Section 4 of the Companies Act 1997 defines a single concept that gates almost every payment out of a company.
Section 4(1) — the test
(a) the company is able to pay its debts as they become due in the ordinary course of business; and
(b) the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.
Paragraph (a) is the cash flow test; paragraph (b) is the balance sheet test. A company that is asset rich but cannot meet its bills fails (a). A company with cash today but liabilities exceeding assets fails (b). Failing either means the company does not satisfy the solvency test, and the transaction cannot proceed.
Section 4(2) — what the directors must do
(a) shall have regard to —
(i) the most recent financial statements of the company that comply with section 179; and
(ii) all other circumstances that the directors know or ought to know affect, or may affect, the value of the company’s assets and the value of its liabilities, including contingent liabilities; and
(b) may rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances.
Paragraph (a)(i) requires the directors to look at the accounts, but paragraph (a)(ii) requires them to look beyond them — at everything they know or ought to know. A pending judgment, a lost customer, a guarantee called, a currency movement, a fall in the market for the company’s stock: all of these bear on solvency even though the last balance sheet says nothing about them.
Paragraph (b) protects a director who relies on a reasonable valuation or estimate. It does not protect reliance on a stale or convenient one. Read it with section 116, on when a director may rely on information and advice from others.
Section 4(4) — valuing a contingent liability
(a) the likelihood of the contingency occurring; and
(b) any claim the company is entitled to make and can reasonably expect to be met to reduce or extinguish the contingent liability.
So a guarantee, a warranty obligation, a disputed tax assessment or a pending claim is not simply taken at face value: its likelihood is weighed, and the value of a counter-claim or an insurance recovery that can reasonably be expected to be met can be set against it. But the recovery must be one the company is entitled to claim and can reasonably expect to receive — not a hope.
Section 4(3) — the amalgamation variant
For an amalgamation, the question is whether the amalgamated company’s assets will exceed its liabilities. The directors of each amalgamating company must have regard to financial statements complying with section 179 prepared as if the amalgamation had become effective, and to all other circumstances they know or ought to know would or may affect the position — again with the ability to rely on reasonable valuations and estimates. Sections 234 and 235 are expressly carved out of the general rule in section 4(2).
Every transaction that depends on the test
| Transaction | Section |
|---|---|
| Distributions, including dividends | s 50 |
| Acquiring or redeeming its own shares | ss 56, 57, 58, 60–62 |
| Financial assistance to acquire its own shares | s 63 |
| Minority buy-out purchases | ss 93, 96 |
| Amalgamations — long form and short form | ss 234, 235 |
| Reduction of shareholder liability, treated as a distribution | s 55 |
What happens if the test was not satisfied
- Recovery from shareholders. Under section 54, a distribution made when the company did not satisfy the solvency test may be recovered from the shareholders, subject to the defences there set out.
- Recovery from directors. Section 54 also allows recovery from the directors who authorised the distribution where the statutory conditions are met — the personal price of signing a solvency certificate that was not justified.
- Insolvent trading and records. Section 348 imposes liability for a failure to prevent insolvent trading, and section 348A liability where proper accounting records were not kept. Section 349 extends the exposure to a holding company for the insolvent trading of a subsidiary.
The test also reappears in liquidation from the opposite direction. Under section 335, a company is unable to pay its debts where it has failed to comply with a statutory demand, execution is returned unsatisfied, or the Court is satisfied it cannot pay its debts as they become due — and inability to pay debts is a ground for the Court to appoint a liquidator.
How a board should record a solvency decision
- Start from compliant financial statements under section 179, and note their date.
- List what has changed since — new commitments, lost revenue, disputes, guarantees, currency and market movements.
- Schedule the contingent liabilities, with the likelihood of each and any recovery reasonably expected to be met.
- Prepare a cash flow forecast covering the period in which debts fall due — limb (a) is a forward-looking question.
- Obtain valuations where asset values are material and uncertain, and record why the valuation is reasonable.
- Resolve expressly that the board is satisfied on reasonable grounds that the company will satisfy the solvency test immediately after the transaction, and sign the certificate the relevant section requires.
- Keep the working papers. If the decision is challenged years later, the file is the defence.
Sources
- Companies Act 1997 — ss 4, 50, 53–58, 60–63, 93, 96, 116, 179, 234, 235, 335, 348, 348A, 349
Before relying on anything here, read the current text of the Companies Act 1997 and check for later amendments. If a decision matters to you, get advice — start with the Office of the Public Solicitor, or find a firm in the law firms directory.