CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS 112
3.1. SOLVENCY AND LIQUIDITY TEST CONCEPT 1 Scope and meaning of this concept
3.1.2. Historical background to the Solvency and Liquidity test concept
The concept of solvency and liquidity test was introduced in an amendment to the 1973 Act by the Companies Amendment Act of 1999. Its introduction was premised at juxtaposing between its full application as in the 2008 Act and a reformation from the capital maintenance rule, which prior to the 1999 Amendment Act was a dominating concept/ or principle. The capital maintenance rule has its origin in English law dating back to more than a century ago in Trevor v Whitworth.155 The underlying object of this rule was to grant creditors protection in that they looked to the company’s equity for payment of their debts.
Capital was viewed to be fixed and readily-ascertained and its purpose was to stand as the absolute hope for creditors of the company, it being a “permanent fund” and/ or a “form of security” and/ or a “guarantee” for repayment of their debts.156 Thus, Lord Halsbury, L.C, in The Ooregum Gold Mining Company of India Ltd v Roper,157 declared that:
“[t]he capital is fixed and certain, and every creditor of the company is entitled to look to that capital as his security.”
This was maintained some decades later in Cohen NO v Segal,158 where the court, in prohibiting the payment of a dividend out of share capital, stated that;
153 Ibid.
154C. P. van de Merwe ‘Reconsidering distributions: A critical analysis of the regulation of distributions to shareholders in the Companies Act 2008, with special reference to the solvency and liquidity Requirement’
unpublished dissertation, Stellenbosch University (2015) 51.
155 1887 12 App CAS 409 (HL).
156F.H.I Cassim and R Cassim ‘The Capital Maintenance Concept and Share Repurchases in South African Law’
I.C.C.L.R. 2004, 15(6), 188-191.
157 [1892] A.C. 125 at 133.
1581970 (3) S.A. 702 (W) at 705H.
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“[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.”
In terms of the “limited liability” principle, creditors have no recourse to shareholders when a company cannot pay their debts and that forces them to rely on a company`s assets. Funds that are raised through the issuing of shares are thus assets of the company which shareholders cannot claim back at the expense of creditors. It is however anomalous to expect creditors to rely on an asset which ordinarily diminishes as business operations demands cash. The court in the Cohen case quoted above said it well that capital may be spent and lost in the carrying on of business. This then leaves the researcher with unanswered questions as to what was the rationale behind expecting creditors to have a guarantee based on something possibly unrealistic or just a mirage projecting to what may not be there in future. The fact that figures of the equity structure remain untainted or unchanged does not entail that the actual funds which shareholders contributed are still there. The main reason for issuing shares is to raise capital which will be used to run specific business operations. It is thus unlikely that any funds may remain when shares have been issued as such money has its purpose to achieve. In this case creditors are left to hope in the unknown. This has been depicted again in the Whitworth case above where creditors were expected to rely on an assumption that capital funds have not been paid out except in the ordinary legitimate course of business.159 What remains is, whether legitimate or illegitimate course of business, the funds raised from capital are always meant to be used up especially where there are losses in the business. Only in instances where the business makes substantial profits will such capital funds be retained, backed up by financial reserves.
Regardless of the above flaws of the capital maintenance concept, it should be noted that the concept had its rules that were meant to protect the integrity of the company`s equity which were as follows;
It was unlawful for dividends to be paid out of capital.160
159 Trevor v Whitworth (1887) 12 App Cas 409 at 423-4 (HL); Lord Watson said: “paid-up capital may be diminished or lost in the course of a company`s trading; that is a result which no legislation can prevent; but persons who deal with, and give credit to, a limited company, naturally rely upon the fact that the company is trading with a certain amount of capital already paid, as well as upon the responsibility of its members for the capital remaining at call; and they are entitled to assume that no part of the capital which has been paid into the coffers of the company has subsequently been paid out, except in the legitimate course of its business”.
160 R Jooste ‘Corporate Finance’ opcit note 31, pp 264.
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It was unlawful for a company to acquire its own shares or shares of its holding company.161
It was unlawful for par value shares to be issued at a discount except under stringent conditions.162
It was unlawful for a company to provide financial assistance for the acquisition of its own shares or shares in its holding company.163
It was thus difficult under the 1973 Act to endeavour into certain transactions which were deemed to have a hold on the capital base of the company. The company`s capital was deemed as its permanent fund and hence a protected territory where much of the restraints were placed to deter any unlawful tempering with the capital fund. The capital maintenance rule was removed in South African company law, in particular from the 1973 Act, by the Amendment Act 1999. This amendment juxtaposed itself in the middleway of the two primary international models of maintenance of capital, namely the English model of the capital maintenance rule and the American solvency and liquidity test. The amendment hence did not completely remove this outdated archaic rule, capital maintenance rule. The rule could not survive the demands of the modern and fast developing business world of South Africa.
The amendment, in favour of the American solvency and liquidity rule, gave leverage for the company to make payments to its shareholders without profit however this was under certain conditions.164 These distributions were done only if the articles of association provides for such. Further there has to be a reasonable belief that after such payment, the company will be able to pay its debts as they become due in the ordinary course of business and if its consolidated assets, fairly valued will exceed the consolidated liabilities of the company.165 Also, companies could now be allowed to buy back their shares and those of their holding companies as long as their articles of association permitted it and also the solvency and liquidity test was met.166 The statutory adoption of the solvency and liquidity test concept benefited company creditors as the concept promotes creditor protection while at the same time advancing interests of the company and other stakeholders. Most transactions that are
161 Ibid.
162 This was only permitted upon fulfilling the requirements of section 81 of the 1973 Act which required there to be a special resolution and sometimes a court order in other circumstances.
163 In terms of s 38 of the 1973 Act no company shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares of the company, or where the company is a subsidiary company, of its holding company.
164 MA Shabangu ‘A critical analysis of capital rules in the Companies Act 71 of 2008’ Unpublished LLM dissertation, University of Pretoria, 2009, 10.
165 That’s the solvency and liquidity test-section 90 of the 1973 Act as amended by the Amendment Act 1999.
166 Section 85 of the 1973 Act as amended by the 1999 Amendment Act.
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meant to affect the company`s financial position undergo this test to ensure that the financial interests of creditors are safeguarded. The application of this concept was however limited in the 1999 Amendment Act as it also required that despite the solvency and liquidity test being met still a company`s articles of association had to approve of such transaction. This is no longer the position when comparing it with its broader application in the 2008 Act; the test is now applied to any qualifying transaction as long as the conditions, restrictions or prohibitions in a memorandum of incorporation are fulfilled. This shall be dealt with in detail in subsequent paragraphs.