Who Is Exposed When the Money Runs Out?
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Most insolvencies do not arrive suddenly. They build over months, usually in plain sight, and the accountant is often the first person to see them in the numbers. A VAT payment is deferred, then PAYE. The overdraft stops moving. Suppliers start asking for cash on delivery.
On its own, none of this is unusual for a small business having a difficult year. Taken together, it may mean the business has crossed a line that carries real legal consequences for its directors, and potentially for those advising them.
This article is about recognising that line. It is not a guide to insolvency litigation, and it does not suggest that accountants should act as insolvency practitioners. The aim is more practical: knowing when a client's position has changed enough that your approach to the engagement should change as well.
Two tests, not one
In conversation, "insolvent" is used loosely. In law it has a more precise meaning, and there are two ways of establishing it.
The first is factual insolvency, a balance-sheet test. A business is factually insolvent when its liabilities exceed its assets, both fairly valued. The words "fairly valued" matter. Book values can flatter a business considerably, and liabilities such as sureties and contingent claims are often not reflected at all. A business can also be factually insolvent and continue trading for a long time.
The second is commercial insolvency, which asks whether the business can pay its debts as they fall due. This is the test that usually brings matters to a head, and it is the basis on which courts wind up companies.
The South African courts have confirmed that a company unable to pay its debts may be wound up even if its assets exceed its liabilities. They have also stated that the enquiry looks to the immediate future and takes contingent and prospective liabilities into account. Looking only at what is due today does not answer the question.
The two tests can point in different directions. Knowing which one a client is failing, or is close to failing, tells you a good deal about how urgent the position is.
The six-month horizon
The Companies Act 71 of 2008 adds a concept that is particularly useful in practice. A company is financially distressed if it appears reasonably likely to fail either test within the next six months.
Financial distress places an obligation on the board. The directors must either resolve to begin business rescue proceedings, or give written notice to affected persons, meaning creditors, shareholders and employees. The notice must state that the company is financially distressed and explain why the board has not adopted a rescue resolution.
Carrying on as though nothing has changed is not one of the options the Act contemplates. A board that does so may later find its conduct measured against the prohibition on reckless trading. Our earlier article, Rescue Me, Accountant, looks more closely at the accountant's role once business rescue is under consideration.
The warning signs
The signs usually appear in the financial information well before a client raises the issue.
On the balance-sheet side, look for:
negative equity, or equity that stays positive only because of a loan from a director;
assets revalued upward without a clear basis;
a going-concern note in the prior year's financial statements;
sureties or contingent liabilities that nobody has quantified.
On the cash-flow side, look for:
arrears with SARS;
suppliers moving the client onto cash terms;
an overdraft that stays at its limit;
salaries paid late or in instalments;
payments made to whichever creditor is applying the most pressure.
SARS arrears deserve particular attention. VAT and PAYE are often the first obligations a struggling business stops meeting, perhaps because SARS seems less immediate than a supplier or a landlord. That is a misjudgement. The Tax Administration Act provides, in certain circumstances, for the persons responsible for a company's tax affairs to be held personally liable for its unpaid taxes.
Acts of insolvency
It helps to separate warning signs, which are commercial, from acts of insolvency, which have legal effect. The Insolvency Act 24 of 1936 lists specific conduct that allows a creditor to apply for a debtor's sequestration without proving that liabilities exceed assets.
The act I would caution clients about most is also the easiest to commit: telling a creditor in writing that the debtor cannot pay. A well-meant email asking a supplier for patience can have that effect. Other acts of insolvency include a sheriff's return that there is nothing to attach, a disposition that prefers one creditor over others, and an offer asking creditors to accept less than they are owed.
Companies are subject to a separate mechanism. The insolvent winding-up of companies is still governed by the relevant provisions of the Companies Act 61 of 1973. Under those provisions, a company is deemed unable to pay its debts if it fails to pay, secure or compound a debt of R100 or more within three weeks of a proper written demand.
Clients should therefore be advised not to acknowledge an inability to pay in writing without first taking advice.
The position of directors
A company is a separate legal person, and its debts are its own. Directors are not ordinarily liable for them. A director who has acted honestly and within their powers is generally not personally exposed when the company fails. This point is often misunderstood, both by directors who are more worried than they need to be and by those who are not worried enough.
Personal exposure arises from conduct, not from the failure itself:
Reckless trading. The Companies Act 71 of 2008 prohibits a company from carrying on business recklessly, with gross negligence or with intent to defraud. A director who knowingly allows this may be personally liable for the resulting loss.
Delinquency. Directors may be declared delinquent.
Personal suretyships. In practice, this is the most common source of personal liability, and it is contractual. Many directors of small companies have signed suretyships for the company's banking facilities or supplier accounts, and those remain enforceable whatever happens to the company.
Tax. The Tax Administration Act route mentioned above is a further source of exposure.
Our article on solvency rules explains how the solvency and liquidity test relates to directors' liability for particular transactions.
Creditors and the order of payment
When a business is liquidated or sequestrated, its creditors are paid in a fixed order:
Secured creditors, such as bondholders and pledgees, are paid from the proceeds of their security.
Preferent creditors follow in the order the Insolvency Act prescribes. This includes the costs of administering the estate, certain amounts owed to employees and certain amounts owed to SARS.
Concurrent creditors, including most trade creditors, share in whatever remains. That is frequently very little.
This is worth explaining to clients who are owed money by a customer in difficulty. They will usually be concurrent creditors, and that should inform any decision to extend further credit.
Once liquidation or sequestration begins, a concursus creditorum is established. Creditors' individual claims give way to a collective process, and control of the estate passes to a liquidator or trustee.
The Insolvency Act also allows certain earlier transactions to be set aside. These include dispositions made without value, and payments that preferred one creditor over others in the period before the insolvency. A payment made while the business was already insolvent may well have to be repaid.
Where things usually go wrong
Much of the damage in these matters is done in the period between the first warning signs and formal proceedings, usually with good intentions. The usual mistakes are:
Continuing to trade in the hope of recovery after a reasonable director would have stopped.
Paying one pressing creditor in full while others go unpaid.
Selling assets below value, or settling director loan accounts.
Overlooking the notice obligation.
Leaving SARS arrears to accumulate.
For accountants, the equivalent mistake is continuing to treat the engagement as routine once the client's circumstances have changed materially.
Business rescue and liquidation
Where a business cannot continue as it is, the choice is broadly between business rescue and liquidation.
Business rescue is intended for a company that is financially distressed but has a reasonable prospect of being rescued. It provides a moratorium on claims against the company, while a business rescue practitioner takes control and prepares a plan for creditors to consider.
Liquidation brings the company to an end. Its assets are realised and the proceeds are distributed in the order described above.
Clients facing a liquidation application often ask whether it can be opposed. A genuine dispute about the underlying debt, raised on reasonable grounds, remains the most reliable defence. The South African courts have long held that winding-up proceedings are not a means of enforcing a disputed debt. By contrast, the argument that the company's assets exceed its liabilities will not usually help, because an inability to pay is enough on its own.
Business rescue is sometimes proposed as a way of stopping a liquidation. It can have that effect, but only where the application is genuine and properly pursued. The courts have not been sympathetic to rescue applications brought mainly to buy time. Where it becomes clear that there is no reasonable prospect of rescue, the practitioner is required to apply for the company to be liquidated.
These are matters for an attorney. Still, it helps a great deal if the accountant can explain the risks to the client early.
What this means for your practice
None of this requires the accountant to give legal advice. It does require recognising when a client's position has changed, and responding to that properly.
A useful starting point is a simple question: if the client had to settle all its debts now, could it? If the honest answer is no, the directors should understand that continuing to trade may have personal consequences for them.
In practice, that means four steps:
Apply both tests to the clients whose position concerns you most.
Where either test is close, record your concern in writing.
Set out what you recommend, including referral to an attorney or a business rescue practitioner where appropriate, and keep that record on file.
If your work expands into restructuring advice, update the engagement letter to reflect it.
As discussed in Your Client Is Drowning in Debt. What's Your Legal Role?, a documented referral protects both the client and you.
Early recognition matters beyond the individual file. Small businesses that deal with distress in time are more likely to survive, and so are the jobs and supplier relationships that depend on them. Accountants are often best placed to raise the issue first.
Join CIBA, and we will help you recognise financial distress in your clients' businesses and respond to it with confidence.
Further Reading
Rescue Me, Accountant: How to Save Clients from Themselves (and Liquidation): the accountant's role before and during business rescue.
Solvency Rules That Could Make or Break Your Practice: how the solvency and liquidity test affects director liability.
Understanding Going Concern: Insights from IFRS and the Companies Act: the reporting consequences when the going-concern assumption fails.
SARS vs JBSA Props: Business Rescue and VAT Liabilities: the treatment of VAT incurred during business rescue.
The Claim Your PI Insurance Won't Cover: why engagement letter scope determines your cover.
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