What Directors Need to Know About the Financial Distress Test
Under the Companies Act 71 of 2008, a South African director has a legally enforceable duty to act the moment their company shows signs of financial distress. Financial distress is defined as being unable to pay debts within the next six months or likely to become insolvent within six months. Ignoring this duty can result in personal liability for the company’s debts.
Most directors assume the corporate structure protects them completely. It does, right up until the point where they know the company is in trouble and do nothing about it.
The window to act is shorter than most directors realise, and a new dedicated Insolvency Court has made creditors faster and more efficient than ever before.
What Does Financially Distressed Mean?
The definition matters because most directors think financial distress means the company is on the verge of collapse. The Act sets the bar much lower than that.
Section 128(1)(f) of the Companies Act sets out a two-limb test:
- Commercial insolvency: The company is reasonably unlikely to be able to pay all of its debts as they fall due within the ensuing six months.
- Factual insolvency: It is reasonably likely that the company will become insolvent (liabilities exceeding assets) within the next six months.
Either limb, on its own, is sufficient to trigger the definition of financially distressed.
The most important thing directors miss: A temporary cash flow problem qualifies, and you do not need to be technically insolvent today. If the reasonable projection is that you will not be able to meet your obligations over the next six months, the duty to act has already arisen.
This catches many directors off guard. A company that is still trading, still paying some creditors, and still generating revenue can already be legally financially distressed under the Act. The question is not where you are today, but where you are likely to be in six months.
What Should Directors Do to Protect Themselves?
As soon as the company is labelled as financially distressed, section 129 of the Companies Act requires action. There are two paths:
Option 1: Commence Business Rescue Proceedings
The board of directors passes a resolution under s129(1) to place the company under business rescue. This triggers a formal process with a licensed Business Rescue Practitioner, a moratorium on legal proceedings against the company, and a structured opportunity to either rescue the business or achieve a better outcome for creditors than immediate liquidation would provide.
Option 2: Notify Affected Persons in Writing
If the board decides not to commence business rescue, it must deliver a written notice to all affected persons under s129(7). “Affected persons” include creditors, shareholders, employees, and registered trade unions representing employees. The notice has to explain why business rescue was not initiated.
This is not optional. The language of s129(7) is peremptory, meaning it imposes a mandatory obligation, and courts have consistently treated it as such.
What Happens if a Director Does Nothing?
A director who is aware of financial distress and takes no action faces exposure across multiple legal fronts simultaneously.
Civil Liability
- Reckless trading: A director can be held personally liable for any loss sustained by the company or any affected person if the company trades recklessly, with gross negligence, or with fraudulent intent. Personal liability here means your personal assets, not just the company’s.
- Contravention of the Act: Any person who contravenes the Companies Act is personally liable to any other person for any loss or damage suffered as a result. This is a broad catch-all provision.
Criminal Liability
Under s214 of the Companies Act 71 of 2008, fraudulent trading is a criminal offence. A director convicted under this section faces imprisonment.
Delinquent Director Declaration
A court can declare a director delinquent under the 2008 Act, resulting in a ban from serving as a director for up to seven years, or for life in serious cases.
Act Sooner, Rather Than Later
Directors who act early and transparently are in a fundamentally different position to those who knew the company was distressed and continued trading without disclosure. If your company is struggling to meet its financial obligations, the most important thing you can do is get advice before the window closes. Contact Cawood Attorneys for a confidential consultation with a qualified attorney and business rescue practitioner. Because early advice costs far less than the personal liability that follows inaction.