With the current economic turmoil and more entities being under severe financial distress, business owners are all considering how to restructure in order to have a streamline enterprise in terms of both operational and cash flow models.
One of the considerations for the owner of a financially distressed entity is to transfer assets from such an entity into a new entity and to leave the first entity with the creditors, but with no real assets for the creditors to attach. Such actions lead to the creditors being stranded and the new entity proceeds with operations as usual, but without the burden of the creditors influencing the viability of the business. The owner usually ensures that the old entity pays the debts of the creditors who the owner will need to proceed with the business in the new vehicle. Such actions are not accepted and the creditors do have their remedies as will be discussed hereunder.
Such an owner of the entity runs great risk from a transaction to transfer assets out of the distressed vehicle into a new vehicle and paying some creditors and not others. Creditors in the distressed vehicle accordingly have their remedies if one of its debtors proceeds with such a transaction. Section 8(c) of the Insolvency Act states that such an action to dispose to the property of an entity which has the effect that the creditors of the entity are prejudiced, that such an action will be seen as an act of insolvency and the creditors will have a right to approach the court to liquidate such entity. Section 340 of the Companies Act 61 of 1973 reads as follows: “Every disposition by a company of its property, which is made by an individual, could, for any reason, be set aside in the event of the company being wound up and unable to pay all its debts”.
A liquidator or trustee has the necessary tools to reverse a transaction under certain circumstances and is therefore able to return the object of such a transaction back to the estate of the insolvent entity.
The following sections of the Insolvency act sets out the different scenarios
The purpose of this section is to prevent a person or entity to impoverish an estate without receiving an advance in return.
Section 29: Voidable preferences:
The purposes of this section is to prevent the selection of one or a few creditors above the rest. This section secures a distribution of the estate’s assets according to the prescribed legal order of preference. This section accordingly assists the trustee or liquidator to set aside dispositions made by the insolvent while contemplating, or, being in fact on the brink of insolvency.
Objectively the disposition must have had the effect of preferring one of the creditors above another in that the debtor paid the creditor at a time where the liabilities already exceeded the assets or where it was already clear that the creditor had an unreasonable benefit above the other creditors. The test is if such a payment would have been made in the normal course of business.
Section 30: Undue Preference
This section states that if a disposition of property was made and this led to the debtor and entity being insolvent, the transaction is voidable.
Section 31: Collusive dispositions before liquidation or sequestration
This sections provides trustees, liquidators or aggrieved creditors with specific remedies if debtor entity is in concert with other creditors and/or third parties to dispose of assets by trying to ring fence certain assets to keep it from being included as assets to be shares amongst the creditors.
This section goes further by stating that any party to such collusive disposition shall have to make good any loss caused by the disposition. Such a party may even have to pay a penalty as ordered by court. If one of the parties to the collusive disposition is a creditor in the insolvent estate, such a party will lose the right to claim against the estate.
Creditors do have the right to pursue such a claim in the name of the estate if the trustee or liquidator does not want to. Usually it will be expected that the creditor will have to indemnify the trustee or liquidator in this respect. The creditor, if successful, will have a preferent claim on the assets which has been brought back into the estate.
Remedies for owners of financially distressed businesses
The law is clear that it will not tolerate dispositions of assets and creditors being preferred above others in a financially distressed business. There are steps which an owner of a financially distressed business can take without having to consider risky actions as set out above. The owner may firstly consider to place the business under business rescue as set out by the Companies Act 71 of 2008. A further possibility is to consider to reach a compromise with all the creditors and to follow the process as set out in section 155 of the Companies Act 71 of 2008. Thirdly, although one will want to avoid it as far as possible, is to proceed with liquidation of the entity. In such a way the owner does not run a risk of being personally liable for steps to try and save the business.
Remedies for creditors
Creditors can take the necessary civil action to interdict a voidable disposition. A voidable disposition itself is however an act of insolvency. The creditor can therefore proceed with liquidation proceedings and will have available all the remedies as set out above.
This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&OE)