The existence of contingent liabilities is a common feature of corporate accounts. Intercompany guarantees are commonplace amongst large corporate structures, long running indemnities arising out of historic transactions may have been given to third parties or successor liability from an assigned contract may affect a business. If a business is being conducted profitably, and the accounts demonstrate the ability of the company to discharge its liabilities as they fall due, is it open to directors of a company to make a distribution to shareholders if they have made a reasonable estimate of the potential liabilities faced by the relevant entity? Or is something more required?
Distributions and the solvency statement
The Companies (Jersey) Law 1991 (“the Companies Law”) does not require distributions to be made out of the profits of a Jersey company. Since an amendment to the Companies Law in 2008, distributions do not have to be made out of profits but a new protection for creditors was been introduced; the directors must make a statement of solvency prior to making any distribution. The statement of solvency must confirm that the directors have formed the opinion:
(a) that, immediately following the date on which the distribution is proposed to be made, the company will be able to discharge its liabilities as they fall due; and
(b) that, having regard to –
(i) the prospects of the company and to the intentions of the directors with respect to the management of the company’s business, and
(ii) the amount and character of the financial resources that will in their view be available to the company,
the company will be able to –
(A) continue to carry on business, and
(B) discharge its liabilities as they fall due,
until the expiry of the period of 12 months immediately following the date on which the distribution is proposed to be made or until the company is dissolved, whichever first occurs.
A director who makes such a statement without having reasonable grounds for the opinion expressed in it is guilty of an offence.
What constitutes “reasonable grounds”?
We are very often asked what the directors should be reviewing and concerning themselves with in order to form the conclusion that they have reasonable grounds to make a solvency statement. The answer to this, of course, is that it depends on the fact pattern in each case. There is no guidance in the Companies Law as to what constitutes reasonable grounds and this is likely to be influenced by the complexity of a company’s trading position and actual and contingent liabilities. Review of management accounts and other financial information available to the board, with projections for the 12 month period following the proposed distribution is, of course, important but directors need to interrogate this information in the context of the particular set of facts and circumstances affecting the business. It may be appropriate to obtain professional advice as part of this exercise.
As part of this process it is important that due consideration is given to the liabilities of the company making the distribution, including any contingent liabilities that could be called upon in order to avoid any accusation that the directors did not have reasonable grounds for making the solvency statement on the date that it was made. A realistic view needs to be taken of any guarantees or indemnities being called upon in the 12 month period following the proposed date of the distribution and the ultimate impact this would have on the liabilities of the distributing company crystallising and the consequences of this. If a subsidiary has guaranteed the liabilities of its parent, the board of the subsidiary making the distribution may wish to satisfy themselves as to the financial position of the parent company and whether such payment being made up the chain will be used to service existing debt.
In circumstances where there is known creditor pressure and the possibility of demands being issued is more likely, whether at the distributing entity directly or elsewhere in the structure that could indirectly affect that entity, directors should also be mindful of their own, personal exposure from a wrongful trading perspective. Any board will need to, in light of the financial information available to them, carefully consider and document why they are able to conclude that the company will be able to discharge its liabilities as they fall due for the period of 12 months immediately following the date on which the distribution is proposed to be made. Failure to rationalise this could result in arguments of recklessness being advanced against directors that authorised the distribution and made the statement of solvency, should the company enter a formal insolvency process in the following 12 month period.
Prior to making any solvency statement in connection with a distribution, directors need to feel comfortable in interrogating the debt levels cited in the accounts and questioning whether provision made for contingent liabilities is adequate, with any exposures and threats to the business borne in mind as part of this exercise. Should a cautious approach be adopted where monies are retained in order to cater for the possibility that the contingencies will vest and liabilities exceed those estimates? This very much depends on the facts in each case and whether the directors have any actual knowledge of the likelihood of contingent liabilities being called upon.
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.