ERIC LEVENSTEIN: Boards of distressed companies overlook notice rules at their peril

Business rescue has been an integral part of SA’s legal and restructuring landscape for more than a decade. It has since its inception served as an effective means through which financially distressed companies may be rehabilitated and restructured through a formal restructuring process. 

Section 129(1) of the Companies Act provides that a company’s board may voluntarily commence business rescue proceedings if it has reasonable grounds to believe that the company concerned is financially distressed and that there appears to be a reasonable prospect of rescuing the company. 

For the act’s purposes, a company will be deemed to be “financially distressed” if 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 (commercial insolvency), or if it appears to be reasonably likely that the company will become insolvent within the immediately ensuing six months (factual insolvency). 

Accordingly, the test for financial distress is simple and comprises a six-month “forward-looking” test that contemplates either commercial insolvency or factual insolvency. For a number of reasons boards of companies experiencing financial difficulties often decide not to file for business rescue proceedings and allow the companies concerned to continue to operate under financially distressed circumstances — outside the formal business rescue process and much to their peril. 

The question that should immediately arise in such instances, but which is often neglected or ignored by boards, is simply, what does the law say? Put differently, is it appropriate for directors to allow the company to continue trading while in financial distress? Alternatively, what are the duties placed on directors in circumstances in which a company is financially distressed, but in which its board nevertheless opts not to file for business rescue? 

Unfavourable outcomes

Section 129(7) of the Companies Act provides that if a board of a company has reasonable grounds to believe the company is financially distressed but opts not to adopt a resolution for the voluntary commencement of business rescue proceedings, the board must deliver a written notice to each affected person (its shareholders, creditors and employees) detailing the company’s financial distress, as well as the board's reasons for not adopting a resolution initiating business rescue proceedings. The rationale behind section 129(7) notices is to place all affected people (particularly creditors) on notice that the company may be financially distressed, and that it has not been placed into business rescue for certain reasons (which must be set out in the notice). 

Given their nature and prescribed content, several unfavourable outcomes may (as a necessary consequence) flow from the issuance of section 129(7) notices to affected people. Liquidation applications, compulsory business rescue applications and creditor enforcement processes readily come to mind. For these reasons it comes as no surprise that few boards of directors comply with the statutory prescripts of section 129(7). Certainly, from our experience we have seen boards of directors being very reluctant to issue section 129(7) notices, even in instances where the companies in question are clearly financially distressed. It is safe to say that section 129(7) has been overlooked, neglected or simply thought away by numerous boards of directors of financially distressed companies. 

While one can understand the rationale behind boards of directors’ hesitancy in sending out section 129(7) notices, it must be accepted that the provisions of the Companies Act cannot be deliberately ignored or circumvented simply because one wishes to avoid certain adverse consequences that may result from compliance with the section. Boards must be aware that the mere fact that section 129(7) does not expressly provide for a sanction or penalty for noncompliance does not necessarily mean that they cannot be held personally liable. 

Appropriate steps

Directors of financially distressed companies must bear in mind that in terms of section 22(1) of the act a company must not “carry on its business recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose”, and in this regard, section 77(3)(b) provides that a director may be held liable for any loss, damage or costs sustained by the company as a direct or indirect consequence of the director having acquiesced in the carrying on of the company’s business despite knowing that it was being conducted recklessly. In addition, in terms of section 218(2) any person, including a director, who contravenes any provision of the act is liable to any other person for any loss or damage they may suffer due to such contravention. 

The scope for personal liability (both to the company itself and to third parties), due to noncompliance with the provisions of section 129(7) of the Companies Act thus very much exists. So boards of directors are encouraged to take appropriate steps, and take legal advice to ensure they do not leave themselves open to such liability. 

When the provisions of the Companies Act are considered in totality, the legal position is simply that if a company is financially distressed the board must adopt a resolution commencing business rescue proceedings. Alternatively, if it decides not to file for rescue it will be obligated to issue a section 129(7) notice clearly setting out that there are reasonable grounds to believe the company is financially distressed, and that there are cogent reasons for not filing for business rescue. These statutorily prescribed steps must not be overlooked by directors as noncompliance may leave them exposed to the risk of personal liability. 

• Dr Levenstein is director and head of insolvency, business rescue & restructuring at Werksmans Attorneys.