Business rescues in new act may have undesirable results
November 11, 2009
By Etienne Swanepoel
The new Companies Act 2008, which is expected to come into force in July next year, introduces many innovations: none less so than the new business rescue provisions. A business rescue becomes of relevance if a company is financially distressed, as defined in section 128 of the act.
This occurs when it appears that in the next six months the company will be unlikely to be able to pay its debts or likely to become insolvent. If applicable, the firm becomes eligible for rescue.
The objective of a business rescue is: the development and implementation, if approved, of a plan to rescue the company by restructuring its affairs, business, property, debt and other liabilities, and equity in a manner that maximises the likelihood of the company continuing in existence on a solvent basis; or if it is not possible for the firm to so continue in existence, results in a better return for the company's creditors or shareholders than would result from immediate liquidation.
Business rescues are, it would seem, based on chapter 11 of the US Bankruptcy Code, which permits reorganisations under the bankruptcy laws of the US. It is said that these proceedings are uncompetitive and prolong the lives of companies that should fail. However, whatever the outcome of this debate, in our jurisdiction the legislature has made a policy decision to include it in debt restructuring options.
Before looking at business rescues in any greater detail, it is useful to consider the options available to those having to deal with companies in financial difficulty. The first option is probably to maintain the status quo if and where possible. The next is to ask whether liquidation is preferable. In between, there is a vast number of options and combinations.
A shareholder or creditor can provide drip finance. This is not always advisable as the getting of security is problematic due to the voidable disposition provisions of the Insolvency Act. Generally speaking, the giving of security by a firm in financial difficulty is voidable inasmuch as it is typically to the detriment of other creditors.
Another option is to ask shareholders to subordinate shareholder claims in favour of the general body of creditors or a specific class of creditor. Subordinations are more complex than meets the eye. They involve a careful consideration of section 424 of the existing Companies Act (dealing with reckless trading, where firms trade in insolvent circumstances) and section 45 of the Auditing Profession Act (dealing with material irregularities, which likewise is the case where a company trades in insolvent circumstances).
These are unlikely to be as effective under the 2008 Companies Act in view of its section 22, which applies when a factual test determines trading in "insolvent circumstances" or trading "recklessly" with gross negligence and intent to defraud. Once section 22 is triggered, directors incur personal liability under section 77 and criminal liability under section 214.
Another option is to ask shareholders to capitalise their loan claims. They may hesitate to do so as the payment of dividends is itself subject to a solvency and liquidity test whereas the payment of interest is not. Dividends are not tax deductible, whereas interest is and so on. One may also disturb the existing proportionate holdings of shareholders. This may have unintended consequences such as amounting to a change of control for regulatory purposes under, for example, the Competition Act and the Securities Regulation Code.
Yet another is to call up the debt in question and rely on the underlying security. This is often cumbersome, and there may not be a ready market for, say, shares in a private company, which may constitute the underlying security of a pledge, or the assets of the company, which forms the subject matter of a special bond.
The creditor may be tempted to capitalise part of its outstanding loan, or provide further funds by way of subscribing for shares. The same change of control issues may arise.
Also, the creditor may not have the expertise or appetite to play a meaningful role as a large shareholder of the firm in question. Most importantly, the exit strategy may not immediately be apparent.
The control issue may be avoided if the conversion uses preference shares. But these instruments, for tax reasons, impose a minimum commitment of at least three years. This can in turn be avoided if the holder obtains a put option of the preference shares against, for example, one of the ordinary shareholders. Such options are also not without difficulty.
Other options include the sale of assets to raise funds and factoring the debtors book. The former may starve the company from future opportunities, while the latter may not be practical due to the absence of any appetite for the industry in which the company operates.
Still other options include compromises with the general body or classes of creditors; likewise, reaching arrangements with shareholders or classes of shareholders. These are technically challenging, potentially time consuming and expensive.
All of these options are rich with legal issues that will be informed by a host of issues. These include the Insolvency Act as already alluded to; the very complex common law provisions applicable to waivers, compromises, settlements, novations, acceleration clauses, set-off, the splitting of claims and the like as all or some of these may form part of whatever restructuring is to take place. Once business rescues become effective, choices relating to restructure and reorganisations will become more complex. Whatever choice is made, it will be prudent to undertake a comparative analysis with reference to business rescues.
Part of the provisions relating to business rescues is unclear and also controversial. The provisions of section 136 are probably more controversial than others. Under section 136(2) a business practitioner, that is, the person appointed to manage the company subject to business rescue proceedings, may despite any provision in the agreement to the contrary, cancel or suspend, entirely, partially, or conditionally, any provision of an agreement to which the company is a party, other than employment agreements. This could on a narrow reading of section 136(2) result in the absurdity that a creditor is required to advance loan funds to the company but the obligation by the firm to repay the loan could be cancelled.
Another is that under section 133(2), during business rescue proceedings, a guarantee or surety by a company in favour of any other person may not be enforced by any person against the company except with leave of the court and in accordance with any terms the court considers just and equitable in the circumstances. This introduces uncertainty insofar as it affects the giving of security by a company. If the obligations of the firm under the suretyship have been secured by means of a pledge, the efficacy of the pledge will obviously be affected adversely by section 133(2).
Simply what this means is that creditors will be likely across the board to re-price the initial giving of credit to take account of the subsequent increased risk of non-payment brought about by the uncertainties introduced by the new business rescue regime, once it becomes effective.
So, it is arguable that though the legislature has made a policy decision to grant commercial leniency to ineffective businesses, like squeezing a balloon, the unintended consequences may undermine the making of policy in this instance.
Etienne Swanepoel is a partner at Webber Wentzel. The views expressed are his own
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