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COVID-19: Financial distress – insolvency and restructuring

1 April 2020
– 6 Minute Read

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Many businesses will be facing some form of financial distress as a result of the economic and social consequences of COVID-19.

Under these circumstances, access to funding and the ability of borrowers to meet their obligations under their existing funding arrangements becomes critical. It is vital for businesses to engage with their bankers and other funders at an early stage to negotiate any possible covenant holidays, forbearances, waivers and possibly standstills and amendments and extensions to existing facilities.

Further, under circumstances of financial distress directors need to be mindful of their duties, including their general statutory and common law duties and potential personal liability for reckless trading.

There is no general obligation on a board of directors either to place a company in liquidation or to take steps to commence business rescue proceedings if a company is financially distressed. The board’s obligations must therefore be assessed in relation to (i) reckless trading in terms of section 424 of the 1973 Companies Act, (ii) reckless trading in terms of section 22(1) of the Companies Act: and (iii) the obligation to provide notice of ‘financial distress’ in section 129(7) of the Companies Act.

The primary consideration, here, is that, although ‘recklessly’ does not mean mere negligence but at least gross negligence, the Courts have stated that if a company continues to carry on business and to incur debts when, in the opinion of the reasonable business person, standing in the shoes of the directors, there would be no reasonable prospect of creditors receiving payment when due, it will generally be a proper inference that the business is being carried on recklessly.

Insolvency or lack of liquidity – options available

In instances where restructuring as described above will not suffice or fails to provide the liquidity required, a formal process may be appropriate. The main options are: 

  • Business rescue

    Chapter 6 of the Companies Act introduces the concept of business rescue, which involves proceedings to facilitate the rehabilitation of a company that is financially distressed by providing for (i) the temporary supervision of the company, and of the management of its affairs, business and property; (ii) a temporary moratorium on the rights of claimants (creditors) against the company or in respect of property in its possession; and (iii) the development and implementation (if approved) of a plan to rescue the company by restructuring its business, property, affairs, debt and other liabilities and equity in a manner that maximises the likelihood of the company continuing in existence on a solvent basis, or, if this is not possible, in a manner that results in a better return for creditors or shareholders than would result from the immediate liquidation of the company.

    The term ‘financially distressed’ means that ‘it appears to be reasonably unlikely that the company will be able to pay all of its debts as they become due and payable within the immediately ensuing six months’, or ‘it appears to be reasonably likely that the company will become insolvent (i.e. liabilities will exceed assets) within the immediately ensuing six months’.

    Business rescue proceedings can be initiated on a voluntary basis by way of a resolution of the board of directors of the company, or by way of an application to court by an ‘affected person’, this being a shareholder, creditor, a registered trade union representing employees or any employee of the company.

    The requirements that must be satisfied for a company to commence business rescue proceedings are (i) that the company is financially distressed; and (ii) that there appears to be a reasonable prospect of rescuing the company.

    In addition to the general moratorium against legal proceedings, the business rescue practitioner may entirely, partially or conditionally suspend, for the duration of the business rescue proceedings, any obligation of the company under any agreement to which it is a party (excluding employment contracts).

    Section 129(7) of the Companies Act requires that if the board of a company has reasonable grounds to believe that a company is financially distressed, but it has not adopted a resolution to place the company in business rescue, the board must deliver a written notice to each ‘affected person’ explaining why it has not adopted such a resolution.

    The section does not contain a sanction if the board fails to comply, and there is currently no case law on the section. However, it is possible that a failure to comply with the obligation could have adverse consequences for directors (such as personal liability) in terms of section 214(1)(c) and section 218(2) of the Companies Act or if the company is subsequently placed in liquidation and creditors suffer a loss, to the extent that it can be shown that the failure to comply caused the loss.

    Clearly notice to affected persons of this nature could prompt them to bring a business rescue application or even launch an application for the liquidation of the company. Creditors may also be unwilling to continue to supply goods and services on favourable credit terms and banks may withdraw facilities. It is therefore important to avoid the need to give such a notice.

    In this regard it is critical for the board to consider the restructuring options available and whether the implementation of them would result in the company not being financially distressed, and therefore avoiding the need to issue a section 129(7) notice. 

  • Liquidation 

    In the very worst of circumstances, a board may need to consider liquidation. Companies may also face liquidation proceedings initiated by creditors.

    The threshold for liquidating a company is essentially that it is unable to pay its debts as they fall due. Factual insolvency (i.e. liabilities exceeding assets) is not a ground for liquidating a company (although may be a factor considered by the Court in adjudicating an application).

    Liquidation should only be considered if consensual restructuring and business rescue options have been exhausted. Companies should take legal advice if faced with an application for liquidation. In some instances it is possible to convince the Court not to grant a liquidation application but instead to order the company to commence business rescue proceedings. If there is a viable business to be saved, business rescue may be a suitable alternative. 

Businesses and boards of directors must act proactively in engaging with creditors and financiers at the early stages of financial distress. The economic consequences of the COVID-19 pandemic are likely to be far-reaching and unprecedented. Good faith engagement at an early stage may be vital in ensuring the support of all relevant stakeholders as we weather this storm.