South African businesses under pressure from the Covid-19 effects may be tempted to apply for business rescue, but the process has a better chance of success if the board takes early steps to find solutions
Many businesses in South Africa have closed down or reduced trading activity as a result of Covid-19 and may not reopen their doors. A large number, fearing the worst, have placed themselves under business rescue, utilising the provisions of Chapter 6 of the Companies Act, in the hope it will provide them with a lifeline to see out the financial crisis.
Chapter 6 provides a framework to rescue companies, either by turning them around to be commercially profitable or by facilitating a better return to creditors than they would receive from a liquidation. Business rescue has existed in South Africa since 1926, when an earlier version of the Companies Act introduced the notion of judicial management, a form of business rescue which has not been very successful.
Although these statutory frameworks to rescue companies in South Africa have been around for nearly a hundred years, prior to their enactment companies and creditors were attending to compromises and restructures without any formal framework to provide assistance. Many of these informal restructures still take place today and are highly successful. The Companies and Intellectual Property Commission (CIPC)’s annual reports show that the average number of companies going into business rescue each year since 2011 is around 400. The CIPC has noted an increase this year in the number of companies being placed in business rescue with early numbers reported by the CIPC signalling a substantial increase in the number of companies being placed in business rescue this year.
What is spurring this increase? Just as attorneys never ask a question unless they know the answer, similarly a business should never enter into business rescue unless it has a plan to exit the process. The plan could simply be to raise additional capital or rearrange the payment of debts, where possible. However, it is important to have one. While there may be good reasons for entering into business rescue, such as the legal moratorium protecting the company against litigation, or the power of the business rescue practitioner to suspend or cancel contracts, or a requirement by lenders who are only willing to provide post-commencement funding within a safe structure, these reasons will not necessarily address the causes of the company’s distress. Business rescue merely provides a framework, as well as time and space for the company to find solutions.
A major drawback of the business rescue process (which may dissuade boards from passing the resolution to start business rescue, or at least delay passing it while they look for alternatives), is that once a business rescue practitioner is appointed, the control and management of the business and affairs of the company (which the Companies Act vests in the board) passes into the hands of a stranger. The board can only exercise any management functions in accordance with the instructions of the business rescue practitioner. This will be the independent business rescue practitioner or sometimes the "not so independent business rescue practitioner".
Often there is no turning back once the company has been placed into business rescue. Unless there is a definite plan or some capital readily available, the business rescue process will limp along, with extensions sought for the publication of the business rescue plan and ending with either the business rescue practitioner terminating the process or an agitated creditor launching an application to set it aside.
Since there are inherent risks in a protracted process, and the potential for replacing an experienced board of directors well versed in the business and affairs of the company with a practitioner that is not, it is critical to engage early with creditors on options and approaches to manage financial distress. This is especially the case now, when many creditors are themselves under financial pressure (as well as suffering the effects of recent, well-documented, corporate failures to which many creditors and lenders were exposed).
Many boards may be motivated to place companies into business rescue for fear of being held liable for reckless trading under section 22 of the Companies Act and section 424 of the old Companies Act (which, together with other provisions relating to corporate insolvency in the old Companies Act, has not been repealed). Section 424 provides that where any business of the company was or is being conducted recklessly or with intent to defraud creditors of the company, or creditors of any other person, or for any fraudulent purpose, the court can hold personally liable any person who was knowingly a party to the conduct of the business. This is an objective test, requiring a degree of gross negligence on the part of the director. Section 22 of the Companies Act specifically refers to gross negligence in this context. The most common situation in practice is that the company takes on debt at a time that the board is aware that it is not in a position to repay.
Where the current lockdown restrictions have caused the business to fail, and there was no improper conduct by the board leading to such failure, there can be little danger of a court finding there was reckless and grossly negligent trading. However, directors can still be held liable for an entire failure to consider the consequences of their actions, i.e. a reckless disregard, where a company continues to carry on business and to incur debts when, in the opinion of reasonable businessmen, standing in the shoes of the directors, there would be no reasonable prospect of the creditors receiving payment when due.
We quote Judge Tsoka in the Marcelle Props case: "business rescue proceedings are not for the terminally ill close corporations. Nor are they for the chronically ill. They are for ailing corporations, which, given time, will be rescued and become solvent." The sooner companies who directors in good faith belief to be in distress either seek an informal arrangement, or enter business rescue with a plan, the greater their chances of survival.