Is your company solvent? Do you know how to tell? A company is generally considered solvent if its assets exceed its liabilities. However, to be legally deemed solvent, the Company must pass two key tests: the liquidity test and the balance sheet test.
What the law says about a solvent company
- The liquidity test of the solvency test requires the solvent company to be able to pay its debts as they become due in the normal course of business
- The balance sheet test of the solvent company test requires the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.
According to the Companies Act 1993 (The Act) in Section 4 (1) defines when a company is solvent. A company is solvent if both of the following are satisfied:
The purpose of the Solvency test rules under the Act is to ensure that shareholders do not receive benefits at the expense of suppliers and creditors. In other words, a company cannot pay dividends to shareholders unless it can prove that it is able to meet its obligations to creditors.
It’s common for directors to assume their company is solvent based solely on the balance sheet test. However, when asked whether the company can actually pay its current bills, the answer is often “no.”
While the Act does not require companies to assess solvency on a daily basis as this is impractical, the Act requires the solvency test to be satisfied immediately after certain key transactions are undertaken. The Act requires that the solvency test must be met immediately after a company:
- Make dividend distribution
- Repurchase or redemption of shares
- Reduce shareholder liability
- Purchase of a major asset
- Amalgamates with another company
Directors’ obligations: the solvent company requirement
Directors are required to resolve that the company will be able to pass the solvency test immediately after the relevant transaction takes place. Knowing whether their company is solvent should be a part of good management for a director.
Directors should, for their own protection, set out in detail the grounds for their opinion that the company is solvent. References should be made to valuations, reports and advice taken or received on which the opinion is based. Failure to provide detailed reasons in the directors’ certificate may later raise an inference, in hindsight, that the directors did not have any reasonable grounds for their belief.
Standard form certificates should be avoided. Instead, each certificate should be specifically tailored to the relevant company and its unique circumstances and financial position.
Directors’ liability
Directors can be held personally liable if:
- A solvency certificate is not completed
- The proper procedure for authorising the relevant transaction is not followed
- There were no reasonable grounds to believe the company could satisfy the solvency test at the time the certificate was signed; or
- A change in the company’s financial position occurs between the approval and execution of the transaction, affecting its ability to meet the solvency test.
Directors who vote in favour of a distribution without signing a solvency certificate commit an offence and may be fined up to $5,000 upon conviction. Additionally, signing a solvency certificate that is false or misleading is an offence, punishable by a fine of up to $200,000 or imprisonment for up to 5 years.
Business insolvency
If the company continues to trade while insolvent, there are implications for directors. The common one is reckless trading.
The perception in the marketplace is that reckless trading prosecutions are rare, and they are, but what is not rare are settlement agreements between directors and their company’s liquidators when directors have run their affairs recklessly.
Also looming as an increasing risk for accounting firms is imprudent advice given by accountants to their clients regarding business solvency. A common mistake is advising clients to take drawings instead of salary to avoid PAYE obligations in an unprofitable business. If directors are later required to repay drawings through their current accounts, the accountant could be exposed to liability.
There are many definitions of solvency and even though a company may trade in and out of solvency day to day, it is important to consider where the line is drawn.
