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Accounting officers’ duty to report commercial insolvency

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Accounting officers for close corporations have long been required to report instances of insolvency to the Companies and Intellectual Property Commission (CIPC).

The problem with this is a lack of clarity between technical and commercial insolvency. This confusion resulted in the CIPC receiving massive volumes of reports and making it difficult to discharge its duties under the Companies Act.

Technical insolvency is when a company’s liabilities exceed its assets. Technical insolvency has long been understood to be a poor measure of a company’s ability to continue trading. For example, the parent company may issue a subordinated loan to a subsidiary so that in the event of liquidation, other creditors will get first bite of the apple. In those circumstances, the loan may effectively be written off. Counting subordinated loans as part of company liabilities provides a distorted measure of technical insolvency.

A more useful measure is commercial insolvency, which is defined in the Companies Act as the inability of a company to pay its debts when they fall due.

The CIPC has just issued a Guidance Notice outlining the responsibilities of accounting officers. If the CIPC has reason the believe that a company is unable to pay its debts when they become due and payable, it may issue a notice to the company “to show cause why it should be allowed to continue carrying on business.”

If the company then fails within 20 days to satisfy the CIPC that it is indeed able to pay its debts as they become due and payable in the normal course of business, the Commission can issue a compliance notice requiring the company to cease trading.

The Companies Act previously stated (under Section 22(1)) that a company must not trade under “insolvent circumstances” but did not make clear whether insolvent meant insolvent in the balance sheet sense (liabilities exceeding assets) or commercial insolvency.

If this was interpreted to mean balance sheet insolvency, it meant potentially thousands of companies would have to shut down, wreaking destruction on the economy.

Section 22(2) of the Act was amended to make it clear the provision was concerned only with commercial insolvency and not balance sheet insolvency. Even commercial insolvency does not have an automatic impact on a company’s right to carry on business. The only consequence is that the CIPC “may” call on the company to show cause why it should be allowed to continue trading.

 The Companies Act says a company must not carry on its business recklessly, with gross negligence, with intent to defraud or is unable to pay its debts as they become due. In any of these circumstances, the CIPC may require the company to stop trading.

A company is considered to have passed the solvency and liquidity test is its assets, fairly valued, are equal to or exceed liabilities (also fairly valued) and the company is able to pay its debts as they fall due for a period of 12 months after the date of the test

This also applies to close corporations (CC) and their accounting officers, who must notify the CIPC if the CC’s liabilities exceed its assets or if the annual financial statements “incorrectly indicate that as at the end of the financial year concerned the assets of the corporation exceed its liabilities, or has reason to believe that such an incorrect indication is given, he shall inform the Registrar by registered post of this fact.”

The fact that liabilities exceed assets does not necessarily mean that a CC is insolvent, though it may be an indicator of future insolvency.

Reports of technical insolvency by accounting officers may not always be investigated y the CIPC. Reports of commercial insolvency will be reviewed by the CIPC, leading to an investigation where this is deemed warranted.

The CIPC does not necessarily view technical insolvency as an instance of trading recklessly.