Guernsey: Distributions, Dividends And The Solvency Test Under The New Guernsey Company Law

Originally published in The Brief, Ozannes' newsletter, March 2009

Probably the most significant change from previous practice in Guernsey law under the Companies (Guernsey) Law 2008 (the "Company Law"), which came into effect on the 1 July 2008, was the consignment to history of the concept of capital maintenance, which was discarded in favour of a solvency model as the basis of a company's ability to pay distributions and dividends.

To recap, the term 'capital maintenance' meant that a company must raise the capital which it has stated it will raise in its memorandum and, broadly, a limited company could not return capital to its shareholders other than in compliance with and as authorised by explicit statutory provisions. Any unauthorised returns were illegal at common law. The rules were primarily intended for the protection of the creditors. However, experience has shown to be questionable the extent to which the capital maintenance rules provided such protection, especially since there were various wide ranging common law and statutory exceptions.

The new solvency test is set out in section 527 of the Company Law. It is required to be met in a variety of corporate procedures (see inset box) but in practice it will be most frequently encountered under the new procedures for making distributions and dividends.

Distributions and Dividends – what are these?

A "distribution" for the purpose of the Company Law (s. 301) "in relation to a distribution by a company to a member, means:

(a) the direct or indirect transfer of money or property, other than the company's own shares, to or for the benefit of a member, or

(b) the incurring of a debt to or for the benefit of a member,

in respect of a member's interests, and whether by means of a purchase of property, the redemption or other acquisition of shares, a reduction of indebtedness, or by some other means."

Section 302(1) defines "dividend" as meaning "every distribution of a company's assets to its members, except distributions by way of:

(a) an issue of shares as fully or partly paid bonus shares,

(b) a redemption or acquisition of any of the company's own shares or financial assistance for an acquisition of the company's own shares,

(c) a reduction of share capital,

(d) a distribution of assets to members during and for the purposes of its winding up,

(e) a distribution of assets to members during and for the purposes of an administration order,

(f) a distribution of assets to members of a cell of a protected cell company during and for the purposes of a receivership order, or

(g) a distribution of assets to members of a cell of a protected cell company during and for the purposes of the termination of the cell."

Dividends may be in the form of money or other property.

The Statutory Solvency Test

The solvency test and its related sections in the Company Law borrow heavily from New Zealand's Companies Act 1993. This in turn follows a formula similar to the solvency test as employed in the United States (particularly the Model Business Corporations Act).

Section 527 "... the company satisfies the solvency test if:

(a) the company is able to pay its debts as they become due;

(b) the value of the company's assets is greater than the value of its liabilities"

The solvency test therefore comprises two tests known colloquially as:

(a) the liquidity or cash flow test; and

(b) the balance sheet solvency test.

The company may be suffering a temporary liquidity crisis whilst still solvent within the balance sheet test. Should the board wish to make a distribution in this case, directors would need to convert sufficient assets to a readily usable form so that the company is in a position to meet all of the debts as they become due and hence satisfy the liquidity test. However, a position where there is liquidity whilst the balance sheet test is not met is not as easily corrected. Asset values would need to increase or shareholders would need to inject further equity capital.

Liquidity Test

The liquidity test concentrates on the present and the future: whether, on the present facts, the company can, in the future, meet its obligations as they mature. The present cannot be viewed in isolation; it is relevant to look at the company's behaviour in the recent past and at obligations maturing in the near future. A failure to pay debts presently due is evidence of a near illiquid position, but it is not conclusive proof of not being able to satisfy the liquidity test. Account must be taken of outstanding debts. The phrase "as they become due" probably means as they become legally due! This is certainly the case under New Zealand case law.

The test concentrates on future cash flows, but there is no guide as to how far ahead directors should look, this is a matter for business judgement.

Balance Sheet Solvency

In essence, the balance sheet test is a net assets test. After making a distribution the company must have positive net assets. There are, however, a number of practical difficulties in relation to the implementation of the test, such as the identification and valuation of assets and liabilities including contingent assets and liabilities as well as the basis for valuation (particularly relevant in the current economic climate).

Procedure for Distributions and Dividends

In respect of both a distribution and a dividend, the Company Law has separate sections dealing with procedures. In each case the board of the directors may authorise the activity if:

(a) the board of directors is satisfied on reasonable grounds that the company will, immediately after payment, satisfy the solvency test; and

(b) it satisfies any other requirement in its memorandum and articles.

The test requires the Board to make a future assessment by making reference to the solvency test being satisfied immediately after the distribution or dividend is made. This must be an informed decision, not only to satisfy the reasonable grounds criteria, but also to comply with the directors' fiduciary responsibilities to the company.

The board of directors must also approve a certificate (implicitly prior to the distribution/dividend and practically usually at the same board meeting on giving its approval) stating:-

"(a) that in their opinion the company will, immediately after the distribution, satisfy the solvency test, and

"(b) the grounds for that opinion,

and the certificate must be signed on their behalf by at least one of them."

If, after a distribution is authorised but before it is paid, the board ceases to be satisfied on reasonable grounds that the company will, immediately after the distribution is made, satisfy the solvency test, any distribution made by the company is deemed not to have been authorised (sections 303(3) and 304(3)). This appears to imply (although not expressly stated) that the Board must monitor the company's financial position so as to ensure that the solvency test continues to be met following an authorisation. This interacts (but rather awkwardly) with section 309(3) and recovery of distributions (see below).

It should be noted, however, that the procedure for distributions (in respect of redeeming shares and the recovery of a distribution) does not apply to Open-Ended Investment Companies (as defined in the Company Law). An open-ended investment company must not, however, redeem its shares unless it satisfies the solvency test (section 321(2)).

Recovery of Distributions

Recovery of distributions from directors and members is the corollary of the flexibility of the distribution regime.

A distribution (which by definition includes a dividend) made to a member at a time when the company did not, immediately after the distribution, satisfy the solvency test may be recovered by the company from the member except to the extent that (these requirements are conjunctive):

(a) the member received the distribution in good faith and without knowledge of the company's failure to satisfy the solvency test;

(b) the member has altered his position in reliance on the validity of the distribution; and

(c) it would be unfair to require payment in full or at all.

If, in relation to a distribution made to members:

(a) the procedure set out for distributions (which may include dividends, redemptions or acquisition of shares giving financial assistance for the purpose of the company's own shares) has not been followed; or

(b) reasonable grounds for believing that the company would satisfy the solvency test did not exist at the time the certificate was signed;

is personally liable to the company to repay to the company so much of the distribution as is not able to be recovered from members.

If a distribution is deemed not to have been authorised (i.e. if after the distribution is approved by the board the board ceases to be satisfied on reasonable grounds that the company will, immediately after the distribution is made, satisfy the solvency test) a director who:

(a) ceased after authorisation, but before the making of the distribution, to be satisfied on reasonable grounds for believing that the company would satisfy the solvency test immediately after the distribution is made; and

(b) failed to take reasonable steps to prevent the distribution being made;

is personally liable to the company to repay to the company so much of the distribution as is not able to be recovered from members.

Conclusion

The implementation of the solvency test as a regime considerably enhances the flexibility by which a company can return money to its investors from a position where profits only were distributable to a position where companies have the freedom to distribute capital and earnings to shareholders in ways that have previously not been available. The definition of distributions is wide and includes share redemptions, buy-backs and financial assistance and directors should be aware of this extended definition and the particular prescribed procedures for making distributions.

However, there is a price to pay for that flexibility in terms of potential liability for directors. This is not to be overstated. It has always been the case that the consequences of unlawful distributions could be reclaimed from shareholders when the shareholders knew that the dividend was unlawful. Common law also provided that the directors who paid dividends improperly could be liable to compensate the company for the loss.

The solvency test presents challenges to the board of a company and it is clear that accounts prepared for financial reporting purposes provide only a starting point for determining the solvency test. Directors must use supplementary information extracted from the company's accounting records, together with their own assessment of the company's present position and future trading prospects, before making a considered assessment of the company's solvency.

Directors will not incur liability just because they got the solvency test wrong. They will incur liability if there is no reasonable justification for the stance taken in their assessment of the solvency test.

For more information about Guernsey's finance industry please visit www.guernseyfinance.com.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.