King III - Chapter 13: Solvency and liquidity tests

Overview
Chapter



13


In section four of the introduction to the Code, entitled “The link between governance principles and law”, it is stated that certain recommendations made in King II have now become matters of law because they are contained in the new Companies Act.

These new provisions of the Act create duties on directors which, if not discharged in the appropriate manner, can result in personal liability exposure.

One of the sections of the Act that has been revised substantially and is specifically referred to in King III revolves around the requirements for solvency and liquidity tests to be applied by directors for certain transactions.

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The main categories of transactions that now require formal solvency and liquidity tests include:
  • Financial assistance to third parties for the acquisition of or subscription for the company’s own shares
  • Loans or financial assistance to related parties (including subsidiaries, fellow subsidiaries, holding companies and directors)
  • Any dividends or distributions to shareholders
  • Capitalisation shares (where there is an option to receive capitalisation shares or cash)
  • Share buybacks.
Directors are required, amongst other things, to ensure that following any of these transactions, the company would satisfy the solvency and liquidity test. The requirement for the solvency and liquidity test is much wider under the new Act and includes common transactions such as dividend payments and inter-group lending, which previously did not require directors to perform this test. Directors therefore have to be particularly vigilant that any transaction proposed, falling into the above new categories, does not breach the application of the test.

In performing a solvency and liquidity test, a director needs to satisfy himself/herself, considering all reasonably foreseeable financial circumstances of the company at the time, that after the transaction:
  • The assets (fairly valued) of the company must exceed liabilities (this would include all reasonably foreseeable contingent assets and liabilities)
  • The company will be able to pay its debts as they become due in the ordinary course of business for a period of 12 months.
A director is personally liable for loss, damage or costs sustained by the company as a direct or indirect consequence of his or her actions if he or she:
  • Was present at the meeting where the resolution was considered or participated in the decision
  • Failed to vote against the resolution despite knowing that it was inconsistent with the requirements of the Act or the company’s memorandum of incorporation or the director did not responsibly consider its impact (this would include the instance where the company undertook any of the above transactions when it was not in a position of solvency and/or liquidity).
The solvency test requires that assets and liabilities are to be fairly valued and that reasonably foreseeable contingent assets and liabilities are taken into account. This necessitates that a more detailed exercise than a simple review of the balance sheet be undertaken.

Items such as the fair valuation of subsidiaries, intellectual property, investment holdings, vendor facilitation on BEE transactions and contracts (to name a few) need to be taken into account. Liabilities too have to be fairly valued, which, for example, may affect the valuation of fixed rate instruments. Contingent liabilities in particular have to be identified and a value placed on these.

The liquidity test requires the development of a 12-month cash flow forecast that takes into account issues such as the details around the debt repayment profile of the company, mandatory capex expenditures and seasonal working capital movements.

  1. Does the transaction being proposed fall into the category of transactions that require a formal liquidity and solvency test?
  2. Do we have the necessary information to allow us to determine whether the company will be solvent and liquid after the transaction?
  3. Have the assets and liabilities been fairly valued in the application of the test, or does the calculation merely reflect the book value of the assets?
  4. Does the calculation take into account all contingent assets and liabilities?
How we can help you
The specialists in PwC’s Transactions division have extensive experience in the valuation of companies and assets and can provide valuable input and assistance in the preparation of cash flow forecasts. The team has vast experience and a proven track record in valuing companies for M&A transactions, providing fairness opinions and working capital statements for regulated transactions, developing purchase price allocation models and preparing cash flow forecasts for clients.

The Transactions team is well placed to give directors external independent third-party confirmation or input concerning the solvency and liquidity test, thereby equipping them with the necessary information upon which to base their decisions in a responsible manner.