As the industry moves into its sixth month without income from international travel bookings, many businesses, through no fault of their own, are finding themselves in the position of insolvency – where their liabilities are greater than their assets. This could either be a short-term cash-flow issue that the business can recover from, or a more serious form of ‘commercial insolvency’, where the business is both insolvent and unable to meet its debt obligations for the next six months. In this instance the Companies Act requires a business to either liquidate or go into business rescue and outlines the serious consequences that the directors of a business could face if they continue to trade recklessly. Brett Evans – LLB, MBA and finance specialist – discusses this topic with Tourism Update journalist Sarah Robertson, breaking down the various options that are available for businesses that find themselves in this position.
The business rescue process was introduced in the new Companies Act, No 71 of 2008 to buy some time and breathing space for companies facing financial distress. Evans explains that although business rescue is an expensive option for a struggling company, as it requires a costly Business Rescue Practitioner to step in, an external expert can often identify and fix problems that are difficult to spot from the inside.
“During this process, a practitioner is appointed to determine whether the business can be returned to profitability or if it should be wound down and closed. The company’s debt repayments are also frozen, allowing the company to build up an injection of cash while the Business Rescue Practitioner negotiates with creditors to minimise debt obligations until such time that the company is in a position to start making repayments again. Business owners, finding themselves short of cash flow, often sign up for what they believe will be short-term loans, at extremely high interest rates. This means that a large part of a business rescue practitioner’s task is often to consolidate this debt with better interest rate repayment terms,” says Evans.
In this case, the directors of an insolvent company make a decision to voluntarily file for liquidation. The Master of the Court then appoints a liquidator who makes contact with all creditors and requests that they submit claims for the money owed to them. The company’s assets are liquidated and the money is put into a pool, which is divided among the claimants. As the company’s liabilities exceed its assets, not all claimants will receive payouts, as preference is given to primary claimants such as banks, employees and the liquidator himself. The shortfall of the debt is then written off.
“A business is seen as a separate legal entity with a limited liability that does not extend to the personal assets of the company’s directors. This means that, in principle, business models allow directors to fail freely with limited consequences. In many cases a liquidation is the best option for an insolvent company, as it allows the directors to cut their losses and start afresh, opening a new ‘post-COVID’ company unencumbered by debt. The brand and the reputation of the original company ceases to exist though, and all of its assets are lost. The directors’ personal assets and any other businesses that they own should not be affected by the liquidation. However, the reality of the situation is that most small business debt is backed by personal surety, which means that the banks will still have a claim on the directors’ personal assets,” says Evans.
“If a business commits an act of insolvency (such as failing to make a debt repayment), a claimant can institute proceedings for the business to be forced into liquidation to recover funds. In many cases this option places less onus on the business owners but claimants do have the option of claiming for reckless trading, which opens the directors up to further risk,” says Evans.
The Companies Act requires business owners to stop trading and move forward with a liquidation or a business rescue process if they find themselves in a position of commercial insolvency.
“If the directors of a company continue to trade, to accept payment for services or to take out loans for a company which they are aware is commercially insolvent, there is a danger that the company’s limited liability protections will fall away and that claimants can hold directors personally liable for the company’s debts. If a company is liquidated and its directors personally sequestrated, the director will also be unable to take out loans or become a director of another company for a period of 10 years,” says Evans.
In the travel industry there is also a fine line between reckless trading and fraud, which opens directors up to the additional risk of criminal charges and jail time. In many instances travel companies begin to roll cash and use their clients’ deposits to pay for their business expenses, eventually finding themselves in a position where they are unable to pay for the services booked for the clients’ holidays. Clients finding that the confirmed hotel voucher given to them by their agent is not attached to a paid hotel booking can open up cases of fraud with the police against the agency’s directors who failed to provide them with the services that they paid for. This is an additional risk that must be considered when trading in a position of insolvency. According to Evans the intention to run away with the client’s cash and not deliver a service would need to be proved in a case of fraud over and above reckless trading.
“That said, travel companies that find themselves in positions of insolvency at present are victims of external circumstances. It would be highly unlikely that a director who took out a COVID-19 loan scheme to keep his or her business (that had been profitable prior to March 2020) afloat while borders were closed, could be found guilty of reckless trading. However, as most COVID-19 loan schemes require directors to sign personal surety for the money they are borrowing, company directors who take out these loans need to be aware that they are voluntarily waiving their limited liability rights in this regard,” says Evans.