THE SOLVENCY TEST

Chee SiYing discusses a new concept under the Companies Act 2016

The Companies Act 2016 (“CA 2016”) introduces the requirement for a solvency test and a solvency statement for certain transactions, namely redemption of preference shares out of capital, reduction of capital by way of special resolution (except for the sole purpose of cancelling share capital which is lost or no longer represented by assets), provision of financial assistance and share buyback.

 

ELEMENTS OF THE SOLVENCY TEST

 

The solvency test applicable to the redemption of preference shares, reduction of capital and provision of financial assistance differs from the test applicable to a share buyback. Both tests comprise two components, namely “cash flow solvency” and “balance sheet solvency”.

 

The solvency test for the redemption of preference shares, reduction of capital and provision of financial assistance is set out in section 112(1) of the CA 2016 and is as follows –

 

(1)      Cash flow solvency – this test is satisfied if (i) immediately after the transaction, there is no ground on which the company is unable to pay its debts; and (ii) either (a) the company will be able to pay its debts as and when they become due during a period of 12 months from the date of the transaction; or (b) if the company is to be wound up within 12 months after the date of the transaction, it will be able to pay its debts within 12 months after the commencement of the winding up; and

 

(2)      Balance sheet solvency – this test is satisfied if the company’s asset exceeds its liability at the date of the transaction.

 

The solvency test for the share buyback is found in section 112(2) and 122(3) of the CA 2016 and is as follows –

 

(1)      Cash flow solvency – this test is satisfied if the company remains solvent after each buyback during the period of six months after the date of the declaration made under section 113(5) of the CA 2016, in that the company will be able to continue to meet its debts as and when they fall due without any substantial disposition of its assets outside the ordinary course of its business, restructuring its debts, externally forced revisions of its operations or other similar actions; and

 

(2)      Balance sheet solvency – this test is satisfied if the share buyback would not result in the company being insolvent and its capital being impaired (that is, when the value of its net assets is less than the aggregate amount of all the shares of the company after the share buyback) at the date of the solvency statement. 

 

The solvency test in relation to redemption of preference shares, capital reduction by special resolution and provision of financial assistance in the CA 2016 is substantially similar to the test in the United Kingdom Companies Act 2006, the Singapore Companies Act (Cap. 50) and the New Zealand Companies Act 1993. The aforesaid companies’ legislation do not contain provisions that correspond with the solvency test for share buyback in the CA 2016.

 

Considerations in applying the solvency test

 

In applying the solvency test and forming an opinion for the purpose of making a solvency statement, section 113(4) of the CA 2016 provides that a director shall (i) inquire into the company’s state of affairs and prospects; and (ii) take into account all liabilities, including contingent liabilities, of the company.

 

THE SOLVENCY STATEMENT

 

The solvency statement shall (i) be made in a manner as may be determined by the Registrar; (ii) state the date on which it is made; (iii) state the name and bear the signature of each director making the statement; and (iv) be supported by a declaration that the directors have made an inquiry into the affairs of the company.

 

Number of directors making the statement

 

The CA 2016 requires a solvency statement relating to a reduction of share capital or redemption of preference shares to be made by all directors of the company. Where the transaction relates to the provision of financial assistance or a share buyback, the statement is to be made by the majority of the directors of the company.

 

Offences regarding solvency statement

 

A director who makes a solvency statement without having reasonable grounds for the opinion expressed in the statement will be liable on conviction to imprisonment for a term not exceeding five years or to a fine not exceeding RM500,000 or to both.

 

PARTICULAR ISSUES

 

Redemption of preference shares

 

A redemption of preference shares out of capital can only be effected after (i) all the directors have made a solvency statement in relation to that redemption; and (ii) a copy of the solvency statement has been lodged with the Registrar.

 

Reduction of capital

 

In the case of a reduction of capital by way of a special resolution, a company meets the solvency requirements if (i) all the directors of the company have made a solvency statement in relation to the capital reduction; (ii) the statement is made in the case of a private company, within the time frames specified in sections 117(3)(b)(i) and 117(5) of the CA 2016 and in the case of a public company, within the time frames specified in sections 117(3)(b)(ii) and 117(6) of the CA 2016; and (iii) a copy of the solvency statement has been lodged with the Registrar together with the notice under section 117(1)(a) of the CA 2016 that a special resolution to reduce the share capital has been passed.

 

For a private company, section 117(3)(b)(i) requires the solvency statement to be made within a period of 14 days ending on the date of the special resolution, and section 117(5) requires (i) where the resolution is to be passed as a members’ written resolution, a copy of the solvency statement to be served together with the special resolution, or where the special resolution is to be passed at a general meeting, the solvency statement or a copy thereof to be made available for inspection by members throughout the meeting; and (ii) the solvency statement or a copy thereof is to be made available at the registered office for inspection by any creditor for a period of six weeks from the date of the resolution.

 

In the case of a public company, section 117(3)(b)(ii) requires the solvency statement to be made within a period of 21 days ending on the date of the special resolution, and section 117(6) requires the solvency statement or a copy thereof to be made available for inspection (i) by members throughout the meeting; and (ii) by any creditor of the company at the registered office for a period of six weeks from the date of the resolution.

 

Financial assistance

 

Section 126 of the CA 2016 permits a company, other than a listed company, to provide financial assistance for the purposes of purchasing or acquiring shares in the company or in its holding company or reducing or discharging a liability for such an acquisition if the conditions set out in section 126(2) are satisfied. These conditions include (i) an obligation on the directors who vote in favour of the resolution (being not less than the majority of the directors) to make a solvency statement in relation to the giving of the financial assistance on the same day as that on which the aforesaid resolution is passed; and (ii) a requirement that the assistance is to be given not more than 12 months after the date on which the solvency statement is made.

 

The company is also required to provide a copy of the solvency statement and other information prescribed in section 126(5) to each member of the company within 14 days from the giving of the financial assistance.

 

Share buyback

 

A solvency statement for a share buyback is required under section 113(5) of the CA 2016 to include a declaration by the directors that the share buyback is necessary and is made in good faith in the interest of the company. The Companies Commission of Malaysia has confirmed in an FAQ that based on section 112(2)(b) of the CA 2016, a solvency statement issued in relation to a share buyback is valid for six months.

 

SOLVENCY TEST IN OTHER JURISDICTIONS

 

New Zealand

 

In New Zealand, the solvency test is set out in Section 4(1) of the Companies Act 1993. As in the case of the CA 2016, it embodies cash flow solvency and balance sheet solvency. In assessing whether the test had been satisfied, the New Zealand Court of Appeal in Petterson v Browne [2016] NZCA 189 focused on the balance sheet solvency. In arriving at its decision, the court referred to the company’s financial statements and found that the company’s current liabilities exceeded its current assets. Further, at the time the payments were made, the company was unable to meet its contingent liabilities i.e. an adjudication claim made pursuant to an indemnity given in favour of a subcontractor. Accordingly, the court held that the solvency test was not satisfied.

 

United Kingdom

 

As in the case of the CA 2016, the United Kingdom Companies Act 2006 permits private and public companies to reduce their share capital by way of a special resolution supported by a solvency statement. The case of BAT Industries plc v Sequana and another [2016] EWHC 1686 concerned a challenge to dividends paid by a company to its parent after the directors had resolved that the company would first reduce its share capital for the dividend distribution. The company in question was exposed to long-term environmental liabilities. The court formed the opinion that where a company had on its balance sheet an estimated provision in respect of a long-term liability, there was no justification for holding that the duty to protect creditors' interests applied for the whole period of the long-term liability. To do so would suggest that the directors are to take account of the creditors' rather than the shareholders' interests when running a business over an extended period. Accordingly, the court found that the directors had validly formed the necessary views when they made the solvency statement.

 

CONCLUSION

 

The introduction of the solvency test and solvency statement under the CA 2016 is welcomed as they impose a duty on directors to act in the interest of not only the shareholders of the company but also of its creditors. The requirement for a solvency statement offers a safeguard to creditors against the risk that directors may improperly distribute or otherwise pay company funds to shareholders at the cost of creditors and provides some assurance that the company will be able to pay its debts as and when they fall due within a foreseeable period of time.

 

Moving forward, it will be interesting to see how the Malaysian courts will interpret the application of the solvency test – will a restrictive approach be adopted to further secure the interests of the creditors or will the courts follow the approach taken by the English court in BAT Industries plc v Sequana and another?

 

 

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