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Published online by Cambridge University Press: 24 February 2015
Many jurisdictions internationally have adopted some form of solvency-based threshold to protect creditors from opportunistic or abusive distributions being paid from corporate capital. When a legislative “test” for distributions involves an enquiry that is too heavily based on a company's balance sheet, and thus on the integrity of the financial reporting standards underpinning its preparation, the utility of such thresholds becomes questionable on a similar basis to that on which the effectiveness of the capital maintenance doctrine has been challenged. Even the addition of a “liquidity” threshold that shifts the emphasis away from a company's balance sheet appears to presume that a corporation's financial health can be accurately determined from its financial statements. This article explores the difficulties involved in so-called “solvency-based” thresholds for distributions and considers other sources of creditor protection that may be more reliable.
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2 By the Companies Amendment Act 37 of 1999, which came into effect on 30 June 1999.
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6 Act 71 of 2008, signed by the state president on 8 April 2009 and came into force on 1 May 2011, as amended by the Companies Amendment Act 3 of 2011, replacing the Companies Act 61 of 1973.
7 “Company finance” in “Explanatory memorandum to the Companies Bill 2007” at 11.
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10 “Explanatory memorandum”, above at note 7 at 11.
11 Van der Linde “The solvency and liquidity approach”, above at note 9 at 224. Van der Linde suggests that, whereas the statement would be true if “capital” were to be understood in an economic sense, referring to “total invested funds or equity”, an understanding of capital in the traditional sense of “nominal” capital would render the statement inaccurate.
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13 Id at 54.
14 As a general rule, an American company will either incorporate in its home state or in Delaware and, for this reason, Delaware's approach to capital regulation is generally of interest. See Cross, FB and Prentice, RALaw and Corporate Finance (2007, Edward Elgar)CrossRefGoogle Scholar at 13. More specifically, the provisions of the DGCL are of interest because they represent a hybrid of both capital-maintenance-based and solvency-test-based theory.
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17 Id at 97.
18 Ibid.
19 Manning and Hanks Legal Capital, above at note 15 at 19.
20 Referred to as the “Memorandum of incorporation” in South Africa and the “Certificate of incorporation” in Delaware.
21 Davis et al Companies and Other Business Structures, above at note 12 at 45.
22 Shareholders, unlike directors, are not subject to any fiduciary duties, either at common law or in company legislation.
23 Manning and Hanks Legal Capital, above at note 15 at 16.
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25 Manning and Hanks Legal Capital, above at note 15 at 19.
26 LS Black Jr “Why corporations choose Delaware” (2007, Delaware Department of State), available at: <http://corp.delaware.gov/whycorporations_web.pdf> (last accessed 26 October 2012) at 1.
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30 Callahan “Statutory protection of creditors”, above at note 1 at 224.
31 Ferran Principles of Corporate Finance Law, above at note 29 at 179.
32 Ibid.
33 Manning and Hanks Legal Capital, above at note 15 at 57.
34 Davis et al Companies and Other Business Structures, above at note 12 at 54.
35 Id at 53.
36 Id at 54.
37 Ooregum Gold Mining Company of India Ltd v Roper [1982] AC 125 (HL) at 133.
38 Cohen NO v Segal 1970 (3) SA 702 (W) at 705 H.
39 (1882) 21 Ch D 519 (CA), later followed in Cohen, id.
40 Davis et al Companies and Other Business Structures, above at note 12 at 54.
41 Ibid.
42 MS Blackman et al Commentary on the Companies Act (loose leaf, revised 2011, Juta) at 5-147.
43 Ibid.
44 Davis et al Companies and Other Business Structures, above at note 12 at 53.
45 Ibid.
46 Miola “Legal capital and limited liability companies”, above at note 24 at 421.
47 Ibid.
48 Id at 418.
49 Kraakman et al The Anatomy of Corporate Law, above at note 28 at 9.
50 Miola “Legal capital and limited liability companies”, above at note 24 at 419.
51 Blackman et al Commentary, above at note 42 at 5-103.
52 Ibid. In South Africa, the capital account and the share premium account together constitute a company's “capital”.
53 Ballantine, HW and Hills, GS “Corporate capital and restrictions upon dividends under modern corporation laws” (1935) California Law Review 229CrossRefGoogle Scholar at 234–35.
54 Ibid.
55 K Van der Linde Aspects of the Regulation of Share Capital and Distributions to Shareholders (LLD thesis, 2008, University of South Africa) at 25.
56 Counterarguments identified in Lutter, M (ed) Legal Capital in Europe (2006, de Gruyter)CrossRefGoogle Scholar, cited in Ferran Principles of Corporate Finance Law, above at note 29 at 182, note 12.
57 Ferran, id at 182.
58 Ibid.
59 Outlined in id at 181–82.
60 Id at 181.
61 RA Booth “Capital requirements in United States corporation law” (December 2005) Villanova University School of Law Working Paper Series (working paper 102), available at: <http://law.bepress.com/villanovalwps/papers/art102> (last accessed 26 October 2012) at 10.
62 Chin and Wong “Deconstructing share par value”, above at note 16 at 89.
63 Ferran Principles of Corporate Finance Law, above at note 29 at 182.
64 Ibid.
65 Ibid.
66 Ibid.
67 Usually about 12 months: ibid.
68 Id at 183.
69 Ibid.
70 Hanks “The new legal capital regime”, above at note 3 at 147.
71 Id at 148.
72 Official comment to the MBCA at 6-58.
73 Ferran Principles of Corporate Finance Law, above at note 29 at 180.
74 See sec 6.40(c) in particular, which contains the model act's solvency and liquidity test.
75 D Aikman et al “Funding liquidity risk in a quantitative model of systemic stability” (15 June 2009, Bank of England working paper no 372) at 3.
76 The requirements for making distributions are set out in secs 46 and 48 of the Companies Act 2008, with reference to sec 4 which contains the solvency and liquidity restrictions.
77 Van der Linde “The solvency and liquidity approach”, above at note 9 at 225.
78 Hanks “The new legal capital regime”, above at note 3 at 138.
79 See MBCA, sec 6.40(c).
80 Hanks “The new legal capital regime”, above at note 3 at 143.
81 Under the DGCL, sec 244(a).
82 Id, sec 244(b).
83 Ibid.
84 Van der Linde “The solvency and liquidity approach”, above at note 9 at 226.
85 Hanks “The new legal capital regime”, above at note 3 at 148.
86 Ibid.
87 CI Haynes “The solvency test: A new era in directorial responsibility” (1996) Auckland University Law Review 126.
88 Id at 131–32.
89 Id at 132.
90 Van der Linde “The solvency and liquidity approach”, above at note 9 at 226. See Ex Parte De Villiers NNO: In re Carbon Developments (Pty) Ltd (in liquidation) 1993 (1) SA 493 (A) at 504.
91 Haynes “The solvency test”, above at note 87 at 137.
92 Van der Linde “The solvency and liquidity approach”, above at note 9 at 229.
93 Ibid.
94 Ibid.
95 Ibid. An example of this kind of presumption may be found in sec 70(2) of the Close Corporations Act 69 of 1984.
96 Id at 230.
97 Jooste, R “Corporate finance” in Cassim, FH et al. (eds) Contemporary Company Law (2011, Juta)Google Scholar 240 at 250.
98 Ibid.
99 See sec 4(2)(b).
100 See sec 6.40.
101 Van der Linde “The solvency and liquidity approach”, above at note 9 at 236.
102 Contained in sec 76(3)(c)(ii) of the Companies Act 2008.
103 Jooste, R “Issues relating to the regulation of ‘distributions’ by the 2008 Companies Act” (2009) 126 South African Law Journal 627Google Scholar at 642.
104 Id at 642.
105 See secs 44(3)(b)(i) and 45(3)(b)(ii).
106 Jooste “Issues relating to the regulation”, above at note 103 at 643.
107 LC Heath and P Rosenfield “Solvency: The forgotten half of financial reporting” (1979) Journal of Accountancy 48 at 49.
108 Tweedie, D and Whittington, G “Financial reporting: Current problems and their implications for systematic reform” (1990) Accounting and Business Research 87CrossRefGoogle Scholar.
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111 Ibid. See Watson, I “Financial distress: The state of the art in 1996” (1996) 4/2International Journal of Business Studies 39Google Scholar.
112 Heath, LCFinancial Reporting and the Evaluation of Solvency (1978, American Institute of CPAs)Google Scholar at 20.
113 Heath and Rosenfield “Solvency”, above at note 107 at 48.
114 Van der Linde Aspects of the Regulation, above at note 55 at 272.
115 Blackman et al Commentary, above at note 42 at 5–16.
116 Required to be kept by sec 76(1) of the Companies Act 1973.
117 Required to be kept by id, sec 98(1)(b).
118 DGCL, sec 170(a), this being “subject to any restrictions contained in [the] certificate of incorporation” and paid “either (1) out of its surplus, as defined in §§ 154 and 244 … or (2) in the case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and / or the preceding fiscal year” (emphasis added). See Wittenberg et al v Federal Mining and Smelting Co 15 Del Ch 147, 133 Atl 48 (1926).
119 See secs 154 and 244.
120 Jooste “Corporate finance”, above at note 97 at 263.
121 Sec 4(b)(i).
122 Id, sec 4(b)(ii).
123 Van der Linde “The solvency and liquidity approach”, above at note 9 at 231.
124 MBCA, sec 6.40(d) (emphasis added).
125 Sec 90(2)(b) of 1973 act.
126 Van der Linde “The solvency and liquidity approach”, above at note 9 at 225.
127 DGCL, sec 154.
128 Van der Linde “The solvency and liquidity approach”, above at note 9 at 230.
129 Secs 28 and 29, governing “accounting records” and “financial statements” respectively.
130 See discussion of “director liability” below.
131 However, the timing rules differ according to the type of transaction: ie “immediately after providing … financial assistance” (secs 44(3)(b)(i) and 45(3)(b)) and “after completing” a proposed distribution (sec 46(1)(b)). See Van der Linde “The solvency and liquidity approach”, above at note 9 at 233.
132 DGCL, sec 244(b).
133 MBCA, sec 6.40.
134 Companies Act 1973, sec 90(2)(a) (emphasis added).
135 Companies Act 2008, secs 46 and 48.
136 Jooste “Issues relating to the regulation”, above at note 103 at 645.
137 By sec 48(6), which enables the company to apply to court to reverse the acquisition.
138 Sec 218(1) provides: “Nothing in this Act renders void an agreement, resolution or provision of an agreement, resolution, Memorandum of Incorporation or rules of a company that is prohibited, void, voidable or may be declared unlawful in terms of this Act, unless a court declares that agreement, resolution or provision to be void.”
139 Jooste “Issues relating to the regulation”, above at note 103 at 645.
140 Liability is imposed by secs 46(6) and 48(7) respectively. See id at 647.
141 See secs 46(6) and 48(7), read with sec 77.
142 See Jooste “Issues relating to the regulation”, above at note 103 at 646, where Jooste submits that “s 46 should be amended so as to deal with the voidness aspect of a contravening dividend and to provide for the recovery of the dividend from the recipient shareholder”.
143 EP Welch et al Folk on the Delaware General Corporation Law (loose leaf, 5th ed, 2011, Wolters Kluwer) at GCL-V-208. A loophole that previously existed at common law was closed in the 1967 revision, which extended directors’ liability to “include unlawful stock repurchases and redemptions, which are often in fact disguised dividends” (Jooste, ibid).
144 Directors are afforded protection under DGCL, sec 174(b) in respect of claims asserted against individual members of the board in that: “Any director against whom a claim is successfully asserted under [sec 174] shall be entitled to contribution from the other directors who voted for or concurred in the unlawful … stock purchase or stock redemption.”
145 Id, sec 174(a).
146 Id, sec 172.
147 Ibid.
148 These limitations relate to reliance on certain representations and directors who are absent or dissent. See id, secs 172 and 174(a).
149 Ferran Principles of Corporate Finance Law, above at note 29 at 180.
150 Armstrong, CS et al. “The role of information and financial reporting in corporate governance and debt contracting” (2010) 50 Journal of Accounting and Economics 179CrossRefGoogle Scholar at 192–93.
151 Secs 46 and 48.
152 Jooste “Issues relating to the regulation”, above at note 103 at 636.
153 Jooste “Corporate finance”, above at note 97 at 263.
154 Armstrong et al “The role of information”, above at note 150 at 181.
155 Enriques, L and Macey, JR “Creditors versus capital formation: The case against the European legal capital rules” (2000) 86 Cornell Law Review 1165Google Scholar at 1189–94.
156 Myers, SC “Determinants of corporate borrowing” (1977) 5 Journal of Financial Economics 147CrossRefGoogle Scholar at 149–55.
157 Manning and Hanks Legal Capital, above at note 15 at 100.
158 Enriques and Macey “Creditors versus capital formation”, above at note 155 at 1189.
159 Manning and Hanks Legal Capital, above at note 15 at 98.
160 Id at 39.
161 Id at 37.
162 Ibid.
163 Ibid.
164 Krauss, DT “Maintenance of a corporation's capital” (1931) 9 Tennessee Law Review 215Google Scholar at 219.
165 Manning and Hanks Legal Capital, above at note 15 at 39 (emphasis original).
166 Ibid.
167 Enriques and Macey “Creditors versus capital formation”, above at note 155 at 1191.
168 Ferran, E “Creditors’ interests and ‘core’ company law” (1999) 20 Company Lawyer 314Google Scholar at 318.
169 Companies Act 2008, sec 7(j).
170 Ahmend, AS and Duellman, S “Accounting conservatism and board of directors characteristics: An empirical analysis” (2007) Journal of Accounting and Economics 411CrossRefGoogle Scholar.
171 Armstrong et al “The role of information”, above at note 150 at 190.
