whether a company is “healthy” enough to be able to settle claims owed to creditors.

The solvency and liquidity model is of broad general relevance, not merely applicable to instances of distribution of capital, but also extending to analyses of risk in financial institutions, “[t]he global financial crisis of 2007–09 [having] illustrated the importance of … accounting for liquidity feedbacks within any model of systemic risk”.Footnote 75 The capital maintenance doctrine has, for the reasons already outlined, been subject to harsh criticism, and the enactment of the Companies Act 2008 invited an opportunity for the legislators in South Africa to abolish the doctrine in its entirety. The removal of all capital maintenance terminology from the new legislation (which embraces solvency and liquidity) removes what may be perceived as an artificial reconciliation of two concepts that are based on contrary understandings of what provides protection for creditors, as was reflected in the Companies Act 1973. The next section will deal with the approach recently adopted by South Africa specifically,Footnote 76 as well as issues arising in relation to the solvency and liquidity approach more generally.

THE SOLVENCY AND LIQUIDITY APPROACH

This article has already discussed the restrictions of solvency and liquidity, which replace those based purely on the idea that a company must maintain its capital and only make distributions from surplus. A test that utilizes these requirements, and specifically the liquidity requirement, would be effective in preventing a company from making distributions that would pose a real threat to the security of creditors’ claims. A test based on solvency “entails that the assets of the company should exceed its liabilities after the distribution has been taken into account”.Footnote 77

In order to prevent abusive depletion of a company's financial worth, it is essential to restrict the financial circumstances in which a company is permitted to make distributions of its capital. Essentially, therefore, a company should only be allowed to distribute its capital when it is in a financially healthy state.

Section 4 of the Companies Act 2008 sets out a “solvency and liquidity test” which is satisfied if, at the relevant time,

“considering all reasonably foreseeable financial circumstances of the company at that time – (a) the assets of the company, as fairly valued, equal or exceed the liabilities of the company, as fairly valued; and (b) it appears that the company will be able to pay its debts as they become due in the ordinary course of business for a period of – (i) 12 months after the date on which the test is considered; or (ii) in the case of a distribution contemplated in paragraph (a) of the definition of ‘distribution’ in section 1, 12 months following that distribution”.

The MBCA contains a similar test, which has remained unamended for more than 25 years,Footnote 78 but it does not provide the board with an opportunity to consider all reasonably foreseeable financial circumstances, nor does it explicitly allow the board to base its decision on the company's liabilities.Footnote 79 These inclusions in the Companies Act 2008 therefore, in principle, improve on the test set out in the MBCA.Footnote 80

The DGCL only provides for a solvency-based threshold for capital reductions. Where a Delaware corporation is empowered to reduce its capital,Footnote 81 that reduction may only be made if “the assets of the corporation remaining after such reduction shall be sufficient to pay any debts of the corporation for which payment has not been otherwise provided”.Footnote 82 This solvency test would theoretically ensure that there is sufficient capital remaining to settle creditors’ claims.

It is important to note that the South African solvency and liquidity test requires that both elements are satisfied: ie the company must be both sufficiently solvent and sufficiently liquid in terms of the test. Each of these elements will be considered separately.

Solvency element: “Balance sheet test” for “bankruptcy solvency”

The test restricting the reduction of capital in the DGCL is a purely solvency-based test requiring that “the assets of the corporation remaining after such reduction shall be sufficient to pay any debts of the corporation for which payment has not been otherwise provided”.Footnote 83

The reason for having this kind of test for “bankruptcy solvency” (included as the “solvency element” of the dual test in the Companies Act 2008) is to give “advance recognition to the ultimate priority that creditors enjoy over shareholders upon dissolution of the company by preventing the company from favouring its shareholders through a partial liquidation”.Footnote 84 It is not certain, however, that the “balance sheet test” involved really provides any protection to creditors.Footnote 85 Hanks notes that “the balance sheet solvency test implicitly assumes that all the liabilities are due and payable currently … [which is] almost never completely the case”Footnote 86 in that some liabilities may only become due in a number of years’ time. Considering that the test in the Companies Act 2008 places emphasis on a 12 month period for assessing liquidity, it seems strange that a long-term liability with a negligible effect on a company's short-term financial situation would still be able to obstruct a distribution.

There are also certain general criticisms that may be levelled at the “balance sheet limb” of a solvency test, on the basis that certain assumptions underlying the utility of asset valuation may serve to distort a true reflection of a corporation's health.Footnote 87 Using the example of meat processing companies, Haynes notes that a corporation's asset value on liquidation would often tend to be lower than would be the case if the corporation was a going concern, and that the value of assets may be relatively higher or lower as compared between two corporations.Footnote 88 In this example, the equipment for processing meat would have little value in relation to any other activity. Furthermore, intangible assets such as goodwill may become problematic when their representation on a balance sheet is only appropriate in relation to the present owner who has generated the goodwill and to the existence of the business as a going concern.Footnote 89

It thus seems as though the rationale underlying a solvency-based test harks back to the misplaced reliance on a company's balance sheet as a reflection of its financial state of affairs. The solvency element of the test does not appear to provide much more protection to creditors than the capital maintenance doctrine did. A solvency standard which places emphasis on a company's balance sheet will tend to be heavily reliant on the integrity of accounting standards and assumes that the relevant rules and principles will be applied in a sufficiently robust manner to create reliable representations of a corporation's financial health.

Liquidity element: “Equity test” for “equity solvency”

The rationale behind the liquidity element of the test is that it “addresses the fundamental expectation of creditors to be paid on time and also fits in well with the representation a company is said to make when it incurs debt, namely that it reasonably expects to be able to pay as and when the debt becomes due”.Footnote 90 In the application of a “liquidity limb” of a solvency test, there will also invariably be a number of assumptions relating to the anticipated demand for the company's goods or services, hence the availability of funds to settle the company's obligations as they arise.Footnote 91

The test required for capital reduction under the DGCL has no liquidity limb at all. The MBCA does contain a liquidity element, without reference to any particular time during which a company must be able to pay its debts. The South African Companies Act 2008 has however gone further and included a liquidity element that also incorporates such a time threshold.Footnote 92 Van der Linde submits that the time threshold in the Companies Act 2008 is an undesirable inclusion because “the specification of a time period … may disadvantage creditors of companies that have clearly foreseeable longer-term commitments that are not payable within twelve months”.Footnote 93 Further, she suggests that a company's liquidity should be judged by its “ordinary course of business”, which should be the decisive factor.Footnote 94

It may be argued that the 12 month period protects creditors by limiting the board's discretion in applying the test; however, the same result could be achieved (without underemphasizing a company's particular circumstances) by creating a “presumption that the company did not satisfy the test if is liquidated within a specific period”.Footnote 95 This kind of presumption would benefit creditors because they would not be burdened with having to prove the directors’ assessment to be unwarranted in the event of a subsequent liquidation,Footnote 96 and the time threshold could also be made longer without burdening directors with the task of soothsaying unreasonably far into the future. It appears then that the accuracy of such predictions would be dependent upon how effectively the relevant legislation ensures an accurate calculation of the company's financial health, which again would turn largely on the integrity of the applicable accounting standards and the directors’ ability accurately to predict the future.

Should the test be objective or subjective?

The “reasonableness” of a director's decision will be a necessary criterion to exonerate him from liability when relying on inaccurate information, but also holds the potential of perpetuating the problem of when a director may reasonably rely on creative calculations to the detriment of creditors. Ultimately, creditors will be concerned with whether a debtor-company is actually solvent subsequent to making a distribution,Footnote 97 not whether the directors would expect it to be solvent, nor whether the accountants could make it look solvent. Although accounting standards ought theoretically to represent an objective reflection of a company's present state of affairs, any judgment to be made in relation to future health gives rise to the question of whether an objective or subjective standard ought to be applied. An approach with narrow scope for the subjective interpretation of facts would best protect the interests of creditors by limiting the ability of directors to err on the side of acting in the interests of the shareholders who appointed them.

In the Companies Act 2008, “neither the solvency nor the liquidity aspects of the test are based on actual solvency and liquidity, but on predictions”.Footnote 98 The presumption suggested by Van der Linde is based on actual insolvency and would therefore be preferable for this reason. Unlike the Companies Act 2008,Footnote 99 the MBCAFootnote 100 prescribes an “objective test independent of any particular person's reasonable belief”.Footnote 101 By drawing an analogy with the test for whether a director has acted with due care, skill and diligence,Footnote 102 Jooste submits that the solvency and liquidity test is purely objective, in that it does not include the subjective factors expressly included in the test for care, skill and diligence.Footnote 103

Jooste also points out that the solvency and liquidity test in the Companies Act 2008 seems to vary, depending on the circumstances in which it is applied.Footnote 104 This means that there may in fact be two different tests, applied in different cases. Financial assistance for the purchase of shares (dealt with in section 44) and loans to directors (dealt with in section 45) are treated differently to distributions, but also have the potential to reduce a company's capital in the old-fashioned sense, and are therefore also restricted by the solvency and liquidity test. In relation to both these transactions, the board only needs to be “satisfied” that “the company would satisfy the solvency and liquidity test”.Footnote 105 This creates the potential for the test to be interpreted as a purely subjective one, the requirement being satisfied “no matter how unreasonable that satisfaction may be”.Footnote 106 If this is the case, and to the extent that it is, the application of the test in relation to these transactions is highly problematic for creditors in South Africa.

Solvency and liquidity as financial health indicators

Any solvency-based threshold is essentially about “evaluating the risk that a company will not be able to raise enough cash before its debts must be paid”.Footnote 107 Whatever benefit is derived from forecasting a company's ability to repay its debts will be diminished in proportion to the amount of time that will lapse before payment is made, together with the accuracy of whatever predictions are made.

The ability to make distributions is certainly an indicator of a corporation's financial affairs, but this relates specifically to the way in which such affairs are reflected in financial statements. In the same way as creative accounting could bypass the protection offered, in principle, by the capital maintenance rule, financial reports of solvency are by no means immune to manipulation. Any solvency-based threshold for distributions is essentially an in-built corporate failure prediction mechanism that relies on inputs from the company itself to determine whether there are sufficient profits to justify a capital distribution.

Despite the potential pitfalls of solvency-based thresholds for distributions, the concept is at the very least an improvement on the capital maintenance doctrine in principle. Whether or not a liquidity threshold is also included appears to be fairly immaterial.

It has been argued that creative accounting is not only permitted, but encouraged, by the flexibility of accounting standards and practices.Footnote 108 The irony is that solvency thresholds are more likely to fail due to financial manipulation when they are most needed; researchFootnote 109 has indicated that financially distressed companies are far more likely to engage in creative accounting and thus remove the protection that creditors would otherwise, in principle, have had.

Aside from the same accountancy-related shortcomings of a purely solvency based standard that served to dethrone the capital maintenance regime, a liquidity threshold may come closer to a true representation of financial health over a certain period of time, but this still tends to assume the infallibility of information in financial reports in so far as the objectivity of such a test is concerned. When subjective predictions must be made based on potentially inaccurate financial information, the problem is exacerbated.

Furthermore, the use of cash flow information generally in predicting corporate failure has been a point of contention.Footnote 110 Research has suggested that, notwithstanding the logical correlation between cash flow and bankruptcy, the use of cash flow analysis and ratios does not necessarily benefit corporate failure prediction models.Footnote 111

The importance of cash flow should not, however, be underestimated in so far as it may represent a strong indication of whether a company will withstand a period of financial trouble.Footnote 112 The concept of solvency is related to that of capital adequacy, but is not solely concerned with a coarse comparison of current assets against current liabilities: it is about whether a company has enough money to settle its debts, and thus whether it has sufficient cash to do so.Footnote 113

ADDITIONAL SOURCES OF CREDITOR PROTECTION

Regulation of source fund (for dividend payments)

Traditionally, payments of dividends in particular were prohibited by the capital maintenance doctrine to the extent that they reduced the company's capital. Thus, only payment from capital “surplus” or company profits was permitted.

In South Africa, under the Companies Act 1973, a company's capital accounts reflected what could not be returned to shareholders,Footnote 114 but in the past these accounts mattered more to shareholders than creditors.Footnote 115 Regulation of a source fund is justifiable, primarily with reference to principles of capital maintenance, and the concepts associated with this doctrine (based on accounting records, which are susceptible to manipulation) have now been abandoned in the Companies Act 2008. There are, therefore, no longer provisions dealing with the technical regulation of accounts such as the “share premium account”Footnote 116 or “capital redemption reserve fund”,Footnote 117 as previously required. Dividends are now regulated as “distributions” and, as such, are subject to the solvency and liquidity requirements of section 4.

In Delaware, corporations may only pay dividends out of either capital surplus or net profits,Footnote 118 thus requiring that invested capital be kept intact. This rule seems to be based on an outdated “legal capital” rationale. Accordingly, because a corporation's capital surplus and net profits (which take into account depreciation) become all-important, it is equally necessary for the DGCL to prescribe meanings for concepts such as “capital”, “surplus”, and “net profits”.Footnote 119 Since there are no longer complicated procedures involved with reducing capital under the Companies Act 2008, such technical regulation of capital funds is not necessary. The solvency and liquidity test provides an alternate method for protecting creditors.

Although the Companies Act 2008 does not draw any distinction between the distribution of profits and any other distributions, a company's memorandum of incorporation may require that dividends be paid out of the company's profits, in which case the common law rules and definitions would appear still to have relevance.Footnote 120

Valuation of assets

Under the Companies Act 2008, directors, when applying the solvency and liquidity test, must consider “a fair valuation of the company's assets and liabilities”Footnote 121 and may consider “any other valuation of the company's assets and liabilities that is reasonable in the circumstances”.Footnote 122 This is a strange provision, in that it is unclear what circumstances would make an evaluation other than a “fair” one reasonable.Footnote 123 Further, the uncertainty implicit in “reasonableness” may be used to justify a valuation as reasonable for the directors to make, weighing the company's interests above those of creditors.

It seems as though this wording may also have been inspired by the MBCA, which allows the board of directors to “base a determination that a distribution is not prohibited [under the solvency and liquidity test] either on financial statements prepared on the basis of accounting practices and principles that are reasonable in the circumstances or on a fair valuation or other method that is reasonable in the circumstances”.Footnote 124 The term “fair valuation” is new to the 2008 version of the test, in that the Companies Act 1973 referred to “the consolidated assets of the company fairly valued”.Footnote 125

Section 4(1)(a) of the Companies Act 2008 requires that “the assets of the company, as fairly valued, equal or exceed the liabilities of the company, as fairly valued”. This implies that distributions may only be made from net assets.Footnote 126 The DGCL deals, although fairly basically, with methods of calculating “capital”, “surplus” and “net profits” for the purpose of determining the amount of lawfully distributable capital.Footnote 127 Since the Companies Act 1973 did not provide any guidelines in this regard, the new act is certainly more proactive.Footnote 128 Although the Companies Act 2008 requires that any financial information relied on be based on records compliant with the provisionsFootnote 129 of the act, this still allows fairly broad discretion regarding the valuation of assets.

“Reasonable grounds” requirement?

Under section 46(b) of the Companies Act 2008, a company may only make a distribution when “it reasonably appears that the company will satisfy the solvency and liquidity test ...”. Section 90(2) of the Companies Act 1973 required “reasonable grounds” for believing that the solvency and liquidity requirements were satisfied. The inclusion of any vague, subjective requirement holds the potential to prejudice creditors where a board's decision that is reasonable for the company may be too risky for the liking of its creditors. The requirements for distributions and reductions of capital under the MBCA and DGCL respectively do not include this “reasonableness” proviso, and therefore appear to be based more substantially on the actual state of a company's financial affairs than the Companies Act 2008, which tends to create more room for guesswork on the part of the directors.

The fact that directors may be held liable under the Companies Act 2008Footnote 130 does seem to justify allowing a broader measure of discretion, because this will ultimately tend to burden creditors with the risk involved in any uncertainty. It is submitted that the more preferable situation would be one in which the board does not authorize a distribution because the actual position is unclear. This would reduce the risk of steering the company too close towards insolvency, and thus preserve not only the business that the company conducts as a part of the broader economy, but also the corporate entity itself, which will potentially also be a future business partner for its creditors.

Timing of restrictions

The Companies Act 2008 requires that a company be solvent and liquid after the completion of a distribution.Footnote 131 Similarly, the DGCL prohibits reductions of capital where the assets “remaining after such reduction”Footnote 132 are insufficient to pay corporate debts, and the MBCA's restrictions on distributions relate to the position “after giving [the distribution] effect”.Footnote 133 The prohibition contained in the Companies Act 1973 extended the liquidity requirement to a company's present ability to pay debts, forbidding a payment to shareholders where “the company is, or would after the payment be, unable to pay its debts...”,Footnote 134 although there does not seem to be any good reason to do so in view of the fact that creditors would be concerned entirely with the effect of a distribution on the company's financial affairs.

Recovery of unlawful distributions to shareholders

The consequences of a distribution having been made in contravention of the solvency and liquidity test or other provisionsFootnote 135 are not clear. It is curious that the Companies Act 2008 does not expressly provide for unlawful dividends to be void.Footnote 136 Whereas it is impliedFootnote 137 that an unlawful acquisition is voidable,Footnote 138 and section 48(6) expressly empowers a court to order the person from whom the company unlawfully acquired the shares to return the amount paid by the company, there is no similar provision for distributions.Footnote 139 This is problematic because, if a debtor-company cannot reclaim money that ought not to have been paid and the distribution is not rendered void, there will be no basis on which a creditor can claim the amount paid either derivatively or on the basis of unjustified enrichment.

Ironically though, creditors would apparently be able to hold directors liable under section 77(3)(e)(vi) for loss resulting from the unlawful payment of a distribution made under either section 46 or 48.Footnote 140 Such liability would require certain knowledge and conduct on the part of the directorsFootnote 141 but, even if creditors could successfully hold one or more directors liable, it would most often be unlikely that such director(s) would be able to compensate the company for loss on the scale of a distribution paid out widely to a vast number of shareholders. An amendment to section 46 in particular, as recommended by Jooste,Footnote 142 would therefore be highly preferable from a creditors’ perspective.

Director liability

Director liability under the Companies Act 2008 is fairly extensive. Section 218(2), dealing with civil actions, provides that “[a]ny person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention”. Read in conjunction with section 77 (dealing with the liability of directors and prescribed officers) and the imposition of liability specifically under sections 38(3)(d), 41(5), 42(4), 44(6), 45(7), 46(6) and 48(7) dealing with issuing shares, shareholder approval for certain issuances of shares, options for subscription of securities, financial assistance, loans to directors, distributions and acquisitions of the company's own shares (respectively), creditors will (in certain circumstances) be able to hold directors personally liable for loss suffered, and seem to be empowered to bring a civil action against any offending director under section 218(2).

Section 174(a) of the DGCL “codifies the [Delaware] common law by making the directors’ duty not to declare improper dividends part of their general duty to manage the corporation in good faith and in the exercise of reasonable care”.Footnote 143 Directors of a Delaware corporation are bound to comply with the restrictions relating to the purchase and redemption of stock (contained in section 160), and failing to do so will expose them to joint and severalFootnote 144 liability for “any wilful or negligent violation” of these sections that occurs under such directors’ administration.Footnote 145 The directors are liable to the corporation directly and, in the case of dissolution or insolvency, to its creditors, such liability being in respect of the full amount unlawfully paid and continuing for six years from the time of the unlawful stock repurchase or redemption.Footnote 146 Directors are also liable for interest from the time that liability accrued,Footnote 147 subject to certain limitations.Footnote 148

Legislative strategies based on solvency and liquidity are typically “underpinned by personal liability attaching to directors or controllers”,Footnote 149 the threat of liability for unlawful distributions thus encouraging directors to apply such tests to the best of their ability. Director liability should therefore not be considered a means of protecting creditors in any substantive way, and holding directors liable cannot be a substitute for effective, well formulated legislative restrictions.

Director liability does serve to disincentivize conduct for which liability will be imposed; creditors could use this to their advantage by, for example, insisting that a financial expert sit on the board, undertaking liability at perhaps a higher standard than would otherwise be the case.Footnote 150 This kind of influence on the part of a creditor does, however, require a substantial degree of bargaining power, which would preclude many more vulnerable categories of creditor.

Often it will become possible for creditors to protect themselves by alternative means, but these often presuppose an evenly weighted distribution of power between debtor and creditor. Some of the alternative sources of (self-) protection for creditors are discussed below.

Certificate of incorporation

In principle, it should be possible for creditors to be able to rely on any additional protection that a company's constituent document may provide. Under the Companies Act 2008, however, it seems as though a distribution made in compliance with the relevant provisionsFootnote 151 of the act will be valid even where that distribution violates terms of the memorandum,Footnote 152 notwithstanding any claims that may arise against directors for decisions made in breach of their duties.

As discussed above, the company's constituent document may at least attempt to impose restrictions on the board of directors in so far as their power to make distributions is concerned, for example by defining concepts such as “profit” for the purposes of declaring dividends;Footnote 153 however it is unlikely that the directors and shareholders will be sufficiently concerned about creditors’ interests to draft special provisions to fetter the board's powers for their protection. Any favourable pre-established working relationship between lenders and management or the board will generally be only informal in nature and, as such, not legally enforceable when things go awry.Footnote 154

Contractual protection: Restrictive covenants on dividends

In view of the fact that, short of the need arising for creditors to be enticed (by favourable provisions in a company's memorandum) to extend credit to a corporation, creditors will not be able to expect to find protection in a company's constituent document. A more plausible option, still of course secondary to securing a claim by the usual methods, may be to impose contractual restrictions on the company's dealing with its money.

“If contract creditors do not impose contractual restrictions on distributions to shareholders, then some involuntary creditors might be worse off in a regime without legal capital protection than in one with such protection. … Because unlawful distributions will not take the form of illegal dividend payments, even the most stringent legal capital rules and restrictions on distributions will not prevent companies from making distributions unless someone (presumably a creditor) monitors their compliance.”Footnote 155

The possibility of effective monitoring will depend directly on the transparency of financial reporting by the company, and creditors will often not have full and unbiased access to the company's financial affairs.

A further practical problem would be the likelihood of additional monitoring costs being involved.Footnote 156 Additional costs for creditors who have become accustomed to relying on a regulatory framework for protection may be less than attractive, particularly when those creditors rely on legislative protection for the very reason that they lack the ability to negotiate protection on favourable terms. The ability to negotiate terms of debt contracts assumes a certain degree of bargaining power, which many smaller creditors will not have.

Trade creditors: Protected by their own vigilance

Trade creditors were never protected by the capital maintenance doctrine, even theoretically on an assumption that it was effective at achieving its purpose, because their “real concerns are at a very close range and in an immediate time frame”Footnote 157 and any creditors primarily concerned with day-to-day dealings with a company would not be concerned with the capital on a corporate balance sheet.Footnote 158 Many creditors will therefore be likely to continue resorting to protection on a more immediate basis than that afforded by the solvency and liquidity requirements.

The general trade creditor's main protection will in all likelihood continue to be as it has always been: “to stay close to the situation, to know his debtor, to spot the slow-downs in payment, the main tell-tale sign of drying up of working capital, to put prudent limits on the amount of credit extended to each trade purchaser, to clear checks immediately, to take instantaneous action, perhaps legal action, when a delinquency is spotted, to badger and cajole the delinquent debtor tirelessly, to see to it that when the next payment is made it does not go to other creditors, etc”.Footnote 159 In this process, increased transparency in financial reporting would provide better protection for creditors by promoting easier access to more internally located warning signs, and would probably also encourage a debtor business to keep its financial affairs in as good a state as possible; this, however, would also be dependent on the ability of accounting standards to ensure the integrity of financial reports.

CONCLUSION

In the light of the preceding analysis of the elements of solvency and liquidity and the discussion of the various alternative sources of creditor protection in relation to prejudicial distributions, the question that remains to be answered is whether a solvency (or liquidity) threshold will be effective in the protection of the “legal capital” fund (or its notional equivalent) that should remain intact to attest to the company's ability to repay its creditors. That is, does a solvency-based test applicable to distributions from capital do what the capital maintenance rule purported to do?

The concept of “legal capital” is really no more than an arbitrary number expressed in currency reflected on a company's balance sheet,Footnote 160 and is therefore neither necessarily a relevant consideration in protecting creditors, nor immune to manipulation that would enable a company to subvert the protection that it purports to afford those creditors in the first place.

Owing to the dependence of the scheme of legal capital on the way in which the assets and liabilities of a company appear on its balance sheet,Footnote 161 and the fact that it is very possible for economic reality to be entirely dissimilar to an accountant's depiction of that reality,Footnote 162 “the efficiency of the legal capital system can rise no higher than the level of verity that can be achieved through ‘generally accepted accounting principles’ and the consistency with which they are followed”.Footnote 163 With regard to the legal capital system's restrictions on distributions, the problem is essentially that “the practical value to the stockholders and the creditors of a rule of law that dividends shall not be declared out of capital depends upon the efficiency of the legal methods for determining whether a profit exists for dividend purposes”.Footnote 164

The concept of legal capital was thus “entirely a legal invention, highly particular in its meaning, historical in reference [in that it reflects a past transfer of assets between the company and its shareholders, but it is] not relatable in any way to the ongoing economic condition of the enterprise”.Footnote 165 The law has, nevertheless, made use of the concept in two ways: as a number reflecting the maximum amount of money potentially claimable from shareholders; and as a bench mark on the basis of which distributions to shareholders will be authorized.Footnote 166

As already alluded to, the suitability of protection offered to creditors by regulating corporate capital will depend largely on the category of the particular creditor: trade creditors would be in a different position to longer-term creditors, and it goes without saying that any secured creditor would be less vulnerable than an unsecured one. The size of the creditor will also affect its bargaining power so, whereas large institutions such as banks will almost inevitably be able to safeguard their own interests, smaller creditors will be more vulnerable.

Since a particularly weak creditor may not even be able to enforce its rights under the governing legislation, one should recognize that many creditors would have no bargaining power at allFootnote 167 and will therefore have to rely completely on whatever protection the legislature is prepared to provide.

According to Ferran, the success of a shift towards a solvency-based system depends on three things: “proper accounting rules that allow for the accurate measurement of solvency … suitable sanctions to deter the responsible managers from making false claims about their company's solvency either deliberately or negligently … [and] effective recovery mechanisms where value is wrongfully transferred to shareholders in priority to creditors”.Footnote 168

Under the South African Companies Act 2008, the sanction of extensive director liability would certainly seem sufficiently severe to deter directors from making false claims about a company's solvency, but including the thresholds of fairness and reasonableness in determining solvency creates leeway for such calculations, which may be problematic. Creditors will be even worse off if the test applied in relation to financial assistance and loans to directors is purely subjective. The uncertainty regarding the consequences of unlawfully declared dividends is also very significant because, to the extent that the effect of unlawfully declared dividends cannot be reversed, the whole system of protection is undermined.

It is submitted that, although it is appropriate for South African company law to protect creditors, the Companies Act 2008 seems to overemphasize the importance of director liability. When the mechanisms in place are violated, what creditors really want is not seeing directors held liable, but having the harm undone. Whether or not, as a matter of policy, imposing liability on directors may be fair, the situation is less than ideal for creditors, and (in view of the uncertainty regarding the effect of unlawful distributions in the Companies Act 2008) whatever protection is afforded by the solvency and liquidity test is, to a large extent, undermined. Although a greater degree of director liability will reduce the risk of directors gambling what has been contributed by creditors, and promote more responsible management of companies,Footnote 169 it will also discourage wider participation in the economy by individuals who are discouraged from serving as directors of companies.

Corporate failure as a result of risk-taking would be discouraged by provisions imposing director liability but, when failure results from a company's adverse financial conditions, directors will often not be liable. Even in cases where financial distress has resulted from bad decisions, directors who would be subject to liability will in all likelihood make use of accounting techniques to misrepresent the company's affairs, this in turn affecting the utility of solvency-based thresholds for distributions. Considering the solvency and liquidity test in particular, the required calculations to be made by the board are no less subject to manipulation than were the accounts reflecting the distributable amount of legal capital under the capital maintenance regime.

Although such mechanisms will provide creditors with some protection, it is important that they do not place too much reliance on solvency standards alone. The most effective protection will likely be afforded by creditors’ own vigilance but, of course, it is not always easy (or indeed possible) to have access to requisite information to be sufficiently aware of a company's affairs and, where information is gleaned from financial reports compiled by clever accountants, the expectation becomes somewhat more unrealistic.

These difficulties have underscored the need for a strong corporate governance framework for corporations, together with robust accounting standards for financial reporting. ResearchFootnote 170 has found that profits are reported more conservatively in firms with more “outside” directors,Footnote 171 but there is still the potential for management to inflate its accomplishments by creatively reporting a corporation's present or future profits, and the viability of any legislative protection for creditors will almost inevitably hinge on the integrity of financial reporting standards imposed by the relevant professional bodies.

Footnotes

1 Callahan, CC “Statutory protection of creditors in reduction of capital stock” (1936) 2 Law Journal of the Student Bar Association Ohio State University 220 at 224.

2 By the Companies Amendment Act 37 of 1999, which came into effect on 30 June 1999.

3 Hanks, JJ Jr “The new legal capital regime in South Africa” (2010) Acta Juridica 131 at 141.

4 Stocker, JE “Model Business Corporation Act Annotated” (1961) Business Lawyer 748 at 748.

5 Gorris, JM, Hamermesh, LA and Strine, LE Jr “Delaware corporate law and the Model Business Corporation Act: A study in symbiosis” (2011) Law and Contemporary Problems 107 at 108.

6 Act 71 of 2008, signed by the state president on 8 April 2009 and came into force on 1 May 2011, as amended by the Companies Amendment Act 3 of 2011, replacing the Companies Act 61 of 1973.

7 “Company finance” in “Explanatory memorandum to the Companies Bill 2007” at 11.

8 “South African company law for the 21st century: Guidelines for corporate reform” (government notice no 1183) in (June 2004) 26493 Government Gazette at 27.

9 van der Linde, K “The solvency and liquidity approach in the Companies Act 2008” (2009) 2 Tydskrif vir die Suid-Afrikaanse Reg 224 at 224.

10 “Explanatory memorandum”, above at note 7 at 11.

11 Van der Linde “The solvency and liquidity approach”, above at note 9 at 224. Van der Linde suggests that, whereas the statement would be true if “capital” were to be understood in an economic sense, referring to “total invested funds or equity”, an understanding of capital in the traditional sense of “nominal” capital would render the statement inaccurate.

12 Davis, D et al. Companies and Other Business Structures in South Africa (2009, Oxford University Press) at 53.

13 Id at 54.

14 As a general rule, an American company will either incorporate in its home state or in Delaware and, for this reason, Delaware's approach to capital regulation is generally of interest. See Cross, FB and Prentice, RALaw and Corporate Finance (2007, Edward Elgar) at 13. More specifically, the provisions of the DGCL are of interest because they represent a hybrid of both capital-maintenance-based and solvency-test-based theory.

15 For an in-depth exposition of the concept, see generally Manning, B and Hanks, JJ JrLegal Capital (3rd ed, 1990, Foundation Press).

16 Chin, LY and Wong, YK “Deconstructing share par value and capital maintenance: Reconstructing creditor protection” (2002) Singapore Law Review 58 at 96–97.

17 Id at 97.

18 Footnote Ibid.

19 Manning and Hanks Legal Capital, above at note 15 at 19.

20 Referred to as the “Memorandum of incorporation” in South Africa and the “Certificate of incorporation” in Delaware.

21 Davis et al Companies and Other Business Structures, above at note 12 at 45.

22 Shareholders, unlike directors, are not subject to any fiduciary duties, either at common law or in company legislation.

23 Manning and Hanks Legal Capital, above at note 15 at 16.

24 Miola, M “Legal capital and limited liability companies: The European perspective” (2005) 2 European Company and Financial Law Review 413 at 419.

25 Manning and Hanks Legal Capital, above at note 15 at 19.

26 LS Black Jr “Why corporations choose Delaware” (2007, Delaware Department of State), available at: <http://corp.delaware.gov/whycorporations_web.pdf> (last accessed 26 October 2012) at 1.

27 Van der Linde, K “Par-value shares or no-par-value shares: Is that the question?” (2007) 19 South African Mercantile Law Journal 473 at 473.

28 Kraakman, R et al. The Anatomy of Corporate Law: A Comparative and Functional Approach (2nd ed, 2009, Oxford University Press) at 9.

29 Ferran, EPrinciples of Corporate Finance Law (2008, Oxford University Press) at 191–92.

30 Callahan “Statutory protection of creditors”, above at note 1 at 224.

31 Ferran Principles of Corporate Finance Law, above at note 29 at 179.

32 Footnote Ibid.

33 Manning and Hanks Legal Capital, above at note 15 at 57.

34 Davis et al Companies and Other Business Structures, above at note 12 at 54.

35 Id at 53.

36 Id at 54.

37 Ooregum Gold Mining Company of India Ltd v Roper [1982] AC 125 (HL) at 133.

38 Cohen NO v Segal 1970 (3) SA 702 (W) at 705 H.

39 (1882) 21 Ch D 519 (CA), later followed in Cohen, id.

40 Davis et al Companies and Other Business Structures, above at note 12 at 54.

41 Footnote Ibid.

42 MS Blackman et al Commentary on the Companies Act (loose leaf, revised 2011, Juta) at 5-147.

43 Footnote Ibid.

44 Davis et al Companies and Other Business Structures, above at note 12 at 53.

45 Footnote Ibid.

46 Miola “Legal capital and limited liability companies”, above at note 24 at 421.

47 Footnote Ibid.

48 Id at 418.

49 Kraakman et al The Anatomy of Corporate Law, above at note 28 at 9.

50 Miola “Legal capital and limited liability companies”, above at note 24 at 419.

51 Blackman et al Commentary, above at note 42 at 5-103.

52 Footnote Ibid. In South Africa, the capital account and the share premium account together constitute a company's “capital”.

53 Ballantine, HW and Hills, GS “Corporate capital and restrictions upon dividends under modern corporation laws” (1935) California Law Review 229 at 234–35.

54 Footnote Ibid.

55 K Van der Linde Aspects of the Regulation of Share Capital and Distributions to Shareholders (LLD thesis, 2008, University of South Africa) at 25.

56 Counterarguments identified in Lutter, M (ed) Legal Capital in Europe (2006, de Gruyter), cited in Ferran Principles of Corporate Finance Law, above at note 29 at 182, note 12.

57 Ferran, id at 182.

58 Footnote Ibid.

59 Outlined in id at 181–82.

60 Id at 181.

61 RA Booth “Capital requirements in United States corporation law” (December 2005) Villanova University School of Law Working Paper Series (working paper 102), available at: <http://law.bepress.com/villanovalwps/papers/art102> (last accessed 26 October 2012) at 10.

62 Chin and Wong “Deconstructing share par value”, above at note 16 at 89.

63 Ferran Principles of Corporate Finance Law, above at note 29 at 182.

64 Footnote Ibid.

65 Footnote Ibid.

66 Footnote Ibid.

67 Usually about 12 months: ibid.

68 Id at 183.

69 Footnote Ibid.

70 Hanks “The new legal capital regime”, above at note 3 at 147.

71 Id at 148.

72 Official comment to the MBCA at 6-58.

73 Ferran Principles of Corporate Finance Law, above at note 29 at 180.

74 See sec 6.40(c) in particular, which contains the model act's solvency and liquidity test.

75 D Aikman et al “Funding liquidity risk in a quantitative model of systemic stability” (15 June 2009, Bank of England working paper no 372) at 3.

76 The requirements for making distributions are set out in secs 46 and 48 of the Companies Act 2008, with reference to sec 4 which contains the solvency and liquidity restrictions.

77 Van der Linde “The solvency and liquidity approach”, above at note 9 at 225.

78 Hanks “The new legal capital regime”, above at note 3 at 138.

79 See MBCA, sec 6.40(c).

80 Hanks “The new legal capital regime”, above at note 3 at 143.

81 Under the DGCL, sec 244(a).

82 Id, sec 244(b).

83 Footnote Ibid.

84 Van der Linde “The solvency and liquidity approach”, above at note 9 at 226.

85 Hanks “The new legal capital regime”, above at note 3 at 148.

86 Footnote Ibid.

87 CI Haynes “The solvency test: A new era in directorial responsibility” (1996) Auckland University Law Review 126.

88 Id at 131–32.

89 Id at 132.

90 Van der Linde “The solvency and liquidity approach”, above at note 9 at 226. See Ex Parte De Villiers NNO: In re Carbon Developments (Pty) Ltd (in liquidation) 1993 (1) SA 493 (A) at 504.

91 Haynes “The solvency test”, above at note 87 at 137.

92 Van der Linde “The solvency and liquidity approach”, above at note 9 at 229.

93 Footnote Ibid.

94 Footnote Ibid.

95 Footnote Ibid. An example of this kind of presumption may be found in sec 70(2) of the Close Corporations Act 69 of 1984.

96 Id at 230.

97 Jooste, R “Corporate finance” in Cassim, FH et al. (eds) Contemporary Company Law (2011, Juta) 240 at 250.

98 Footnote Ibid.

99 See sec 4(2)(b).

100 See sec 6.40.

101 Van der Linde “The solvency and liquidity approach”, above at note 9 at 236.

102 Contained in sec 76(3)(c)(ii) of the Companies Act 2008.

103 Jooste, R “Issues relating to the regulation of ‘distributions’ by the 2008 Companies Act” (2009) 126 South African Law Journal 627 at 642.

104 Id at 642.

105 See secs 44(3)(b)(i) and 45(3)(b)(ii).

106 Jooste “Issues relating to the regulation”, above at note 103 at 643.

107 LC Heath and P Rosenfield “Solvency: The forgotten half of financial reporting” (1979) Journal of Accountancy 48 at 49.

108 Tweedie, D and Whittington, G “Financial reporting: Current problems and their implications for systematic reform” (1990) Accounting and Business Research 87.

109 Sharma, DS and Stevenson, PA “The impact of impending corporate failure on the incidence and magnitude of discretionary accountancy policy changes” (1997) 29 The British Accounting Review 129.

110 Sharma, DS “The role of cash flow information in predicting corporate failure: The state of the literature” (2001) 27/4Managerial Finance 3 at 3.

111 Footnote Ibid. See Watson, I “Financial distress: The state of the art in 1996” (1996) 4/2International Journal of Business Studies 39.

112 Heath, LCFinancial Reporting and the Evaluation of Solvency (1978, American Institute of CPAs) at 20.

113 Heath and Rosenfield “Solvency”, above at note 107 at 48.

114 Van der Linde Aspects of the Regulation, above at note 55 at 272.

115 Blackman et al Commentary, above at note 42 at 5–16.

116 Required to be kept by sec 76(1) of the Companies Act 1973.

117 Required to be kept by id, sec 98(1)(b).

118 DGCL, sec 170(a), this being “subject to any restrictions contained in [the] certificate of incorporation” and paid “either (1) out of its surplus, as defined in §§ 154 and 244 … or (2) in the case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and / or the preceding fiscal year” (emphasis added). See Wittenberg et al v Federal Mining and Smelting Co 15 Del Ch 147, 133 Atl 48 (1926).

119 See secs 154 and 244.

120 Jooste “Corporate finance”, above at note 97 at 263.

121 Sec 4(b)(i).

122 Id, sec 4(b)(ii).

123 Van der Linde “The solvency and liquidity approach”, above at note 9 at 231.

124 MBCA, sec 6.40(d) (emphasis added).

125 Sec 90(2)(b) of 1973 act.

126 Van der Linde “The solvency and liquidity approach”, above at note 9 at 225.

127 DGCL, sec 154.

128 Van der Linde “The solvency and liquidity approach”, above at note 9 at 230.

129 Secs 28 and 29, governing “accounting records” and “financial statements” respectively.

130 See discussion of “director liability” below.

131 However, the timing rules differ according to the type of transaction: ie “immediately after providing … financial assistance” (secs 44(3)(b)(i) and 45(3)(b)) and “after completing” a proposed distribution (sec 46(1)(b)). See Van der Linde “The solvency and liquidity approach”, above at note 9 at 233.

132 DGCL, sec 244(b).

133 MBCA, sec 6.40.

134 Companies Act 1973, sec 90(2)(a) (emphasis added).

135 Companies Act 2008, secs 46 and 48.

136 Jooste “Issues relating to the regulation”, above at note 103 at 645.

137 By sec 48(6), which enables the company to apply to court to reverse the acquisition.

138 Sec 218(1) provides: “Nothing in this Act renders void an agreement, resolution or provision of an agreement, resolution, Memorandum of Incorporation or rules of a company that is prohibited, void, voidable or may be declared unlawful in terms of this Act, unless a court declares that agreement, resolution or provision to be void.”

139 Jooste “Issues relating to the regulation”, above at note 103 at 645.

140 Liability is imposed by secs 46(6) and 48(7) respectively. See id at 647.

141 See secs 46(6) and 48(7), read with sec 77.

142 See Jooste “Issues relating to the regulation”, above at note 103 at 646, where Jooste submits that “s 46 should be amended so as to deal with the voidness aspect of a contravening dividend and to provide for the recovery of the dividend from the recipient shareholder”.

143 EP Welch et al Folk on the Delaware General Corporation Law (loose leaf, 5th ed, 2011, Wolters Kluwer) at GCL-V-208. A loophole that previously existed at common law was closed in the 1967 revision, which extended directors’ liability to “include unlawful stock repurchases and redemptions, which are often in fact disguised dividends” (Jooste, ibid).

144 Directors are afforded protection under DGCL, sec 174(b) in respect of claims asserted against individual members of the board in that: “Any director against whom a claim is successfully asserted under [sec 174] shall be entitled to contribution from the other directors who voted for or concurred in the unlawful … stock purchase or stock redemption.”

145 Id, sec 174(a).

146 Id, sec 172.

147 Footnote Ibid.

148 These limitations relate to reliance on certain representations and directors who are absent or dissent. See id, secs 172 and 174(a).

149 Ferran Principles of Corporate Finance Law, above at note 29 at 180.

150 Armstrong, CS et al. “The role of information and financial reporting in corporate governance and debt contracting” (2010) 50 Journal of Accounting and Economics 179 at 192–93.

151 Secs 46 and 48.

152 Jooste “Issues relating to the regulation”, above at note 103 at 636.

153 Jooste “Corporate finance”, above at note 97 at 263.

154 Armstrong et al “The role of information”, above at note 150 at 181.

155 Enriques, L and Macey, JR “Creditors versus capital formation: The case against the European legal capital rules” (2000) 86 Cornell Law Review 1165 at 1189–94.

156 Myers, SC “Determinants of corporate borrowing” (1977) 5 Journal of Financial Economics 147 at 149–55.

157 Manning and Hanks Legal Capital, above at note 15 at 100.

158 Enriques and Macey “Creditors versus capital formation”, above at note 155 at 1189.

159 Manning and Hanks Legal Capital, above at note 15 at 98.

160 Id at 39.

161 Id at 37.

162 Footnote Ibid.

163 Footnote Ibid.

164 Krauss, DT “Maintenance of a corporation's capital” (1931) 9 Tennessee Law Review 215 at 219.

165 Manning and Hanks Legal Capital, above at note 15 at 39 (emphasis original).

166 Footnote Ibid.

167 Enriques and Macey “Creditors versus capital formation”, above at note 155 at 1191.

168 Ferran, E “Creditors’ interests and ‘core’ company law” (1999) 20 Company Lawyer 314 at 318.

169 Companies Act 2008, sec 7(j).

170 Ahmend, AS and Duellman, S “Accounting conservatism and board of directors characteristics: An empirical analysis” (2007) Journal of Accounting and Economics 411.

171 Armstrong et al “The role of information”, above at note 150 at 190.

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