An appraisal of the application and soundness of the solvency and liquidity test in the implementation of statutory mergers

Abstract

The integration of the solvency and liquidity test into the South African company law has the effect of, among others, rendering the capital maintenance principle obsolete. The pertinent statutory provisions of statutory mergers require that both limbs of the test must be satisfied: solvency in the form of a forecast that the merging companies’ assets are equal to and/or exceed their liabilities and liquidity in the form of a forecast that the merging companies’ debts would be paid when due. The solvency and liquidity test is valid within 12 months after the test was considered,a set period which, we argue, is inadequate to protect the interests of long-term creditors and shareholders. According to reports, the largest leveraged buyout (LBO) in South Africa, the acquisition of Edcon by Bain in 2007, resulted in post-merger trade losses and high borrowing rates for Edcon. The post-mortem of the Edcon LBO reveals that the merged entity failed to honour creditors’ repayment obligations, resulting in the shareholders losing proprietary interests to the creditors, heightening the need for having effective solvency and liquidity test. In addition, most of the recent corporate scandals emanating from deceptive accounting practices have exposed the inadequacy of the solvency and liquidity test, considering the heavy reliance on the solvency and liquidity test on financial records. To bolster creditor and shareholder protection, the article makes some suggestions that include making it mandatory that financial statements used in the forecasting be independently audited by external auditors and that the merging companies can only pass the solvency and liquidity test when their assets are greater than their liabilities, rather than simply being equal to the liabilities, as is currently the case. The suggested yardstick for assing the solvency and liquidity test only when their assets are greater than their liabilities must be adopted in all capital reduction/altering transactions, including statutory mergers, and during the pay-outs of fair value to dissenting shareholders in the context of appraisal remedy.