When your liabilities exceed your assets
The textbook definition of insolvency is when you are unable to pay your liabilities - in other words, when the fair value of your assets does not exceed your liabilities.
There is a difference between actual insolvency and commercial insolvency, which refers to circumstances where a business's assets exceed its liabilities but, because of cash flow problems, it is unable to pay its debts. Insufficient cash flow is not the same as insolvency.
A company has the following options when it cannot pay its debts: consolidate its debt; ask its creditors for a grace period (moratorium); voluntary distribution; business rescue; compromise in terms of Section 155 of the Companies Act; voluntary liquidation; or compulsory liquidation.
Section 4 of the Companies Act states that the solvency and liquidity of a company is determined by considering the accounting records, financial statements and fair valuation of current and reasonably foreseeable assets and liabilities.
A company will satisfy the solvency and liquidity test when, after consideration of the above, the assets equal or exceed the liabilities.
The calculation of your solvency and liquidity position should be done by your accountants or auditors. If you are insolvent, liquidation happens either as a voluntary liquidation or a forced liquidation.
The inability to pay debts is at best merely evidence of insolvency. A person who has insufficient assets to settle his or her debts, although satisfying the insolvency test, is not treated as insolvent.
The purpose of business rescue is to rehabilitate a financially distressed company by providing temporary supervision and management of the company's assets.
A company is financially distressed when it is reasonably likely that it will be unable to pay its debts or remain solvent in the following six months.
A moratorium is created against claims from creditors and the company’s assets are protected during the business rescue period.
The independent business rescue practitioner will propose a plan to rescue the business and return it to prosperity, solvency and liquidity.
If the liquidation proceedings have already commenced, an application for business rescue will suspend the liquidation proceedings until the business rescue application has been refused by the court, or, where the court ordered that the business rescue proceedings should continue, until such proceedings are finalised.
The courts will give preference to business rescue over liquidation only where there is a genuine attempt to achieve a true rescue. There is, however, always the risk of the business rescue may be abused, and there is no prospect of a financial recovery. This may be why so many creditors frown on the process.
A board may resolve that a company voluntarily begins business rescue proceedings if the board has reasonable grounds to believe the company is financially distressed and a prospect of rescuing it exists.
An affected person may apply to the court to set aside the business rescue resolution if there are no reasonable grounds for believing that the company is financially distressed, there are no reasonable prospects of rescuing the company, or the procedural requirements set out in Section 129 of the Insolvency Act were not complied with.
An alternative is reaching a compromise with creditors. A company could engage with its creditors or a specific class of creditors to achieve a debt compromise.
However, Section 155 of the Companies Act does allow the company to enter into an agreement of compromise with only one class of creditors where it will sufficiently address the financial challenges of the company. Notice must be given to every creditor and to the Companies and Intellectual Property Commission by delivering a copy of the proposal and a notice which sets out the date, time and place of the meeting at which the proposal will be considered.
The compromise has to be a formal proposal and contain all information reasonably required to assist all the creditors in their decision whether or not to accept or reject the proposal.
Willem Oberholzer CA (SA) is chief executive of Probity Advisory and director of Kreston South Africa. Lyndall Mulock Houwer BCom (Law), LLB is company law specialist at Probity Advisory.