DealMakers - Q2 2020
Temporary respite for companies trading in insolvent circumstances
by Candice Meyer and Daveraj Sauls
Many companies may be trading in insolvent circumstances, potentially in contravention of the Companies Act 71 of 2008 (Act).
In light of the COVID-19 pandemic and the declaration of the national state of disaster (NSD) under the Disaster Management Act, 57 of 2002, the Companies and Intellectual Property Commission (CIPC) has confirmed that it will not invoke its powers to issue compliance notices, under certain conditions.
The South African Government declared the NSD in March 2020, and the ensuing extended lockdown continues to devastate the already battered South African economy. Many companies are on the brink of financial collapse and unemployment is rising at an alarming rate. Large companies, such as Comair and Edcon, are now in business rescue. Many businesses are, or are at risk of, trading in insolvent circumstances.
The inability of a company to pay debts when they become due and payable focuses on the liquidity and commercial insolvency of the company. A company is commercially insolvent when it is unable to pay its fixed costs and operational expenses, such as rent, even though its balance sheet may indicate that its assets exceed its liabilities.
Section 22(1) of the Act provides that: “A company must not carry on its business recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose”.
Section 22 of the Act provides that: “(2) If the Commission has reasonable grounds to believe that a company is engaging in conduct prohibited by subsection (1), or is unable to pay its debts as they become due and payable in the normal course of business, 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. (3) If a company to whom a notice has been issued in terms of subsection (2) fails within 20 business days to satisfy the Commission that it is not engaging in conduct prohibited by subsection (1), or that it is able to pay its debts as they become due and payable in the normal course of business, the Commission may issue a compliance notice to the company requiring it to cease carrying on its business or trading, as the case may be.”
The COVID-19 pandemic and ensuing lockdown under the NSD have placed companies at risk of non-compliance with s22. As such, the CIPC issued a Practice Note on 24 March 2020 under paragraph 4(1)(d) of the Companies Regulations (the Practice Note). In terms of the Practice Note, the CIPC will not invoke its powers to issue compliance notices under s22 of the Companies Act if a company is temporarily insolvent and still carrying on its business, but only if the CIPC believes that the insolvency is due to business conditions which were caused by the COVID-19 pandemic. As such, the Practice Note may afford distressed companies little relief.
Risk of liability
Companies are still prohibited under s22 of the Act from carrying on business recklessly, with gross negligence, intent to defraud any person, or for any fraudulent purpose, irrespective of the Practice Note.
A company is trading with gross negligence when it departs from the standards of a reasonable person ordinarily involved in the conduct of the business. It “must involve a departure from the standard of a reasonable person to such an extent that it may properly be categorized as extreme”.
Recklessness consists of a dual objective/subjective test. The objective test evaluates the alleged reckless conduct against the conduct of a reasonable person. The subjective test adopts the standard of a reasonable person that is informed by the knowledge, skill and the class of the person whose conduct is under scrutiny. In determining whether a company is conducting its business recklessly, the court has recently considered:
the scope of the operations of the company;
the functions and powers of its directors;
the debts and other financial difficulties of the company; and
the prospect of recovery from its financial difficulties.
The Practice Note does not address the position of directors who may be personally liable if they have acquiesced or knowingly carried on the business of the company while it is insolvent, even if the insolvency is due to business conditions caused by the COVID-19 pandemic. Directors may be liable for breach of their fiduciary duties if their conduct falls foul of the standard of care required in terms of the Companies Act.
A director is complicit in carrying on the business of the company with gross negligence if he ignores or fails to maintain even the most basic degree of care owed to the company and its stakeholders, such as its creditors.
A director may be held liable for loss, damage and costs which are directly or indirectly sustained if he or she knowingly participated or acquiesced in carrying on the business in a manner prohibited in s22(1). ‘Knowingly’ includes the failure of a director to take reasonable measures to determine whether a company was trading under circumstances prohibited by s22.
The definition of director in S77(1) of the Act includes prescribed officers and board or audit committee members, irrespective of whether or not they are also members of the company’s board of directors. A director found to be liable for contravening s22 cannot be indemnified and may subsequently be declared a delinquent director.
A director may also be held criminally liable for contravening s22 if he or she is party to an act or omission with intent to defraud an employee, creditor or a holder of the company’s securities, or with another fraudulent purpose. Criminal liability is limited to a fine or imprisonment for a period not exceeding 10 years.
The Practice Note will lapse 60 days after the NSD is lifted, the timing of which is currently indeterminate. From then, the CIPC may issue compliance notices under s22 of the Act, without regard for the impact of the NSD and COVID-19 pandemic on a company.
It is extremely unlikely that businesses will have adequately recovered from their financial distress within the permitted grace period in the Practice Note. The 60-day period following the lifting of the NSD may not be sufficient to allow companies to trade out of their insolvent circumstances. South Africa’s economy is predicted to contract significantly over the next year, at least, and we are possibly only seeing the start of the economic fallout due to the COVID-19 pandemic.
Different business activities were regulated differently under the lockdown restrictions imposed in the NSD Regulations. “Essential services” could continue to operate under Lockdown Level 5, while other business activities, such as tourism and beauty-related services, were only recently permitted to re-commence operations under Lockdown Level 3.
Businesses which had to remain closed until recently, or which had to curtail operations significantly, are at a distinct disadvantage compared to those that have been permitted to operate throughout the lockdown, and they potentially face greater insolvency risk. The CIPC should consider this disadvantage when determining whether or not to exercise its enforcement powers under s22 of the Act.
Meyer is a Partner and Sauls a Candidate Attorney, Corporate & Commercial, Webber Wentzel.
1 CIPC Guidance Note Application of Section 22 on Close Corporations (23 June 2015).
2 GNR 351 of 26 April 2011.
3 Transnet Ltd t/a Portnet v Owners of the MV “Stella Tingas” and Another 2003 (2) SA 437 SCA para 7.
4 Philotex (Pty) Ltd and others; Braitex (Ply) Ltd and others v Snyman and others 1998 (2) SA 138 (SCA) at 143 G.
5 Philotex (Pty) Ltd and Others v Snyman 1998 (2) SA 138 (SCA) 8.
6 Corinth Trading (Pty) Limited v Greunen and Others  ZAGPPHC 101 para 8.
7 Section 77(3)(b) of the Act.
8 Section 1 of the Act.
9 See Reg 38(1)(a) Companies Regulations (GG 34239 of 26 April 2011) provides persons qualifying as prescribed offices.
10 Section 77(1) of the Act.
11 Section 78(6)(a)(i) Act.
12 Section 162(5)(c)(iv)(bb) Act.
13 Section 214(c) Act; see Companies Amendment Act 3 of 2011.
14 Section 216(a) Act.
15 Disaster Management Act 57 of 2002: Risk-Adjusted-Strategy-Regulations (GG 43258 of 29 April 2020).