Company Management and the Solvency Test

by The FindLaw Team

The solvency test plays an important role in the management of companies. The solvency test is set out in s 4(1) of the Companies Act 1993 (the Act). The Act does not require the solvency test to be met each day a company trades. However, the Act does require the solvency test to be met immediately after a company implements certain types of transaction. In most cases, a company that is prudently managed will meet the test without difficulty. However, if a company is marginally solvent, directors need to take particular care to satisfy themselves, when the transaction is authorised, that the company will meet the solvency test immediately after the transaction is implemented. Directors also need to continue to monitor the company’s solvency during the interim period between authorisation and implementation of the transaction.

When must a company meet the solvency test?

The Act requires that the solvency test must be met immediately after a company:

  •  Makes distributions (including by way of dividends, financial assistance, share buy-backs and share redemptions) under Part 6 of the Act;
  • Approves (or continues) a discount scheme under s 55 of the Act;
  •  Exercises powers under s 107(1) of the Act;
  •  Exercises certain buy-out rights under ss 110-115 of the Act; 
  • Amalgamates under Part 13 of the Act;
  • Transfers its registration under Part 19 of the Act.  

 

What does the solvency test require?  

The solvency test has two limbs   -   the liquidity limb and the balance sheet limb. Both limbs must be met, immediately after implementation of the relevant transaction, in order for the solvency test to be satisfied:

  • The liquidity limb of the solvency test requires the company to be able to pay its debts as they become due in the normal course of business; and
  • The balance sheet limb of the solvency test requires the value of the company’s assets to exceed the value of its liabilities, including contingent liabilities.

In determining whether the balance sheet limb of the solvency test will be met, directors must have regard to:

  • The most recent financial statements of the company that comply with s 10 Financial Reporting Act 1993; and
  • All other circumstances that the directors know (or ought to know), affect (or may affect) the value of the company’s liabilities, including its contingent liabilities.  

In determining whether the balance sheet test will be met, contingent liabilities must also be taken into account. Contingent liabilities may include, by way of example, guarantees, uncalled share capital, letters of credit, bills of exchange, pending litigation, lease obligations, performance bonds, underwriting obligations, and deferred payment obligations.

In valuing a contingent liability, the Act allows the likelihood of the contingency occurring to be taken into account. It also allows account to be taken of any counterclaims the company is entitled (and can reasonably be expected) to make.

The Act does not expressly provide for contingent assets to be taken into account, when determining whether the solvency test will be met. It is consequently usually prudent to ignore contingent assets, except to the extent that the company’s counterclaims may be taken into account in determining contingent liabilities.  

What obligations do directors have in connection with the solvency test?

Directors must ensure, when authorising a transaction to which the solvency test applies, that the solvency test will be met by the company immediately after the company implements the transaction. For practical purposes, directors should state clearly, in all directors’ resolutions and directors’ solvency certificates, the grounds upon which the directors rely in determining that the solvency test will be met. Directors should also state clearly any reports, financial statements, valuations or estimates upon which the directors rely in determining that the solvency test will be met.

The courts have confirmed that the solvency test should be applied with a sense of commercial reality. Directors may consequently look to the immediate past and the immediate future, as well as the present, in determining whether the company will meet the test. Existing and anticipated demand for the company’s goods and services are relevant considerations.  

Can directors rely on the opinions of others?

In determining whether the balance sheet limb of the solvency test will be met, directors are entitled under ss 4(2) and (3) to rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances. 

Directors are generally entitled under s 138 of the Act to rely on reports, statements, financial data and other information, and professional or expert advice, given by:

  • Employees that the director believes, on reasonable grounds, to be reliable and competent in the matters concerned;
  • Professional advisers or experts, in relation to matters the director believes, on reasonable grounds, are within their professional or expert competence;
  • Another director, or independent committee of directors, in relation to matters within their designated authority.

Directors so relying must act in good faith. Directors must also make proper enquiries where circumstances indicate. Directors must also have no knowledge that reliance is unwarranted. 

What are directors’ liabilities in connection with the solvency test? 

Directors may be personally liable to repay distributions if a solvency certificate required under the Act is not given, or if a certificate is given without reasonable grounds for believing that the solvency test will be met.

Directors may be personally liable to the company under s 137 of the Act if they fail to exercise the care, diligence and skill of a reasonable director, when determining whether the solvency test will be met. Failure to comply with the solvency certificate requirements of the Act may also constitute a breach of directors’ duties under s 134 of the Act not to contravene the Act. Entry into a transaction where the solvency test is not met may breach directors’ duties under ss 135 and 137 of the Act not to permit reckless trading, and not to incur certain obligations.  

Directors may also be personally liable if they fail to monitor the company’s solvency between authorisation and implementation of the transaction. The company is required to meet the test immediately after the relevant transaction is implemented. If it fails to do so, the transaction is treated as unauthorised. Directors who gave solvency certificates in respect of such a transaction may be personally liable, even though there were reasonable grounds for the directors to believe, at the time the certificates were given and the transaction was authorised, that the solvency test would be met immediately after the transaction was implemented.

This article is intended as a general overview only. If you have any questions or need more information, please seek the help of a legal practitioner. 



We welcome your feedback

Hi there! We want to make this site as good as it can for you, the user. Please tell us what you would like to do differently and we will do our best to accommodate!


 
 
We've updated our Privacy Statement, before you continue. please read our new Privacy Statement and familiarise yourself with the terms.
Feedback