The Liquidation Process of Insolvent Companies in South Africa

Including the provisional divisions of the High Court in which applications for liquidations can be filed

What is liquidation?

In the world of business, liquidation is the process of eventually dissolving a business, such as a company. It is also referred to as winding-up, meaning to bring the activities and business operations of a business to an end.

The article will focus on insolvent companies. Although close corporations are not specifically mentioned in the article, by implication, they are included in the explanation of the liquidation process.

Keep in mind, where the proceeds of the assets of a company are distributed to the company’s shareholders, the proceeds of a close corporation’s assets are distributed to its members.

Liquidation of insolvent companies, which some liquidation attorneys describe as ‘a relatively simple process,’ includes the following basic steps:

• Selling the assets of a company by means of:
• public auction, which is a method to sell the assets by allowing members of the public to bid and sell to the highest bidder, or
• private treaty, a process in which the selling price of an asset is privately negotiated between the seller and the buyer.
• Using the first portion of the proceeds from the sales of the assets to pay for the costs incurred in the liquidation process.
• Distributing the balance of the proceeds of the assets, according to ranking, to the creditors of the company. (Refer to ‘The ranking of creditors in the liquidation process’ at the end of the article.)
• Distributing the remaining proceeds (if any) to the owners (shareholders) of the company.

The liquidation process can be classified into solvent liquidation and insolvent liquidation. This article deals with the liquidation of insolvent companies.

When is a company considered insolvent?

A company is considered insolvent if:

• its liabilities exceed its assets, a situation referred to as factual insolvency, or
• it defaults on its debt obligations when they become due, a scenario called commercial insolvency.

Analysts and liquidation experts consider commercial insolvency a more valid and appropriate test for a company’s insolvency because companies are often factually solvent whilst they are unable to repay their debts due to cash-flow problems.

Looking from a different angle, a company is regarded insolvent when it cannot pass the solvency and liquidity test as set out in section 4 of the Companies Act (Act 71 of 2008), hereafter referred to as the new Act. The section requires a company to satisfy the test at a particular time while considering all ‘reasonably foreseeable financial circumstances of the company.’

This implies, amongst others, the following requirements:

• The assets of the company have to equal or exceed its liabilities. The assets and liabilities must be calculated at their fair value, which is defined by IFRS (International Financial Reporting Standards) 13 as: ‘The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’
• It must be obvious that the company will be able to repay its debts ‘as they become due in the ordinary course of business.’
• In addition, the company must be able to repay its debt for a period of one year after the date of the solvency and liquidity test.
• The company is obliged to use financial information based on accurate and complete accounting records, and financial statements that ‘present fairly the state of affairs and business of the company.’

The responsibility of company directors regarding the liquidation process

Regardless of how the liquidation process commences, directors of companies shoulder a huge responsibility regarding the winding-up of an insolvent company.

Section 22 of the new Act is significantly important in this regard. The section deals with reckless trading, prohibiting a company to ‘carry on its business recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose, or trade under insolvent circumstances.’ (Accentuation by the article writer.)

Due to their responsibilities and functions, there is an obligation on the directors (board of directors) of a company to apply for liquidation when the company trades under insolvent circumstances.

The new Act is quite clear about the duties and responsibilities of directors, stating:

• ‘The business and affairs of a company must be managed by or under the direction of its board, which has the authority to exercise all of the powers and perform any of the functions of the company,’ permitting that the new Act or the company’s Memorandum of Incorporation (MOI) does not provide otherwise. (Section 66)
• Section 76, in particular, requires a director to exercise and perform the functions of the director in good faith and for a proper purpose in the best interests of the company.

In addition, company directors are subject to the common law as confirmed in court judgments and rulings.

Hence, although the winding-up of a company can be viewed as a challenging and discouraging process, it is usually in the best interest of the directors and shareholders of the company. Actually, a court may decide that the directors may be personally liable if it is apparent that the company had been operating under insolvent conditions when it should in fact have applied for liquidation.

The winding-up of insolvent companies explained

In South Africa, an insolvent company may be liquidated either voluntarily, or by way of a court order.

Contrarily to solvent companies, which are liquidated in terms of the new Act, the winding-up of insolvent companies are executed in terms of Chapter 14 (sections 337 – 426) of the Companies Act 61 of 1973 (old Companies Act).

Voluntary winding-up

A voluntary liquidation may be initiated by using one of the following methods:

• the board of directors adopts a resolution to that effect,
• the company’s shareholders pass a special resolution, referred to as members’ voluntary winding-up, usually initiated by the directors, concluding that the company be liquidated, or
• the creditors of the company request a voluntary liquidation referred to as creditors’ voluntary winding-up.

Voluntary liquidation is requested from the Companies and Intellectual Properties Commission (CIPC) by way of an administrative request.

The steps involved in a voluntary liquidation process of an insolvent company are, inter alia:

• The special resolution must be filed with the CIPC together with several compulsory documents and prescribed forms. The date the special resolution is filed is considered the commencement date of the voluntary liquidation.
• A statement of affairs of the company, prepared and attested by a director of the company, must also accompany the special resolution. The statement can also be in the form of an affidavit.

The statement includes the following:

• particulars about the assets and liabilities of the company,
• information regarding any litigation proceedings the company is currently involved in,
• the following details concerning each creditor of the company: contact details, respective claims against the company, and particulars regarding any security held for the amounts owed by the company.
• When the CIPC is satisfied with the filed documents, the Registrar of Companies will register the company as being ‘in liquidation,’ and will, without delay, send a copy of the special resolution to the Master of the High Court.
• The Master will appoint a liquidator to drive and manage the liquidation process. Typically, in the case of a members’ winding-up, the shareholders will nominate an acceptable liquidator to be appointed by the Master. In the case of a creditors’ winding-up, the Master will appoint an acceptable liquidator which was nominated by the creditors.
• Once appointed, the liquidator is responsible for, amongst others, the following duties: securing and selling all the assets of the company, distributing the proceeds to the creditors (refer, ‘The ranking of creditors in the liquidation process,’ at the end of the article), distributing funds (if available) to shareholders, and dealing with the employees of the company.

In a voluntary winding-up, the liquidator is allowed to use all powers in terms of the old Companies Act given to the liquidator in a winding-up by a court, without the permission of the court. Although, these powers are subjected to:

• such directions as may be given by the company if it is a members’ voluntary winding-up, or
• such directions as may be given by the creditors in the case of a creditors’ voluntary winding up.
• The costs incurred in the winding-up process, for which the company is liable, are deducted from the proceeds of the assets before distributing them to the creditors.

Pros and cons of voluntary liquidation

Some pros of the voluntary liquidation process are that the process is quick, simple, inexpensive, and convenient.

Some of the disadvantages are that insolvency inquiries are not allowed, and creditors may not immediately know that the company has passed a resolution to be voluntarily liquidated.

The effect of a voluntary winding-up on the status of a company and its directors

In terms of section 353 of the old Companies Act, a company which is in the process of a voluntary liquidation shall ‘remain a corporate body and retain all its powers as such but shall from the commencement of the winding-up cease to carry on its business, except in so far as may be required for the beneficial winding up thereof.’ (Accentuation by the article writer.)

Regarding the directors of such a company, section 353 states that from the start of the voluntary winding-up all their powers ‘shall cease’, except when the continuance of their powers is sanctioned:

• by the liquidator or the company in a general meeting in the case of a members’ voluntary winding up, or
• by the liquidator or the creditors when it is a creditors’ voluntary winding-up.

Winding-up by court order

Section 344 of the old Companies Act lists several circumstances in which a company may be wound up by court. Circumstances such as:

• the company has by special resolution resolved that it be wound up by the court,
• the company is unable to pay its debts as described in section 345 of the old Companies Act, or
• if it appears to the court that it would be just and equitable that the company should be liquidated.

An application to the court to start the liquidation process can be made by:

• the company itself, in which case a resolution by the shareholders is required,
• a creditor or creditors, or
• a shareholder or shareholders of a company.

Usually, a court application is brought either by the company or a creditor, based on the assumption that the company will default on its debt obligations as they become due.

As with a voluntary winding-up, the commencement of liquidation by court order is deemed to be the date the application is presented to the court.

The application is made on an affidavit under oath by one of the directors of the company and is filed in the provisional division of the High Court in the area where the company has its registered address. See below under ‘List of the provisional divisions of the High Court in South Africa’ for a complete list.

Once the application is filed, a certain procedure is followed which may differ from division to division. Although, the basic procedure can briefly be explained as follows:

• Approximately two weeks after filing, the first hearing date takes place at which a provisional order of winding-up is granted, placing the company in liquidation.

Based on creditor support, the Master of the High (Master) court also appoints a provisional liquidator. The court will also schedule a return date, usually around six weeks after the provisional order has been granted.

• The period of six weeks allows for any creditors or affected parties to object to the application to liquidate the company.
• After the six weeks-period, on the return date, the applicant (the company itself/creditor/shareholder) returns to the court to have the provisional order made a final winding-up order.
• After the final liquidation order is granted, the Master will as soon as possible summon a meeting of creditors, allowing the creditors to, inter alia, nominate a final liquidator or liquidators to wind down and administer the company’s affairs and business operations.

Pros and cons of liquidation by court order

Pros are, amongst others:

• The availability of an insolvency inquiry to obtain information regarding the trade, dealings, affairs, assets, and liabilities of a company.
• The affairs of the company can be wound up in an orderly and objective way to the benefit of the creditors.

Cons

• The process is expensive because of the preparation and issuing of a formal application to one of the provisional divisions of the High Court.
• If the application is opposed by a creditor or an affected party, it may take several months to finalise.

List of the provisional divisions of the High Court in South Africa

In South Africa, applications for liquidations of insolvent companies can be filed in one of the following provisional divisions of the High Court.

As mentioned, an application to start the liquidation process must be filed in the provisional division of the High Court in the region where the company has its registered address.

For example:

The ranking of creditors in the liquidation process

Concerning liquidations, creditors are classified into three categories:

• Secured creditors are creditors with secured claims, holding security for their claims in the form of a pledge, right of retention, special mortgage, or landlord’s hypothec, which is a right established by law over a debtor’s property that remains in the debtor’s possession, as defined by OxfordLanguages.

They have preference above preferent and concurrent creditors.

• Preferent creditors are creditors with unsecured claims but have preference above concurrent creditors. Examples of preferent creditors are the South African Revenue Service (SARS) and employees’ remuneration.
• Concurrent creditors are paid from the remaining proceeds of unencumbered assets after preferent creditors have been paid in full. They are paid proportionally to the amounts due to them.

Disclaimer: This article does not intend to provide legal advice and is for information purposes only.