SUBMISSION BY KATHY IDENSOHN: UNIVERSITY OF CAPE TOWN
DEPARTMENT OF COMMERCIAL LAW
KATHYIDENSOHN
BA LLB (CUM LAUDE) (CAPE TOWN) LLM (CANT AB) ATTORNEY OF THE HIGH COURT OF SA
14 February 2011
PRELIMINARY ADVICES: THE COMPANIES AMENDMENT BILL 40 OF 2010
I refer to previous correspondence with Margot Herling and Andre Hermans requesting legal advice in relation to certain aspects of the Companies Amendment Bill 40/ 2011 ('the Bill') as read with the Companies Act 71/2008 ('the Act').
1.TERMS OF REFERENCE
I have been briefed with the following background documentation:
1.Draft 4: Companies AIB Issues emerging from submissions excluding ACCAand PASA - 3 February 2011;
2.Submissions received from the DTI headed 'Companies Amendment Bill, 40of 2010. Proposals for Consideration by the Portfolio Committee on Trade and Industry'.
In terms of my e-mail to Margot Herling dated 21 January 2011 and her reply of 31 January 2011, I agreed to furnish advice in relation to the following specific issues:
1.The reckless trading and other implications of technical vs. commercialinsolvency
2.The position of regulators under business rescue schemes
3.Shareholder appraisal rights within the context of possible commercialinsolvency
4.The powers of business rescue practitioners to demand the return of booksand documents belonging to the company.
My advices are accordingly limited to submissions received in relation to these particular matters and exclude those referred to in, inter alia, Andre Herman's e-mail to me dated 8 February 2011.
2.RECKLESS TRADING AND OTHER IMPLICATIONS OF TECHNICAL VS.COMMERCIAL INSOLVENCY
(S 22 as read with s4 of the Act)
2.1 The provisions of the Act and Bill
Section 22(1) of the Act prohibits reckless, grossly negligent and fraudulent trading and trading under insolvent circumstances.
Section 22(2) then provides that:
'If the Commission has reasonable grounds to believe that a company is engaging in conduct prohibited by subsection (1), the Commission may issue a notice to the company to show cause why the company should be permitted to continue carrying on its business, or to trade, as the case may be.'
Thus effectively empowers the Commission to cause companies to cease trading if they are in 'insolvent circumstances', unless they are able to satisfy the Commission that they ought to be permitted to continue operating.
The concept 'insolvent circumstances' is not defined but may be interpreted as including companies that trade whilst they are 'technically insolvent' in that their liabilities exceed their assets. This interpretation is based on the fact that section 22(1) refers to 'reckless' trading, 'grossly negligent' trading and 'trading under insolvent circumstances'. In terms of the general rules of statutory interpretation, this implies that each of these three concepts has a different meaning. Since the courts have already determined that 'reckless' trading refers to trading whilst commercially insolvent (Le. whilst a company is unable to pay its debts as they fall due in the ordinary course of business, at least for a certain future period), theimplication is that 'trading in insolvent circumstances' means trading whilst technically insolvent.
2.2The submissions
A number of stakeholders have argued that section 22(2) should either be deleted in its entirety or at least amended so as to refer only to companies that are 'commercially insolvent' on the grounds that:
1.A large number of companies (particularly those that are newly incorporatedor affected by currency fluctuations) operate whilst they are technically insolvent.
2.Many such companies are able pay their operating expenses and otherdebts in the ordinary course despite their technical insolvency. As such, they do not represent an undue risk for creditors in the same way that commercially insolvent companies do. The section fails to take account of this commercial reality.
3.Insofar as section 22(2) does allow for companies to be required to ceaseoperating if they are technically insolvent, it is a new and unnecessary and addition to our law, particularly since creditors are already adequatelyprotected by various provisions that cater for reckless trading andcompanies that are 'financially distressed'.
4.The failure to distinguish between technical and commercial insolvency andthe inclusion of technical insolvency within the ambit of section 22 also has the following additional 'knock-on' implications:
4.1 Directors of technically insolvent companies will be unable to benefitfrom the indemnity and insurance provisions of section 78 of the Act.
4.2 It will require directors of technically insolvent companies to adopt a resolution placing the company under business rescue proceedings or, alternatively, to send a notice to all affected persons informing them of the company's position, including the fact that it is technically insolvent. This will have adverse implications for the company's reputation and may affect its future viability.
4.3 Technically insolvent companies that are audited will be unable to obtain unqualified audited financial statements because they will be in contravention of section 22.
4.4 SMEs that are technically insolvent will be required to file quarterlynotices, which is unduly burdensome for them.
2.3 Opinion
I am in agreement with the submission that section 22 should be amended so as to make it clear that it only refers to commercial insolvency (which should be defined with reference to the section 4 liquidity criterion) but not to technical insolvency or a failure to satisfy the section 4 solvency criterion.
The primary purpose of regulating companies in financial difficulty is to protect their creditors against undue and significant risks of non-payment of their claims against the company. This aim must however be balanced against the need to encourage commercial activity and ensure that commercially viable companies that do not in fact pose an undue or unacceptable high level of risk to their creditors are allowed to continue operating. It is only once they represent an unacceptably high risk that a cessation of trading becomes necessary and justified.
Our law has traditionally relied on the distinction between technical and commercial insolvency to draw the line between acceptable and undue levels of risk to creditors and, thus, to define the circumstances in which companies ought to cease trading. It is only when they are commercially insolvent that they should be required to stop operating.
This reliance on commercial insolvency as the proper indicator of unacceptable creditor risk is reflected in, for example, the grounds on which companies in financial difficulty may be liquidated and wound up. Sections 344 - 345 of the Companies Act 61/1973 empower a court to wind a company up if it is unable to pay its debts. The Supreme Court of Appeal has held that this means that the company must be commercially insolvent. Mere technical insolvency alone is insufficient unless, in the particular circumstances of the case, the technical insolvency indicates commercial insolvency and an inability by the company to pay its debts. (See Johnson v Hivotech (Pty) Ltd 2000 (4) SA 930 (SCA) 933-4.)
The inclusion of technical insolvency as a ground for mandatory cessation of operations therefore goes further than is reasonably necessary to protect creditors and represents an unjustified restraint on commercial activity. Creditors are already adequately protected by the various provisions that combat reckless trading / trading whilst commercially insolvent. The placing of the onus on the company concerned to satisfy the Commission that it ought to be allowed to continue operating may be extremely burdensome for the company even if it only has to do so on the ordinary civil standard of a balance of probabilities.
In addition, I agree with the concerns regarding the abovementioned further implications of the general failure to distinguish between commercial and technical insolvency.
An undertaking by the Commission that it will not use its powers under section 22(2) against companies that are only technically insolvent is not a viable solution. It is doubtful whether such an undertaking would be lawful or enforceable. In addition, it will not relieve the company and its directors of the other consequences referred to above.
If however it is decided to retain section 22 and the intention is for it to apply to technical insolvency then I would suggest that, at least, the concept of trading 'under insolvent circumstances' be defined. If it is to include trading whilst technically insolvent, the definition should refer to a contravention of the relevant portions of the section 4 solvency and liquidity test.
3. THE POSITION OF REGULATORS UNDER BUSINESS RESCUE SCHEMES
(Sections 133 -136 & 142(4) of the Act, clauses 80 - 82 & 85 of the Bill)
3.1 The provisions of ss133 - 136 of the Act
Section 133 imposes a general moratorium on all legal proceedings against companies that are under business rescue, except in certain specified circumstances. These specified circumstances do not include regulatory action by regulators.
3.2 The submissions
A number of stakeholders have submitted that section 133 should be amended so as to make it clear that it does not prevent regulators from either initiating or continuing lawful regulatory action against such companies.
In addition, it has been submitted that the section 128(1)(a) definition of an 'affected party' should be amended so as to include regulatory authorities, which would then give them certain rights to apply to court under section 130 to have the business rescue proceedings set aside.
SARS has argued in this regard that section 133 will prevent it from collecting current, payable taxes even when they are collected by the company from other persons such as employees (as in the case of employees' tax and UIF), customers (as in the case of VAT) and other third parties (as in the case of withholding tax on royalties and dividends).
THE FSB has argued more generally that section 133 will prevent it from fulfilling its regulatory functions in an efficient and effective manner.
3.3 Opinion
The purpose of the section 133 moratorium is primarily to protect the company and its creditors by ensuring that the company's assets are placed under the business rescue practitioner's control and used for the benefit of the company and its creditors in accordance with the agreed business rescue plan.
Given this underlying rationale, the moratorium should only apply to proceedings involving assets which the company owns or is legally entitled to. It should not apply to assets that the company has but which it holds for on behalf of another person. It is for this reason that section 133(1)(e) expressly states that the moratorium does not apply to 'proceedings concerning any property or right over which the company exercises the powers of a trustee.'
I am accordingly in agreement with SARS' submission that the section should be amended so as to exclude action by SARS to recover employees' tax, UIF, withholding taxes and VAT which are collected by the company on behalf of SARS and which do not fall part of the company's assets.
4. THE POWERS OF BUSINESS RESCUE PRACTITIONERS IN RELATION TO COMPANY BOOKS AND DOCUMENTS
4.1 The provisions of s142(4) the Act
Section 142 of the Act sets out the business rescue practitioner's powers to obtain books and records relating to the company once business rescue proceedings have commenced.
Subsection (4) provides that:
'No person is entitled, as against the practitioner of the company, to retain possession of any books or records of the company, or to claim or enforce a lien over any such books or records.'
The Bill does not seek to amend this particular subsection.
4.2 The submissions
The concern has been expressed that this provision enables business rescue practitioners to require the return of books and records by regulators and law enforcement agencies on demand, despite the fact that they may be relevant to an ongoing lawful investigation.
It has been suggested by SARS that this be amended to exclude any records held under a search warrant or other statutory authority, subject to an obligation on the regulator to provide copies to the practitioner.
4.3 Opinion
I agree that business rescue proceedings should not (and should not be allowed to be used in order to) frustrate lawful regulatory investigations or proceedings. On the other hand, the interests of the company and its creditors do require that the business rescue practitioner be given access to all company books and records.
The SARS suggestion that section 142(4) be amended so as to exclude books and documents held under a search warrant or other statutory authority subject to anobligation on the regulator to make copies available to the business rescue p[practitioners seems to be a reasonable and pragmatic compromise.
Consideration could however also be given to including a further provision requiring the regulator to comply with the practitioner's request for books or documents within a reasonable period of time. An obligation could also be imposed on the regulator to make certified copies available (or even to release the original and retain a copy) where possession of a certified copy or the original is necessary for the practitioner to take legal action on the document concerned.
5. SHAREHOLDER APPRAISAL RIGHTS
5.1 The provisions of s164 of the Act
Section 164(19) of the Act provides that it is not necessary for a company to comply with the section 4 solvency and liquidity criteria when making a payment to a shareholder pursuant to an exercise of the latter's appraisal rights.
The only 'qualification' to this is section 164(17) which provides that if there are reasonable grounds for believing that the payment would result in the company being unable to pay its debts, the company may apply to court for an order varying the company's payment obligations.
5.2 The submissions
It has been submitted that appraisal rights should not be permitted to prejudice the company's other stakeholders (particularly its creditors). As such, the section should be amended so as to require the company to apply to court whenever there are reasonable grounds that an appraisal right payment to a shareholder may result in the company being unable to pay its debts.
5.3 Opinion
The Act's solvency and liquidity requirements reflect a general underlying theme of reasonable creditor protection against any conduct by companies that does or might result in an unacceptably high level of creditor risk.
Payments to shareholders pursuant to an exercise of their appraisal rights is conduct that may have such an effect. As such I am in agreement with the suggestion that the section be amended so as to oblige (rather than entitle) companies making such payments to apply to court to mediate the relevant competing interests in cases of reasonable risk of commercial insolvency.
The above constitute my preliminary advices on the specific matters I undertook to advise on. Please let me know if you require any further clarification or explanation from me or if you wish me to meet with members of the Committee.
Yours faithfully.
KATHYIDENSOHN