A guidance to solvency statements

A company may look to reduce its share capital for a number of reasons – perhaps the company wants to create distributable reserves so it can pay dividends or it may want to return surplus capital to its shareholders.

Private companies can reduce their share capital by way of a special resolution, supported by a solvency statement made by the company’s directors. A recent case looked at the lawfulness of this method where the directors who made the solvency statement knew that the company could not meet its liabilities.

Solvency statement

A valid solvency statement must be made in writing, be signed by all the directors and be made within 15 days of the members’ special resolution, passed to approve the reduction of capital. In the statement the directors must confirm that:

• on the date of the statement, there is no ground on which the company could become unable to pay its debts; and
• the company will be able to pay its debts as they fall due during the year immediately after the date of the statement.

It is a criminal offence for company directors to file a solvency statement where they do not have reasonable grounds to believe the content of it. This offence could result in an unlimited fine or up to two years in prison.

Group reorganisation

In a recent case, LRH Services Limited (LRH), acting by its liquidators, claimed against its former directors for breach of duty arising out of a group reorganisation which took place in 2009. LRH did not trade itself but was the tenant of a number of commercial properties which were occupied by other group companies, including LRH’s own subsidiary companies.

As part of the reorganisation, LRH reduced its share capital to £1, cancelled its share premium account and paid a dividend of approximately £21 million to its parent company. In order to reduce the company’s share capital, Mr Trew, the sole director of LRH at the time, made a solvency statement.

Mr Trew stated that he had relied on the advice of the group’s financial director and internal accountants, who had prepared financial documents relating to the reorganisation, when making the solvency statement. He claimed to have only a summary balance sheet in front of him when making the solvency statement and did not consider LRH’s solvency during the year after the date of the statement.

No enquiry was made into LRH’s potential liability for the properties in the event that the party responsible for making rent payments defaulted, which it had done in the past, and Mr Trew assumed that if LRH could not pay its immediate and future liabilities another group company would step in and make the required payments.

Decision

The court held that when making the solvency statement Mr Trew had not sufficiently taken into account LRH’s liabilities because he did not consider LRH’s liability over the commercial properties, how much was outstanding under those leases or what might be expected to be received from the rent payments.

Mr Trew also assumed that whatever was outstanding, or might fall due, would be covered by the other group companies. But in doing so the court said he applied the wrong test because the resources of the group companies were not assets to which LRH was entitled. The court found that Mr Trew did not properly hold the opinions expressed in the solvency statement.

As a result, the solvency statement was invalid and therefore the dividend declared, and the special resolution passed, on the basis of that statement were both unlawful. Mr Trew had breached his duties as a director and was liable to the company for the full amount of the assets which were unlawfully paid away (potentially up to the amount of the dividend itself – £21 million).

The lesson

Where a solvency statement is made to support a reduction of share capital, the director making the statement needs to understand that, whilst they are able to rely on information supplied by others within the business, it is ultimately their responsibility to ensure the opinions given in the solvency statement are supported and can be justified.

The Law Society has published guidance on the practical steps directors can take before making a solvency statement to reduce the risk of committing an offence. These suggestions include:

• recording any information which forms the basis of an opinion – this can help the director demonstrate that he/she has exercised reasonable care, skill and diligence in forming that opinion; and
• obtaining reports from third parties – there is no legal requirement to do this but where deemed appropriate directors may wish to obtain advice to help satisfy themselves that their opinion is legally sound.