Director’s duties in dealing with financial distress

Our common law has historically viewed directors as occupying a position of trust and as such has obliged them to carry out their duties as cautiously, prudently and diligently as if they were managing their own affairs.

The Companies Act 71 of 2008 (“the Act”), which came into effect on 1 May 2011, has codified many of the directors’ duties that existed at common law and provides additional duties and responsibilities with which directors are to comply that did not previously exist under the Companies Act 61 of 1973 (“the 1973 Companies Act”). Some of these additional duties are triggered when a company finds itself in financial difficulty. The consequences of a failure to comply with these duties in the manner prescribed by the Act are potentially severe and may expose non compliant directors to personal liability.

Unfortunately some of the provisions of the Act are unclear and certain important terms are not adequately defined or not defined at all. Such provisions will have to be interpreted and applied by our courts in order to provide clarity for directors and lawyers and other professionals that advise them.

The duties specific to a scenario where a company is experiencing financial difficulties are to be found in the provisions of sections 128 and 129 of the Act, dealing specifically with business rescue. These provisions provide that if the board of directors of a company has reasonable grounds to believe that the company is financially distressed, the board is obliged to consider whether it should resolve that the company voluntarily begin business rescue proceedings and place such company under supervision.

The term “reasonable grounds” is not defined. It is my view that this term must have been envisaged by the legislature to be a subjective test to be applied by the board of directors with reference to the specific circumstances of the company at the time and known to the board of directors.

The term “financially distressed” is however defined as being where the company at a point in time appears to be reasonably unlikely to pay all its debts as and when they fall due within the ensuing six months, or where a company appears to be reasonably likely to become insolvent within the immediately ensuing six months.

The term “insolvent” in the definition of “financially distressed” is unfortunately not defined by the drafters of the Act.   However, if one has regard to the judicial interpretation of the term “insolvent”, one finds references to the terms factual insolvency and commercial insolvency. Factual insolvency refers to the scenario where factually a company’s liabilities exceed its assets and commercial insolvency is where a company may be factually solvent but is nonetheless unable to pay its debts in the ordinary course of business.  I am of the view that the term insolvent must have been intended by the legislature to relate to commercial insolvency by virtue of the continued application of the winding up provisions of the 1973 Companies Act and the fact that commercial insolvency has been retained as one of the grounds for winding up, whilst factual insolvency, although often indicative of commercial insolvency, is not a ground for winding up. It follows thus that a company would be likely to be insolvent within the ensuing six months if it is likely that it will be unable to pay its debts, and this thus  equates to the company being reasonably unlikely to pay its debts as and when they fall due within the ensuing six months. Thus the alternative meaning provided for in the definition of “financial distress” in the Act, in my view, has the same meaning.

If the board of directors is of the view that the company is financially distressed, the duty to consider whether the company voluntarily begins business rescue proceedings and accordingly whether it should be placed under supervision is triggered. This entails a consideration and evaluation by the board as to whether there are reasonable grounds to believe that there is a reasonable prospect of rescuing the company. If there is no such reasonable prospect then the alternative that the board would have to consider is whether to wind-up the company. What is meant by the “reasonable prospect of rescuing the company” is also not defined nor are guidelines provided in the Act. It has been held by our courts to entail an objective test going beyond mere speculation.  There ought to be an evaluation of inter alia the cause of the distress and how such cause can be remedied, the costs of continuing to trade and source of funding to meet day to day expenditure. My view is that the board would only be in a position to conclude that there is a reasonable prospect of rescuing the company if it is able to formulate a workable and sustainable plan to do so, which would include the company having access to funding during its supervision.

If the board of directors decides not to pass a resolution that the company voluntarily begin business rescue proceedings and accordingly be placed under supervision, the board is obliged to deliver a written notice to shareholders, creditors and employees or their representatives setting out the basis of the company’s financial distress and the board’s reason for not adopting the resolution. The effect of delivering such notice would practically result in creditors refusing to extend further credit, banks withdrawing facilities and key employees resigning. It would also provide unassailable grounds for a creditor to institute winding-up proceedings which has its own pitfalls for a company. Although it seems that the intention is to give affected parties notice so that they have an opportunity, given the board’s election not to proceed with voluntary business rescue, to bring business rescue proceedings, it is difficult to envisage how these provisions could ever be effectively implemented. In this regard, should the board elect not to resolve to place the company under supervision they, in my view, have a duty to proceed to wind up the company.

Thus it is crucial that when a company is in financial difficulty that the directors comply with their duties set forth in the Act to avoid personal liability.